IS-LM MODEL: GENERAL EQUILIBRIUM IN GOODS AND …general equilibrium model of goods and money...

IS-LM MODEL: GENERAL

EQUILIBRIUM IN GOODS

AND MONEY MARKETS

Dongpeng Liu

Department of Economics

Nanjing University

PARTIAL vs. GENERAL EQUILIBRIUM

Income expenditure model sheds light on goods market

equilibrium

In the last lecture, we discussed money market equilibrium

Equilibrium in a single market is called partial equilibrium

The economy as a whole is in equilibrium only when all markets

are in equilibrium simultaneously (general equilibrium)

General equilibrium model of goods and money markets: the IS-LM

model

MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2

ROADMAP


INCOME

EXPENDITURE

LIQUIDITY

PREFERENCE

IS

CURVE

LM

CURVE

AGGREGATE

DEMAND

SHORT-RUN

LABOR

MARKET

AGGREGATE

SUPPLY

AS-AD

MODEL

IS-LM

MODEL

PHILLIPS

CURVE

INTERMEDIATE-RUN

SOLOW

MODEL

LONG-RUN w/

CAPITAL

ACCUMULATION

LONG-RUN

AS-AD

MODEL

LONG-RUN w/o

CAPITAL

ACCUMULATION

GOODS MARKET AND THE IS RELATION

IS relation: total output (or income) Y equals total

expenditure Z

𝑌 = 𝑍 = 𝐶 𝑌 − 𝑇 + 𝐼 + 𝐺

Investment is assumed to be exogenously given in the income

expenditure model

This assumption is not realistic

Now, let’s relax it


INVESTMENT

Total amount of investment hinges on interest rate

𝐼 = 𝐼 𝑖

𝐼 𝑖 is a decreasing function of 𝑖

Interest rate determines the cost of investment


INVESTMENT AND INTEREST RATE

If a firm borrows money to finance its investment, higher

interest rate raises borrowing cost, making the firm less

willing to borrow and invest

If the firm uses its own fund to invest, the opportunity cost

includes the interest income that could have been earned from

the funds. Higher interest rate raises the opportunity cost of

investment and lowers firms’ willingness to invest


AN ALTERNATIVE PERSPECTIVE

If we deposit $1 today, we can withdraw $(1+i) next year

$1 today is equivalent to $(1+i) next year

In other words, $1 next year is equivalent to $1/(1+i) today

Future cash flow can be discounted to today’s value (present

value)

Interest rate and the present value of a future cash flow are

negatively related


AN ALTERNATIVE PERSPECTIVE

An investment is a tradeoff between current cash outflow and

future cash inflows

A firm shall only make an investment if the PV of all future

cash flows is higher than the current cash outflow

An increase in interest rate causes the PV of future cash flows

to fall

If the PV of all future cash flows falls below the current cash

outflow, the investment will no longer make sense

Therefore, the economy-wide total amount of investment and

interest rate are negatively related


DETERMINATION OF OUTPUT

Let’s recall the IS relation

𝑌 = 𝑍 = 𝐶 𝑌 − 𝑇 + 𝐼(𝑖) + 𝐺

Higher total output leads to higher disposable income and higher Z

Z is an increasing function of Y

Goods market equilibrium is demonstrated by the intersect of the

total expenditure line and the 45 degree line


DETERMINATION OF OUTPUT


FROM INCOME EXPENDITURE MODEL TO IS CURVE

What happens if interest rate increases

Investment cost increases

Total investment decreases

For any given level of total income, total expenditure decreases

Total expenditure line shifts downwards

Equilibrium output and income decreases

IS curve characterizes the negative relationship between

interest rate and total output (income), given the goods market

equilibrium

Income expenditure model can be perceived as a special case of

IS curve in which interest rate is constant


FROM INCOME EXPENDITURE MODEL TO IS CURVE


FISCAL POLICY AND THE IS CURVE

What happens if government decides to collect more taxes

Given any level of interest rate, disposable income decreases

Consumption expenditure, autonomous expenditure and total

expenditure drop

Total income decreases

IS curve shifts to the left



What happens if government purchases more goods and services

Given any level of interest rate, total expenditure increases

Goods market equilibrium indicates that total output and income will

rise accordingly

IS curve shifts to the right (by how much)


ROADMAP


INCOME

EXPENDITURE

LIQUIDITY

PREFERENCE

IS

CURVE

LM

CURVE

AGGREGATE

DEMAND

SHORT-RUN

LABOR

MARKET

AGGREGATE

SUPPLY

AS-AD

MODEL

IS-LM

MODEL

PHILLIPS

CURVE

INTERMEDIATE-RUN

SOLOW

MODEL

LONG-RUN w/

CAPITAL

ACCUMULATION

LONG-RUN

AS-AD

MODEL

LONG-RUN w/o

CAPITAL

ACCUMULATION

THE DETUCTION OF LM CURVE

Recall the liquidity preference theory, what will happen if Y

increases?

Given any level of interest rate, real money demand increases

Money demand curve shifts to the right

Real money supply remains unchanged

Excess money demand

Interest rate increases, money market equilibrium is restored

LM curve characterizes the positive relationship between

interest rate and total output (income), given the money market

is in equilibrium


MONETARY POLICY

What will happen if real money supply increases

Money supply curve shift to the right

Given the output Y, money demand curve remains at the same position

Excess money supply

Interest rate falls, money market equilibrium reaches the new

equilibrium

The reasoning above holds for any level of Y

LM curve shifts downwards


MONETARY POLICY


ROADMAP


INCOME

EXPENDITURE

LIQUIDITY

PREFERENCE

IS

CURVE

LM

CURVE

AGGREGATE

DEMAND

SHORT-RUN

LABOR

MARKET

AGGREGATE

SUPPLY

AS-AD

MODEL

IS-LM

MODEL

PHILLIPS

CURVE

INTERMEDIATE-RUN

SOLOW

MODEL

LONG-RUN w/

CAPITAL

ACCUMULATION

LONG-RUN

AS-AD

MODEL

LONG-RUN w/o

CAPITAL

ACCUMULATION

THE IS-LM MODEL

Goods market equilibrium: higher interest rate leads to lower

output

Money market equilibrium: higher output leads to higher

interest rate

When the IS curve and LM curve intersect, the two markets are

in equilibrium simultaneously

The intersect of the two curves determines the equilibrium

output and equilibrium interest rate


THE IS-LM MODEL


IS relation: Y C Y T I Y i G( ) ( , )

LM relation: M

P YL i( )

EXPANSIONARY FISCAL POLICY

Based on the IS-LM model, what will happen if the government purchases more goods and services

IS curve shifts to the right, equilibrium point moves along the LM curve

Given any interest rate, total expenditure increases and total expenditure line shifts upwards

Goods market equilibrium condition indicates total output and income will rise

IS curve shifts to the right

Meanwhile, as income increases, so does real money demand

Excess money demand

Interest rate increases. Money market equilibrium is restored

Higher government expenditure leads to higher output and interest rate


EXPANSIONARY FISCAL POLICY


CROWDING OUT EFFECT

If we had only considered goods market equilibrium, the economy

should have ended up with point C

However, the predicted increase in output according to the IS-

LM model is not that large

Higher income leads to higher interest rate (money market

equilibrium)

Higher interest rate discourages investment expenditure and thus,

total expenditure

Relative to point C, income is lower

Relative to point C, consumption is lower due to the lower income

The reduction of investment (and consumption) due to the

expansionary fiscal policy is often referred as the crowding

out effect


CONTRACTIONARY FISCAL POLICY

Based on the IS-LM model, what will happen if the government

collects more taxes

IS curve shifts to the left, equilibrium point moves along the

LM curve

Given any interest rate, disposable income and consumption

expenditure decrease

Total expenditure falls and total expenditure line shifts downwards


Meanwhile, as income falls, so does real money demand

Excess money supply

Interest rate decreases. Money market equilibrium is restored

Higher taxes leads to lower output and interest rate


CONTRACTIONARY FISCAL POLICY


EXPANSIONARY MONETARY POLICY

Based on the IS-LM model, what will happen if central bank

increases money supply

LM curve shifts downwards, equilibrium point moves along the IS

curve

Given any level of income, there is excess money supply

Interest rate drops. Money market equilibrium is restored


Lower interest rate stimulates investment expenditure

Total expenditure increases and total expenditure line shifts

upwards. Total output and income increase.

Consumption expenditure increases

Expansionary monetary policy leads to higher output and lower

interest rate


EXPANSIONARY MONETARY POLICY


CONTRATIONARY MONETARY POLICY

Based on the IS-LM model, what will happen if central bank

reduces money supply

LM curve shifts upwards, equilibrium point moves along the IS

curve

Given any level of income, there is excess money demand

Interest rate rises. Money market equilibrium is restored

LM curve shifts upwards

Higher interest rate discourages investment expenditure

Total expenditure decreases and total expenditure line shifts

downwards. Total output and income decrease.

Consumption expenditure decreases

Contractionary monetary policy leads to lower output and higher

interest rate


IS-LM MODEL AND ECONOMIC POLICY

IS shift LM shift Output Interest rate

Increase in T Left No shift Decrease Decrease

Decrease in T Right No shift Increase Increase

Increase in G Right No shift Increase Increase

Decrease in G Left No shift Decrease Decrease

Increase in M/P No shift Downwards Increase Decrease

Decrease in M/P No shift Upwards Decrease Increase


CLINTON-GREENSPAN POLICY COMBINATION

Clinton administration wanted to reduce federal budget deficits

Contractionary fiscal policy: reduced government expenditure

and increased taxes


Meanwhile, federal reserve would like to keep total output

stable

Federal reserve resort to an expansionary monetary policy to

cancel the negative effect of the contractionary fiscal policy



CLINTON-GREENSPAN POLICY COMBINATION


SUMMARY

Goods market equilibrium: IS curve

Money market equilibrium: LM curve

IS-LM model

Fiscal policies and the crowding out effect

Monetary policies

Policy combination


IS-LM MODEL: GENERAL EQUILIBRIUM IN GOODS AND …general equilibrium model of goods and money...

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