IS-LM Revisited

Simple Income DeterminationProperties of IS & LM Curves

Equilibrium Output & Interest RatesEconomic Policy

(1) Simple Income Determination* Eco 1002

* Goods Market (IS)

* Exogenous Interest Rate & Prices

* Endogenous Income (GDP)

(2) IS-LM Model* Eco 2101 (Keynesian Short-Run)

* (1) + Money Market

* Endogenous Income & Interest Rate (Fixed P)

• Endogenous Policy

Simple Income Determination(Eco 1001)

• Behavioral Assumptions:

Consumption = C (y, r)

y = disposable income = Y – T

r = interest rate

MPC = where 0 < Cy < 1

Investment = I(r)

Government Purchases = G• Exogenous: r, P, Fiscal Policy: G, T• Endogenous:Y• Linear Examples

yCyC /

0/ rIrI

• Equilibrium:

• Some Basic Results:

(interest rates and GDP)

(Gov. Spending Multiplier)

(Tax Multiplier)

EGrIryCY )(),(

11

1/

yCdGdY

01

/

y

rr

C

ICdrdY

01

/

y

y

C

CdTdY

IS-LM Model (Eco 2101)

• Goods & Money Market Equilibrium

• IS-LM Model

Exogenous: P, Fiscal Policy: G, T

Monetary Policy: Ms

Endogenous: Y and r

IS and the Goods Market

• Goods Market Equilibrium:

Y = C(y,r) + I(r) + G (IS equation)

where y = Y – T = disposable income

0< Cy < 1

Ir < 0

G and T are exogenous policy variables

• Properties of IS curve:

Slope*:

Government spending multiplier:

(shifts right)

Tax Multiplier:

(shifts left)

01

y

rrIS C

IC

dr

dY

11

1

yCdG

dY

01

y

y

C

C

dT

dY

LM and the Money Market

• Real Money Demand = L(Y,r)

• Money Market Equilibrium:

Ms = P*L(Y,r) (LM equation)

Ms is an exogenous policy variable.

0/ YLYL

0/ rLrL

• Properties of LM curve

Slope*:

Real Money Supply:

(shifts right)

0Y

rLM L

L

dr

dY

01

)(

rs PLMd

dr

• The Simple IS-LM Model - (Y,r) which solves:

(IS)

(LM)

GrIryCY )(),(

),(* rYLPM s

Policy in IS-LM Model

Exogenous: PEndogenous: Y, rPolicy Variables: G, Ms, T

• Fiscal Policy(1) Government Expenditures (dG)

but less than 1/(1-Cy)!

0)/)(()1(

1

)()1(

*

rYrryrrYry

r

LLICCICLLC

L

dG

dY

Crowding-out effect!• Effectiveness of G:

If (IS Flat)

or (LM verticle)

then . (Complete crowding-out!)

(2) Taxes (dT): dY/dT = ?, dr/dT = ?

0)()1(

*

rrYry

Y

ICLLC

L

dG

dr

rr CI ,0rL

0dGdY

• Monetary Policy (dMs):

0)()1(

*

rrYry

rrs ICPLPLC

CI

dM

dY

0)()1(

1*

rrYry

y

s ICPLPLC

C

dM

dr

• Effectiveness of monetary policy:If (IS vertical)

or (LM flat)

Then

(Ineffective Monetary Policy)

0, rr CI

rL0sdM

dY

Liquidity Trap and Interest Rate Insensitivity

• Great DepressionYear UR i r = i - 1930 8.9 3.6 -2.6 6.21931 16.3 2.6 -10.1 12.71932 24.1 2.7 -9.3 12.01933 25.2 1.7 -2.2 3.41934 22.0 1.0 7.4 -6.61935 20.3 0.8 0.9 -0.11936 17.0 0.8 0.2 0.6

• 2008-09 Recession

Jan 2007 – Jan 2010, Federal funds rate cut from 6% to 1%.

i UR

Jan 2007 5.25% 4.6%

Jan 2008 3.94% 5%

Jan 2009 0.15% 7.7%

Jan 2010 0.12% 10%

Business Cycles in IS-LM

• Shocks to Consumer confidence )C = C(Y,r where C > 0

dY*/d > 0dr*/d

• Shocks to money demand L = L(y,r where L> 0

dY*/d < 0dr*/d

Endogenous Policy

• Monetary/Fiscal Policy responds to economic conditions to achieve goal.

Objective: dY = 0 (output stability) OR

dr = 0 (interest rate stability)

Exogenous: Policies - Ms or G, or T

Shocks – or

Endogenous: Policies - Ms or G, or T

• Example: An increase in G and Fed’s objective is to keep r constant (prevent crowding out).

• Step 1: Set dr = 0

Step 2: Treat dY and dMs as endogenous, dG as exogenous.

Step 3: Use Cramer’s Rule to solve for

dY/dG and dMs/dG.

Suppose instead Fed wanted to keep output stable (dY = 0). Find dr/dG and dMs/dG.

Evaluation of Simple Keynesian IS-LM Models

• Provided reasonable explanation of business cycles.

• Guides policymakers on stabilizing economic fluctuations.

• Can be applied easily to think about current events.

Shortcomings

• Criticisms of IS-LM Model:

(1) Emphasis on aggregate demand.

(2) Static Model.

(3) Lack of solid microeconomic foundations.

• Lucas Critique on Policy Evaluation

• Examples: Consumption, Phillips Curve

Modern Macro

• Dynamics

• Expectations (rational)

• Microeconomic Foundations

Most modern macro models (New Classical and New Keynesian) have these features.