Lecture #2, The IS-LM Curves and Policy Analysis
Transcript of Lecture #2, The IS-LM Curves and Policy Analysis
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IS-‐LM Model and Policy Analysis
Lecture #2Public Finance
MPPA – Linkage Program
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IS/LM Model• The IS/LM model, first developed by Sir John Hicks (1937) and later
extended by Alvin Hansen (1949) to summarize John Maynard Keynes’ General Theory of Employment, Interest, and Money.
• The horizontal axis represents national income or real gross domestic product and is labeled Y. The vertical axis represents the interest rate, r. The graph thus represents the interface between the “real” and the “monetary” parts of the economy.
• The point where these schedules intersect represents a short-‐runequilibrium in the real and monetary sectors (though not necessarily in other sectors, such as labor markets). In IS/LM equilibrium, both product markets and money markets are in equilibrium. Both the interest rates and real GDP are determined.
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The IS curve• An IS (Investments = Savings) curve shows the different combinations of income (Y) and interest rates (r) at which the goods market is in equilibrium.
• Remember, the IS curve shows the effect of interest rates in shifting AD and the resultant level of income
• If anything else changes, the IS curve will shift.
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r0
45⁰ line
AD1
Income
Aggregate
Demand
Income
Interest
Rate
Y0
Y0
Now suppose that interest rates are lowered, to r1. Lower interest rates boost consumer spending and investment, and so AD rises.
We draw a new AD curve at AD2. At this higher level of AD, the economy’s goods market equilibrium is achieved at Y1.
AD2
Y1
Now we plot a point at the intersection of Y1 and r1 to indicate the point at which the goods market is in equilibrium.
r1
Y1
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r0
45⁰ line
AD1
Income
Aggregate
Demand
Income
Interest
Rate
Y0
Y0
AD2
Y1
r1
Y1
We can repeat this process for all interest rates, and then plot all of the relevant points on the bottom diagram.
If we join the dots, we create an IS curve.
IS
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Shifting the IS curve: ΔGAt any value of r, ↑G⇒↑E ⇒ ↑Y
slide 6
Y2Y1
Y2Y1 Y
E
r
Y
E =C +I (r1 )+G1
E =C +I (r1 )+G2
r1
E =Y
IS1
The horizontal distance of the IS shift equals
IS2
…so the IS curve shifts to the right.
11 MPC
Y GΔ = Δ−
ΔY
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Shifts in the IS curve• What would happen to the IS curve if:– Government spending increased?– Consumer confidence fell?– Business optimism about future profits improved?
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The LM Curve:Real Money, Real Income,and the Interest Rate
• The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:
MP
YL i= ( )
$Y YP=
§ From chapter 2, recall that Nominal GDP = Real GDP multiplied by the GDP deflator:
$YP
Y=Equivalently:
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Deriving the LM Curve
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Shifts of the LM Curve
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IS – LM model
• Equilibrium on the goods market and on the financial market
• Find (i,Y) such that both markets are in equilibrium
• IS: Combination of i and Y such that the goods market is in equilibrium
• LM: Combination of i and Y such that the financial market is in equilibrium
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Putting the IS and theLM Relations Together
IS relation: Y = − + +C Y T I Y i G( ) ( , )
LM relation: MP
= YL i( )
The basic relations between Fiscal and Monetary policies
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IS -‐ LMi
Y
LM
IS
§ Monetary Policy: M, shifts the LM curve
§ Fiscal Policy: T,G, shifts the IS curve
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Using a Policy Mix• The combination of monetary and fiscal polices is known as
the monetary-‐fiscal policy mix, or simply, the policy mix.
Table 1 The Effects of Fiscal and Monetary Policy.
Shift of ISShift of LM
Movement of Output
Movement in Interest Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
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Example: The Clinton-‐Greenspan Policy Mix
Table 2 Selected Macro Variables for the United States, 1991-1998
1991 1992 1993 1994 1995 1996 1997 1998
Budget surplus (% of GDP) (minus sign = deficit)
−3.3 − 4.5 − 3.8 − 2.7 − 2.4 − 1.4 − 0.3 0.8
GDP growth (%) −0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7
Interest rate (%) 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8