M03 gart 7928_03_ppw_ch03

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Gartner, Macroeconomics, 3rd Edition © Manfred Gartner 2009

Lecture 2

IS-LM Model

Chapter 2 and 3

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Figure 3.2 Rising interest rates raise the opportunity costs of holding money. Therefore they drive down the demand for money at given income levels (panel (a)). Rising income raises transactions and shifts the money demand curve to the right. The money supply curve is vertical. Changing supply shifts the curve left or right(panel (b))

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Figure 3.3 In 2001 Australian households’ assets (gross wealth) totaled 3,200 billion Australian dollars. Wealth comprises non-financial assets, things like houses and cars, and financial assets. About a fourth of all financial assets, some 11% of total wealth, is held as money (currency and deposits with banks)

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Figure 3.4 Money demand and supply are equal at one interest rate i0. At higher interest rates there is an excess supply. A lower interest rate generates an excess demand

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Figure 3.5 Panel (a) shows a vertical money supply and a negatively sloped money-demand curve. Rising income raises money demand at any interest rate, shifting the money- demand curve right. To retain equilibrium, the interest rate must rise to contain money demand at its old level. Transferring points A and B into panel (b) gives two points on the LM curve, the money-market equilibrium line

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Figure 3.6 In panel (a) the money supply increase shifts the vertical money-supply curve to the right. To retain equilibrium, money demand must be spurred by lowering the interest rate from i0 to i1. Transferring points A and B to panel (b) gives two money-market equilibrium points on two different LM curves, each one drawn for a different money supply

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Figure 3.7 In order to keep the interest rate at i, the central bank must accommodate an increase in the demand for money, caused by a rise in income from Y0 to Y1, by raising the money supply from M0 to M1 (panel (a)). Transferring equilibrium points A and B to panel (b) gives two money-market equilibrium points on two different LM curves, each one drawn for a different money supply. Both points sit on one lm curve, however, drawn for a given interest rate target

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Figure 3.8 The dark blue line shows a money market equilibrium line, an lm curve, derived from a monetary policy rule such as (3.3) in which both the money supply and the interest rate feature as targets. When only the money supply is targeted (a = 0), the equilibrium line turns into the steeper, light blue LM curve. When only the interest rate is targeted (a ), the money market equilibrium line becomes horizontal

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Figure 3.9

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Figure 3.10

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Figure 3.11 All goods market equilibria form a plane in R-i-Y space. It slopes up as we move towards the rear (depreciation generates excess demand; to reverse this, the interest rate must rise). The plane slopes down as we move to the right (rising income leads to an excess supply; to eliminate this, the interest rate must fall). Placing a vertical cut parallel to the income axis carves out an equilibrium line (IS curve) for a given real exchange rate

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Figure 3.12 The IS curve shows all combinations of interest rates and income thatmake aggregate spending equal to output. It is drawn for given governmentexpenditures, world income and a given exchange rate. As these variables rise,the IS curve moves up (or to the right)

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Figure 3.13 This shows how what we learned in this chapter fits into the circular flow diagram. If i falls, I goes up. I increases by the grey segment of the investment injection. This demand rise adds to income. Since this stimulates consumption, second-round effects set in. The fact that leakages also get larger (not shown in graph) ensures that income does not continue to rise forever. Eventually, the stream of income settles into a new width determined by the multiplier. Note that changes of world income, the exchange rate or taxes affect the circular flow in a similar way

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Figure 3.14 While points A, B and C indicate goods market equilibria and A, D and E mark money market equilibria, only point A is an economy-wide equilibrium with both markets being in equilibrium at the same time. At F there is disequilibrium in both markets. The arrow indicates how such a disequilibrium might be removed. Our IS-LM model does not really cover this. It only tells where the equilibrium is, not how we get there

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Figure 3.15 When the money supply increases, the LM curve shifts to the right, indicating that we need higher income or lower interest rates (or some combination of these effects) to induce people to increase money demand. The slope of the IS curve causes the macroeconomic equilibrium to move from A to B. Only the indicated fall in the interest rate and the indicated rise in income will keep the goods market in equilibrium while restoring money market equilibrium after the money supply increase

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Figure 3.16

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Figure 3.17 The IS-LM model rests on the Keynesian cross, but extends this. In the Keynesian cross, an increase in government spending moves the aggregate expenditure line up, moving the economy from A to B. In the IS-LM diagram the IS curve moves to the right. The same macroeconomic equilibrium B would only obtain if the interest rate did not change. Since money market equilibrium requires the interest rate to rise, investment is driven down and the new equilibrium is in C, where LM and the new IS curve intersect. In the Keynesian cross this rise in i and fall in I moves the AE line down and the new equilibrium is also at C

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Figure 3.18

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Figure 3.19 An increase in government spending shifts the IS curve to the right. If the money supply was kept unchanged, this would move the economy up from A along LM0, raising the interest rate and crowding out some private investment. When the central bank wants to keep the interest rate unchanged at i instead, it must increase the money supply appropriately and shift LM into LM1, moving the economy into point B. Expansionary fiscal policy has a bigger income effect when the central bank fixes the interest rate. Crowding out is prevented because the central bank is forced to respond to an increase in government spending by expanding the money supply

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Table 3.1

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Table 3.2

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Figure 3.20

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Table 3.3Sources: IMF-IFS and Statistics Norway

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Table 3.4

M03 gart 7928_03_ppw_ch03

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