Slide 0 CHAPTER 9 Introduction to Economic Fluctuations 9. ISLM model

CHAPTER 9 Introduction to Economic Fluctuations slide 1

9. ISLM model


In this lecture, you will learn…

an introduction to business cycle and aggregate demand

the IS curve, and its relation to the Keynesian cross the loanable funds model

the LM curve, and its relation to the theory of liquidity preference

how the IS-LM model determines income and the interest rate in the short run when P is fixed


Short run

In the following lectures, we will study the short-run fluctuations of the economy (business cycles)

We focus on three models: ISLM model (lecture 9) Mudell-Fleming model (lecture 10) Model AS-AD

AD (lectures 9 and 10) AS (lecture 11)


Facts about the business cycle

GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run.

Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP.

Unemployment rises during recessions and falls during expansions.

Okun’s Law: the negative relationship between GDP and unemployment.


Growth rates of real GDP, consumptionGrowth rates of real GDP, consumption

-4

-2

0

2

4

6

8

10

1970 1975 1980 1985 1990 1995 2000 2005

Real GDP growth rate

Average growth

rate

Consumption growth rate

Percent change from 4

quarters earlier


Growth rates of real GDP, consumption, investmentGrowth rates of real GDP, consumption, investment

-30

-20

-10

0

10

20

30

40

1970 1975 1980 1985 1990 1995 2000 2005

Percent change from 4

quarters earlier

Investment growth rate

Real GDP growth rate

Consumption growth rate


UnemploymentUnemployment

0

2

4

6

8

10

12

1970 1975 1980 1985 1990 1995 2000 2005

Percent of labor

force


Okun’s LawOkun’s Law

Percentage change in real GDP

Change in unemployment rate

-4

-2

0

2

4

6

8

10

-3 -2 -1 0 1 2 3 4

1975

198219912001

1984

1951 1966

2003

1987

3.5 2

Y

uY


Time horizons in macroeconomics

Long run: Prices are flexible, respond to changes in supply or demand.

Short run:Many prices are “sticky” at some predetermined level.

The economy behaves much differently when prices are sticky.


Recap of classical macro theory (Chaps. 3-8)

Output is determined by the supply side: supplies of capital, labor technology.

Changes in demand for goods & services (C, I, G ) only affect prices, not quantities.

Assumes complete price flexibility.

Applies to the long run.


When prices are sticky…

…output and employment also depend on demand, which is affected by fiscal policy (G and T ) monetary policy (M ) other factors, like exogenous changes in

C or I.


The model of aggregate demand and supply

the paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy

shows how the price level and aggregate output are determined

shows how the economy’s behavior is different in the short run and long run


IS-LM

This chapter develops the IS-LM model, the basis of the aggregate demand curve.

We focus on the short run and assume the price level is fixed.

This lecture focuses on the closed-economy case.

Next lecture presents the open-economy case.


The Keynesian Cross

A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)

Notation:

I = planned investment

E = C + I + G = planned expenditure

Y = real GDP = actual expenditure

Difference between actual & planned expenditure = unplanned inventory investment


Elements of the Keynesian Cross

( )C C Y T

I I

,G G T T

( )E C Y T I G

Y E

consumption function:

for now, plannedinvestment is exogenous:

planned expenditure:

equilibrium condition:

govt policy variables:

actual expenditure = planned expenditure


Graphing planned expenditure

income, output, Y

E

planned

expenditure

E =C +I +G

MPC1


Graphing the equilibrium condition

income, output, Y

E

planned

expenditure

E =Y

45º


The equilibrium value of income

income, output, Y

E

planned

expenditure

E =Y

E =C +I +G

Equilibrium income


An increase in government purchases

Y

E

E =Y

E =C +I +G1

E1 = Y1

E =C +I +G2

E2 = Y2Y

At Y1,

there is now an unplanned drop in inventory…

…so firms increase output, and income rises toward a new equilibrium.

G


Solving for Y

Y C I G

Y C I G

MPC Y G

C G

(1 MPC) Y G

1

1 MPC

Y G

equilibrium condition

in changes

because I exogenous

because C = MPC

Y

Collect terms with Y on the left side of the equals sign:

Solve for Y :


The government purchases multiplier

Example: If MPC = 0.8, then

Definition: the increase in income resulting from a $1 increase in G.

In this model, the govt purchases multiplier equals

1

1 MPC

YG

15

1 0.8

YG

An increase in G causes income to increase 5 times

as much!

An increase in G causes income to increase 5 times

as much!


Why the multiplier is greater than 1

Initially, the increase in G causes an equal increase in Y: Y = G.

But Y C

further Y

further C

further Y

So the final impact on income is much bigger than the initial G.


An increase in taxes

Y

E

E =Y

E =C2 +I +G

E2 = Y2

E =C1 +I +G

E1 = Y1Y

At Y1, there is now

an unplanned inventory buildup……so firms

reduce output, and income falls toward a new equilibrium

C = MPC T

Initially, the tax increase reduces consumption, and therefore E:


Solving for Y

Y C I G

MPC Y T

C

(1 MPC) MPC Y T

eq’m condition in changes

I and G exogenous

Solving for Y :

MPC

1 MPC

Y TFinal result:


The tax multiplier

def: the change in income resulting from a $1 increase in T :

MPC

1 MPC

YT

0.8 0.84

1 0.8 0.2

YT

If MPC = 0.8, then the tax multiplier equals


The tax multiplier

…is negative: A tax increase reduces C, which reduces income.

…is greater than one (in absolute value): A change in taxes has a multiplier effect on income.

…is smaller than the govt spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.


The IS curve

def: a graph of all combinations of r and Y that result in goods market equilibrium

i.e. actual expenditure (output) = planned expenditure

The equation for the IS curve is:

( ) ( )Y C Y T I r G


Y2Y1

Y2Y1

Deriving the IS curve

r I

Y

E

r

Y

E =C +I (r1 )+G

E =C +I (r2 )+G

r1

r2

E =Y

IS

I E

Y


Why the IS curve is negatively sloped

A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ).

To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.


The IS curve and the loanable funds model

S, I

r

I (r ) r1

r2

r

YY1

r1

r2

(a) The L.F. model (b) The IS curve

Y2

S1S2

IS


Fiscal Policy and the IS curve

We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output.

Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve…


Y2Y1

Y2Y1

Shifting the IS curve: G

At any value of r, G

E Y

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.

1

1 MPC

Y G Y


The Theory of Liquidity Preference

Due to John Maynard Keynes.

A simple theory in which the interest rate is determined by money supply and money demand.


Money supply

The supply of real money balances is fixed:

sM P M P

M/P real money

balances

rinterest

rate sM P

M P


Money demand

Demand forreal money balances:

M/P real money

balances

rinterest

rate sM P

M P

( )d

M P L r

L (r )


Equilibrium

The interest rate adjusts to equate the supply and demand for money:

M/P real money

balances

rinterest

rate sM P

M P

( )M P L r L (r )

r1


How the Fed raises the interest rate

To increase r, Fed reduces M

M/P real money

balances

rinterest

rate

1M

P

L (r )

r1

r2

2M

P


CASE STUDY:

Monetary Tightening & Interest Rates

Late 1970s: > 10%

Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflation

Aug 1979-April 1980: Fed reduces M/P 8.0%

Jan 1983: = 3.7%

How do you think this policy change would affect nominal interest rates?

How do you think this policy change would affect nominal interest rates?

Monetary Tightening & Rates, cont.

i < 0i > 0

8/1979: i = 10.4%

1/1983: i = 8.2%

8/1979: i = 10.4%

4/1980: i = 15.8%

flexiblesticky

Quantity theory, Fisher effect

(Classical)

Liquidity preference(Keynesian)

prediction

actual outcome

The effects of a monetary tightening on nominal interest rates

prices

model

long runshort run


The LM curve

Now let’s put Y back into the money demand function:

( , )M P L r Y

The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances.

The equation for the LM curve is:

dM P L r Y ( , )


Deriving the LM curve

M/P

r

1M

P

L (r ,

Y1 )

r1

r2

r

YY1

r1

L (r ,

Y2 )

r2

Y2

LM

(a) The market for real money balances (b) The LM curve


Why the LM curve is upward sloping

An increase in income raises money demand.

Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate.

The interest rate must rise to restore equilibrium in the money market.


How M shifts the LM curve

M/P

r

1M

P

L (r , Y1 ) r1

r2

r

YY1

r1

r2

LM1

(a) The market for real money balances (b) The LM curve

2M

P

LM2


Policy analysis with the IS -LM model

We can use the IS-LM model to analyze the effects of

• fiscal policy: G and/or T

• monetary policy: M

( ) ( )Y C Y T I r G

( , )M P L r Y

ISY

rLM

r1

Y1


causing output & income to rise.

IS1

An increase in government purchases

1. IS curve shifts right

Y

rLM

r1

Y1

1by

1 MPCG

IS2

Y2

r2

1.2. This raises money

demand, causing the interest rate to rise…

2.

3. …which reduces investment, so the final increase in Y

1is smaller than

1 MPCG

3.


IS1

1.

A tax cut

Y

rLM

r1

Y1

IS2

Y2

r2

Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G…

and the IS curve shifts by

MPC

1 MPCT

1.

2.

2.…so the effects on r and Y are smaller for T than for an equal G.

2.


2. …causing the interest rate to fall

IS

Monetary policy: An increase in M

1. M > 0 shifts the LM curve down(or to the right)

Y

r LM1

r1

Y1 Y2

r2

LM2

3. …which increases investment, causing output & income to rise.


Interaction between monetary & fiscal policy

Model: Monetary & fiscal policy variables (M, G, and T ) are exogenous.

Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.

Such interaction may alter the impact of the original policy change.


The Fed’s response to G > 0

Suppose Congress increases G.

Possible Fed responses:

1. hold M constant

2. hold r constant

3. hold Y constant

In each case, the effects of the G are different:


If Congress raises G, the IS curve shifts right.

IS1

Response 1: Hold M constant

Y

rLM1

r1

Y1

IS2

Y2

r2

If Fed holds M constant, then LM curve doesn’t shift.

Results:

2 1Y Y Y

2 1r r r



IS1

Response 2: Hold r constant

Y

rLM1

r1

Y1

IS2

Y2

r2

To keep r constant, Fed increases M to shift LM curve right.

3 1Y Y Y

0r

LM2

Y3

Results:


IS1

Response 3: Hold Y constant

Y

rLM1

r1

IS2

Y2

r2

To keep Y constant, Fed reduces M to shift LM curve left.

0Y

3 1r r r

LM2

Results:

Y1

r3



Estimates of fiscal policy multipliers

from the DRI macroeconometric model

Assumption about monetary policy

Estimated value of Y / G

Fed holds nominal interest rate constant

Fed holds money supply constant

1.93

0.60

Estimated value of

Y / T

1.19

0.26


IS-LM and aggregate demand

So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed.

However, a change in P would shift LM and therefore affect Y.

The aggregate demand curve (introduced in Chap. 9) captures this relationship between P and Y.


Y1Y2

Deriving the AD curve

Y

r

Y

P

IS

LM(P1)

LM(P2)

AD

P1

P2

Y2 Y1

r2

r1

Intuition for slope of AD curve:

P (M/P )

LM shifts left

r

I

Y


Monetary policy and the AD curve

Y

P

IS

LM(M2/P1)

LM(M1/P1)

AD1

P1

Y1

Y1

Y2

Y2

r1

r2

The Fed can increase aggregate demand:

M LM shifts right

AD2

Y

r

r

I

Y at each value of P


Y2

Y2

r2

Y1

Y1

r1

Fiscal policy and the AD curve

Y

r

Y

P

IS1

LM

AD1

P1

Expansionary fiscal policy (G and/or T ) increases agg. demand:

T C

IS shifts right

Y at each value of P

AD2

IS2


IS-LM and AD-AS in the short run & long run

Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices.

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short-run equilibrium, if

then over time, the price level will


The Big Picture

KeynesianCrossKeynesianCross

Theory of Liquidity Preference

Theory of Liquidity Preference

IScurve

IScurve

LM curveLM

curve

IS-LMmodelIS-LMmodel

Agg. demand

curve

Agg. demand

curve

Agg. supplycurve

Agg. supplycurve

Model of Agg.

Demand and Agg. Supply

Model of Agg.

Demand and Agg. Supply

Explanation of short-run fluctuations

Explanation of short-run fluctuations

Chapter SummaryChapter Summary

1. Keynesian cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income.

2. IS curve comes from Keynesian cross when planned

investment depends negatively on interest rate shows all combinations of r and Y

that equate planned expenditure with actual expenditure on goods & services

CHAPTER 10 Aggregate Demand I slide 61


3. Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest

rate

4. LM curve comes from liquidity preference theory when

money demand depends positively on income shows all combinations of r and Y that equate

demand for real money balances with supply



5. IS-LM model Intersection of IS and LM curves shows the unique

point (Y, r ) that satisfies equilibrium in both the goods and money markets.



2. AD curve

shows relation between P and the IS-LM model’s equilibrium Y.

negative slope because P (M/P ) r I Y

expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right.

expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right.

IS or LM shocks shift the AD curve.

CHAPTER 11 Aggregate Demand II slide 64


APPENDIX: The Great Depression


The Great Depression

Unemployment (right scale)

Real GNP(left scale)

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

bill

ion

s o

f 19

58

do

llars

0

5

10

15

20

25

30

pe

rce

nt o

f la

bo

r fo

rce


THE SPENDING HYPOTHESIS:

Shocks to the IS curve

asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IS curve.

evidence: output and interest rates both fell, which is what a leftward IS shift would cause.


THE SPENDING HYPOTHESIS:

Reasons for the IS shift Stock market crash exogenous C

Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71%

Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain

financing for investment

Contractionary fiscal policy Politicians raised tax rates and cut spending to

combat increasing deficits.


THE MONEY HYPOTHESIS:

A shock to the LM curve

asserts that the Depression was largely due to huge fall in the money supply.

evidence: M1 fell 25% during 1929-33.

But, two problems with this hypothesis: P fell even more, so M/P actually rose slightly

during 1929-31. nominal interest rates fell, which is the opposite

of what a leftward LM shift would cause.


THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

asserts that the severity of the Depression was due to a huge deflation:

P fell 25% during 1929-33.

This deflation was probably caused by the fall in M, so perhaps money played an important role after all.

In what ways does a deflation affect the economy?




The stabilizing effects of deflation:

P (M/P ) LM shifts right Y

Pigou effect:

P (M/P )

consumers’ wealth

C

IS shifts right

Y




The destabilizing effects of expected deflation:

e

r for each value of i

I because I = I (r )

planned expenditure & agg. demand income & output




The destabilizing effects of unexpected deflation:debt-deflation theory

P (if unexpected)

transfers purchasing power from borrowers to lenders

borrowers spend less, lenders spend more

if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

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Slide 0 CHAPTER 9 Introduction to Economic Fluctuations 9. ISLM model