macroeconomics - licence 1 economie gestionremi.bazillier.free.fr/coursmacro_chap6_en.pdf ·...

The Goods market and the IS relationFinancial markets and the LM relation

The IS-LM model

Macroeconomics - Licence 1 EconomieGestion

Chapter 6: Goods and Financial markets: the IS-LM model

Rémi Bazillier 1

1 [email protected]://remi.bazillier.free.fr

Université d’Orléans

Rémi Bazillier Chapter 6: The IS-LM model

[email protected]

http://remi.bazillier.free.fr


The IS-LM model

Plan

1 The Goods market and the IS relation

2 Financial markets and the LM relation

3 The IS-LM modelFiscal policy, activity and the interest rateMonetary policy, activity and the interest rateUsing a policy mix



The IS-LM model

Introduction

John Mayard Keynes published his General theory in 1936In 1937, John Hicks summarized what he saw as one ofKeynes’s main contributions: the joint description of goodsand financial marketsHis analysis was later extended by Alvin Hansen→ IS-LMmodelDespite its simplicity, the model captures much of whathappens in the economy in the short run



The IS-LM model

The Goods market and the IS relation

Reminder:Demand:

Z = C(Y − T ) + I + G (1)

Equilibrium condition:

Y = C(Y − T ) + (I) + G (2)

We looked at the factors that moved equilibrium output(changes in government spending or in consumptiondemand)

Now, we will introduce the interest rate into the analysis



The IS-LM model

Investment, sales and the interest rate

Investment depends primarily on two factors:Level of sales - increase in sales→ increase production→may need to buy additional machines→ increaseinvestmentThe interest rate - If a firm needs to borrow to finance itsinvestment: the higher is the interest rate, the less attractiveis to borrow and thus invest

I = I(Y , i) (3)(+,−) (4)



The IS-LM model

Determining output

Condition for equilibrium is now:

Y = C(Y − T ) + I(Y , i) + G (5)

An increase in the output leads to an increase in incomeand thus to an increase in disposable income. The increasein disposable income leads to an increase in consumption(see chapter 4)An increase in the output also leads to an increase ininvestment (see the investment function)



The IS-LM model

Deriving the IS curve

Suppose that the interest rate increases from i to i ′

This higher level of interest rate leads to a lower level ofinvestment and thus lower demandthe demand curve ZZ shifts downThe increase in interest rate decreases investment. Thedecrease of investment leads to a decrease in output,which further decreases consumption and investment,through the multiplier effectThe relation between the interest rate and output isrepresented by a downward sloping curve→ the IS curve



The IS-LM model

Deriving the IS curve



The IS-LM model

Shift of the IS curve

Changes in T , G and other autonomous spending will shiftthe IS curveSuppose an increase of T :

At a given interest rate, i , disposable income decreases,leading to a decrease in consumption, leading to adecrease in the demand for goods, and a decrease inequilibrium output.

Changes in factors that decrease the demand for goods,given the interest rate, shift the IS curve to the left.Changes in factors that increase the demand for goods,given the interest rate, shift the IS curve to the right.



The IS-LM model

Shifts of the IS curve



The IS-LM model

Financial markets and the LM relation

Determination of the interest rate: relation between money,nominal income and the interest rate

M = $YL(i) (6)

Relation between money, real income (income in terms ofgoods) and the interest rate:

MP

= YL(i) (7)

the real money supply (money stock in terms of goods) beequal to the real money demand, which depends on realincome, Y and the interest rate, iThe LM relation



The IS-LM model

Deriving the LM curve

Effect of an increase in income from Y to Y ′

It increases the demand for money at any given interest rateMoney supply is givenIncrease of the interest rate→ The increase in income thatleads people to want to hold more money / the increase inthe interest rate that leads people to want to hold lessmoney - cancel each other outThe demand for money is equal to the unchanged moneysupply, but at a higher level of interest rate



The IS-LM model

Deriving the LM curve

“Higher economic activity puts pressure on interest rates”



The IS-LM model

Shifts of the LM curve

An increase in the nominal money supply MGiven the fixed price level, the real money supply increasesM/PAt any level of income, the interest rate consistent with theequilibrium in financial markets is lowerThe LM curve shifts down

Increase in the level of income:For a given level of real money supply, an increase in thelevel of income increases the demand for moneyIt leads to an increase in the interest rate. →upward-sloping LM curve



The IS-LM model

Shifts of the LM curve



The IS-LM model

Fiscal policy, activity and the interest rateMonetary policy, activity and the interest rateUsing a policy mix

Putting the IS and the LM relations together

The IS relation: the supply of goods must be equal to thedemand for goods. It tells us how the interest rate affectsoutput.

IS : Y = C(Y − T ) + I(Y , i) + G (8)

The LM relation: the supply of money must be equal tothe demand for money. It tells us how output affects theinterest rate.

LM :MP

= YL(i) (9)

Any point on the downward-sloping IS curve correspondsto equilibrium in the goods marketAny point on the upward-slopping LM curve correspondsto equilibrium in financial marketOnly one point are both equilibrium conditions satisfied.



The IS-LM model


The IS-LM model



The IS-LM model


Fiscal policy, activity and the interest rate

Suppose that the government wants to reduce the budgetdeficit: fiscal contraction or consolidation

It affects equilibrium in the goods market (IS curve)Because people have less disposable income, the increasein taxes decreases consumption, and through the multiplierdecreases output. At any level of interest rate, outputdecreases.What happens to the LM curve when taxes are increased?Nothing! Taxes do not appear in the LM relationThe IS curve shifts to the left. The economy moves alongthe LM curve→ the interest rate decreases.



The IS-LM model


In words...

The increase in taxes leads to lower disposable income, whichcauses people to decrease their consumption. This decrease indemand leads, in turn, to a decrease in output and income. Atthe same time, the decrease in income reduces the demand formoney, leading to a decrease in the interest rate. The decline ininterest rate reduces but does not completely offset the effect ofhigher taxes on the demand for goods.



The IS-LM model


The effects of an increase in taxes



The IS-LM model


Deficit reduction: Good or bad for investment?

I = S + (T −G) (10)

Given private saving, if the government reduces its deficit(T-G goes up), investment must goes up.But fiscal contraction leads to lower output and lowerincome→ Private saving also goes downInvestment may decrease if private saving decreases bymore than T-G increases.Fiscal contraction may decrease investment (and fiscalexpansion may increase investment)



The IS-LM model


Two specific cases

The classic LM curveFull crowding out effect: budgetary policy is completelyinefficient

The liquidity trapFull liquidity preference. Lack of trust in the financialsystem.



The IS-LM model


The classic LM curve

The LM curve is verticalThe demand for money does not change with interest rateFiscal policy leads to changes in interest rate but not inoutput→ Ineffectiveness of fiscal policy



The IS-LM model


The liquidity trap

Lack of trust in the financial system: liquidity preferenceThe demand for money does not have any impact on theinterest rate: no crowding out effect→ LM curve ishorizontalFull effectiveness of fiscal policy



The IS-LM model


The elasticity of interest rate and the demand formoney

The more sensitive is the demand for money to the interestrate, the more effective is the fiscal policy (liquidity trap)



The IS-LM model


Monetary policy, activity and the interest rate

An increase in money supply: monetary expansionA decrease in money supply: monetary contraction (ortightening)The case of a monetary expansion:

The central bank increases nominal money, M throughopen market operationGiven the assumption that price-level is fixed, it leads to anincrease in real money M/PIS curve: The money supply does not directly affect eitherthe supply or demand for goods. A change in M does notshift the IS curveLM curve: An increase in the money supply shifts the LMcurve down. At a given level of income, an increase inmoney leads to a decrease in interest rate.



The IS-LM model


The effects of a monetary expansion



The IS-LM model


In words...

The increase in money leads to a lower interest rate. The lowerinterest rates leads to an increase in investment and, in turn, toan increase in demand and output.



The IS-LM model


Two specific cases

The liquidity trap:The monetary policy is inefficient: no influence of moneysupply on the interest rate

The classic LM curve:The monetary policy is efficient: the demand for moneyfollows the money supply

→ the more sensitive is the interest rate elasticity, the lessefficient is the monetary policy



The IS-LM model


The interest rate’s elasticity of investment

The transmission channel between the interest rate andthe demand for goods and services: investmentThe effectiveness of the monetary policy thus depends onthe influence of interest rate on investmentthe more sensitive is the investment towards the interestrate:

The more efficient is the monetary policy (a fall of interestrate leads to a higher increase in invesment)The less efficient is the fiscal policy (the higher would bethe crowding-out effect)



The IS-LM model


Using a policy mix

The combination of fiscal and monetary policies: policymix

The use of fiscal and monetary policy in the same direction(eg. The US recession of 2001 when both monetary andfiscal policy were used to fight the recession)The use of the two policies in two directions (eg. combininga fiscal contraction with a monetary expansion.Clinton/Greespan policy mix: fiscal contraction combinedwith monetary expansion to avoid recessive effects ofdeficit reduction)

Goal of the policy mix:Avoid the crowding out effect in a fiscal policyAvoid the regressive effects of a fiscal contractionConstrained policy mix: when the government and thecentral bank does not share the same goals (eg.maximizing GDP for the government against fight againstinflation for the central bank)



The IS-LM model


Three examples of policy mix

1 The German reunification2 The Clinton-Greespan policy mix3 The US recession of 2001



The IS-LM model


Example 1: The German reunification and the fightbetween the fiscal and the monetary policy

Table: Some macroeconomic variables in Western Germany(1988-1991)

1988 1989 1990 1991Growth GDP 3.7 3.8 4.5 3.1

Growth Investment 5.9 8.5 10.5 6.7Fiscal surplus -2.1 0.2 -1.8 -2.9

Short-term interest rate 4.3 7.1 8.5 9.2



The IS-LM model





The IS-LM model



Goal of German central bank: fight against inflation. Fearthat the fiscal stimulus leads to a rapid increase of inflation.Monetary contraction to counter-balance the fiscal policyRemark: negative spill-over for all European economies

The increase in interest rate in Germany leads to anincrease in other European countriesFor these countries: monetary contraction without fiscalstimulusEuropean recession 1992-1993



The IS-LM model


Example 2: the Clinton-Greespan policy mix

1991 1992 1993 1994 1995 1996 1997 1998Fiscal surplus (%) -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 3.7Interest rate 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8



The IS-LM model





The IS-LM model



Election of Bill Clinton in 1992: fiscal deficit 4.5% (thehighest since 1945) and economic crisis in 1990-1991How decreasing the deficit without reducing the output?

The deal with Greespan: monetary expansion against a fallin fiscal deficit

Does the monetary policy explain everything?No, virtuous cycle of growth (improvement of trust)The FED did not have to further decrease the level of theinterest rate



The IS-LM model


Example 3: The 2001 US recession

The end of “irrational exuberance” (the fact that firms hadbeen extremely optimistic during the second part of the1990s)

Growth rate of investment from 1995 to 2000 exceeded10%It became clear to firms that they had been overly optimisticThis led them to cut back on investment (-4.5% in 2001)This led to a decrease in demand and, through themultiplier, a decrease in GDP



The IS-LM model



Recession could have been much worse. But a strongmacroeconomic policy response:

Starting in early 2001, the FED started increasing themoney suppl and decreasing the federal funds rate (from6.6% in January to 2% at the end of the year)Fiscal policy:

Bush Jr. was elected on a program of tax cut (both 2001 and2002 budgets included substantial reductions in tax rates)The events of September, 11, 2011, led to an increase inspending, mostly on defense and homeland security



The IS-LM model





The IS-LM model


Is a policy-mix always possible? the example of theEurozone

Today in the Eurozone:European Central Bank: only goal is the fight againstinflationNo European GovernmentFiscal policies constrained at the National level (Stabilityand Growth Pact today, tomorrow fiscal treaty?)

Which policies for the Eurozone?



The IS-LM model


How does the IS-LM model fit the facts?


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