24ECA001 - The IS-MP Model

Page 1: Introduction

• Title: Goods and Money Market Equilibrium – The IS-MP Model

• Speaker: Dr. Sinchan Mitra

• Context: Principles of Macroeconomics Lecture 5 and 6

Page 2: References

• Economics, 12th edition by Begg, Vernasca, Fischer and Dornbusch, Chapter 23.

• Economics, 13th edition by Lipsey and Chrystal, Chapter 20.

• Note: Assigned adaptive reading on Connect based on Chapter 23.

Page 3: Overview of the IS-MP Model

• Topic Introduction:

  • Focuses on simultaneous equilibrium in goods and money markets.

  • Examines how income and interest rates are jointly determined.

  • Discusses the role of monetary and fiscal policies in stabilizing aggregate demand/output.

  • Notes that the external sector/foreign trade is omitted for this analysis.

  • Upcoming discussions will cover the labor market in the AD-AS model in the next chapter.

Page 4: Equilibrium in Goods Market

• Assumptions: Prices are assumed to be fixed.

• Goods Market Equilibrium:

  • Achieved when aggregate demand equals output/income.

  • Depicted by the IS schedule:

    • Negatively sloped: Higher output requires higher aggregate demand and a lower interest rate to maintain equilibrium.

  • Factors Shifting the Curve:

    • Government expenditure (G), taxes (T), and expectations of future income growth.

Page 5: The IS Schedule

• Graph Depiction:

  • Illustrates how changes in interest rates affect aggregate demand and short-run equilibrium output.

  • A lower interest rate increases demand and output.

  • Any factor affecting aggregate demand shifts the IS schedule.

Page 6: Changes Along and Shifts in the IS Schedule

• Interest Rate Changes:

  • Movements along the IS schedule occur with changes in interest rates.

  • Shifts in the IS schedule occur with other changes affecting aggregate demand.

• Question on IS Schedule Shape:

  • Should it be a straight line or curved?

  • Slope reflects sensitivity of aggregate demand to interest rate changes.

Page 7: The Money Market (MP) Schedule

• Introduction to the MP Schedule:

  • Depicts money market equilibrium.

• Monetary Policy Question:

  • Is monetary policy about choosing a value for an instrument (e.g., interest rates) or defining how the central bank sets that value based on other economic variables?

• Analysis Implication:

  • A lower interest rate can indicate a rightward shift of the MP curve.

Page 8: Representation of the MP Schedule

• Overview of MP Schedule:

  • Represents money market equilibrium conducive to achieving desired interest rates at all real income levels.

Page 9: Details of the MP Schedule Graph

• Graph Insight:

  • Shows central bank’s desired interest rates at various income levels.

  • Money supply adjusts to meet money demand at given income-interest rate combinations.

Page 10: Equilibrium in Money Market

• Characteristics of the MP Schedule:

  • Central bank's desired interest rates correlate with real income levels.

  • Interest rates reflect money demand levels.

  • High output may lead to elevated interest rates.

Page 11: IS-MP Model's Equilibrium

• Graph Analysis:

  • Goods market equilibrium exists on IS schedule; money market equilibrium on the MP schedule.

  • Interplay between income, interest rates, and money supply is key.

Page 12: Fiscal Expansion Impacts

• Economy-Wide Equilibrium:

  • Both goods and money markets must be balanced (shown in previous graphs).

• Fiscal Expansion Analysis:

  • Increase in G shifts IS curve right, resulting in new equilibrium (from E to E1).

  • Central bank increases interest rates in response.

  • Higher rates may dampen investment—known as the "crowding out" effect.

Page 13: Effects of Fiscal Expansion on IS

• IS Shift Explanation:

  • IS schedule shifts right (from IS0 to IS1) but LM remains unchanged (at MP0).

  • Result: output increases from Yo to Y1.

  • If monetary policy is also expanded, output could rise further (to Y2).

Page 14: Financing Government Expenditures

• Government Funding for Expansion:

  • Can involve issuing debt or borrowing, affecting competition for private sector savings.

• Implications:

  • Fiscal expansion financed by borrowing may raise the need for higher interest rates.

Page 15: Relationship Between G and I

• Public vs. Private Investment:

  • Does public spending “crowd out” private investment or “crowd in” private investment?

  • Context-dependent; public investment can enhance private productivity.

• Resource Link:

  • OBR provides insights into UK public finances.

Page 16: Looser Monetary Policy and Fiscal Expansion

• Monetary Policy Effects:

  • A looser monetary policy shifts MP curve down, reducing interest rates across income levels.

  • Fiscal contractions also illustrated showing effects on the IS schedule.

Page 17: Changes in Money Demand

• Central Bank's Response:

  • Adjusts money supply in line with changes in demand; interest rates remain stable as they depend on output levels.

Page 18: Introduction to Fiscal Policy

• Context Transition:

  • Shifting focus from monetary policy to fiscal policy.

  • Suggested resource for further reading on fiscal policy implications from the IMF.

Page 19: Fiscal Policy Effectiveness

• Fiscal Multiplier Factors:

  • Depends on the extent of spending resulting from fiscal stimulus, along with concerns about leakage to imports.

• Debt Sustainability:

  • Rising interest rates and concerns surrounding government debt efficacy.

Page 20: Fiscal Policy Trade-Offs

• Assessment of Government Approaches:

  • Trade-offs exist in targeting fiscal stimulus (e.g., focusing on the poor vs. funding capital investments).

  • Governments must navigate complex spending challenges in short periods.

Page 21: Monetary Policy Trends

• Bank Rate Trends in the UK (2008-2018):

  • Graph exhibits fluctuations in the UK bank rate over the specified period.

Page 22: Rational Consumers and Fiscal Policy

• Theory of Ricardian Equivalence:

  • Suggests that rational consumers anticipate the need to repay government borrowing through future taxes.

  • This may lead to reduced current spending in favor of saving.

Page 23: Practical Implications of Fiscal Policy

• Observations on Fiscal Multipliers:

  • Generally positive, especially in recessions.

  • Challenges emerge with high deficits and unsustainable debt levels.

Page 24: Evidence for Fiscal Stimulus

• Historical Insights:

  • Notable fiscal expansions during major wars were associated with economic booms, supporting the case for fiscal stimulus effectiveness.

Page 25: Coordination of Monetary and Fiscal Policies

• Graph Analysis:

  • Examines scenarios involving expansionary fiscal policy with tight monetary policy and vice versa.

  • Highlights the composition effect of fiscal and monetary policies on income/output.

Page 26: Policy Mix for Income Targeting

• Strategies for Achieving Target Income:

  • Combinations of fiscal and monetary policy can yield desired income levels, with respective impacts on interest rates and investment shares.

Page 27: Welfare Costs of Recessions

• Economic Considerations:

  • Recessions can inflict severe welfare costs that threaten long-term economic health.

  • Inquiry into the feasibility of fine-tuning policies to preempt such economic downturns.

Page 28: Aggregate Demand Management

• Potential Output Concept:

  • Defined as the economy’s production capacity under fully employed resources, impacted by technology and labor force.

  • Discussions of managing output gaps (negative and positive) through policies.

Page 29: Effectiveness of Demand Management Policies

• Challenges for Policy Implementation:

  • Reliance on potentially flawed macroeconomic data, lag times for policy effects, and issues like zero lower bound in monetary policy create difficulties.

Page 30: Limitations of Fiscal Policy

• Effectiveness Concerns:

  • High debt levels may restrict fiscal policy's impact; pessimism around future economic conditions can inhibit spending.

Page 31: Topics Covered/Sample Questions

• Focused Topics:

  • Description and discussion of the IS-MP model.

  • Analysis of fiscal expansion's impact within the model.

  • Government policies for stimulating the economy during downturns.

  • Evaluation of fiscal policy's effectiveness in managing aggregate demand.