Lecture 5_ISLM

The LM (Liquidity-Money) Relation

• The Central Bank (CB) selects the interest rate, denoted as 𝑖.

• The target interest rate (rtarget) signifies the goal set by the Central Bank.

The Money Market and the LM Relation

• Money Supply (𝑀𝑆):

  • Determined by the Central Bank and is adjusted through open market operations (OMOs).

• Money Demand (𝑀𝐷):

  • Represents the demand for liquidity for transactions and is influenced by the interest rate from bonds.

• Equilibrium Condition:

  • The formula 𝑀𝑆 = 𝑀𝐷 indicates market equilibrium.

  • Real Money Supply: 𝑀𝑆/𝑃

  • Real Money Demand: 𝑀𝐷/𝑃

  • If the price level (𝑃) remains constant, the Central Bank can change the real money supply by altering the money supply (𝑀𝑆).

Given Level of Output (𝑌)

• Real Money Supply is represented as 𝑀𝑆/𝑃.

• Real Money Demand behaves as: 𝑀𝐷/𝑃 = 𝑌𝐿(𝑖).

• Money Market Equilibrium Condition states: 𝑀/𝑃 = 𝑌𝐿(𝑖).

Effect of Increased Output (𝑌)

• When output rises to 𝑌′:

  • Money Demand (𝑌𝐿(𝑖)) increases for all values of interest rate (𝑖), causing the 𝑀𝐷/𝑃 curve to shift to the right.

  • To maintain the interest rate (𝑖), the Central Bank increases money supply (𝑀𝑆), which also shifts the 𝑀𝑆/𝑃 curve to the right.

The IS-LM Model

• Each point on the IS curve reflects equilibrium in the goods market.

• Each point on the LM curve indicates equilibrium in the money market.

General Equilibrium in the Short Run

• IS Curve Equation:

  • 𝑌 = 𝐶(𝑌 − 𝑇) + 𝐼(𝑌, 𝑖) + 𝐺

• LM Curve Equation:

  • 𝑖 = 𝑖̅

• The intersection of the IS and LM curves denotes equilibrium in both markets.

Fiscal Contraction/Consolidation

• Refers to government decisions aimed at reducing the budget deficit, often through tax increases (𝑇 ↑) while maintaining government spending (𝐺) constant.

• Fiscal expansion involves increasing deficits via higher government spending or tax reductions.

• The rationale for fiscal contraction can be seen in the context of bolstering short-run economic strength and promoting long-term sustainability of government debt.

Real World Examples

• US Case:

  • Common budget deficits with rising debt-to-GDP ratios.

• Greek Crisis (2009-2010):

  • Skyrocketing debt led to tax increases and reductions in public spending.

Public Response to Austerity

• Widespread public protests in response to austerity measures, notably in Athens in May 2011.

Impact of Increased Taxes in the Short Run

• Higher taxes (𝑇 ↑) shift the IS curve left, reducing output (𝑌) at any interest rate (𝑖).

• Increases in government spending (𝐺 ↑) or consumption (𝑐0 ↑) can help counteract this contraction.

Shifted IS Curve Diagram

• demonstrates the leftward shift of the IS curve (IS') due to increased taxes, showing a new equilibrium output in relation to LM.

Effects of Increased Taxes

• Result in decreased equilibrium output (𝑌 ↓), with the IS curve shifting leftward.

• As output declines, money demand (𝑀𝐷) falls too, prompting the Central Bank to decrease money supply (𝑀𝑆) to keep the target interest rate stable.

Behind the Scenes Diagram

• Visualizes the movements in the money market as interest rates fluctuate due to tax increases.

Impact on Key Economic Variables

• Evaluating changes in consumption (𝐶), investment (𝐼), government spending (𝐺), taxes (𝑇), public saving, and private saving in response to fiscal adjustments.

Monetary Expansion/Easing

• The Central Bank can lower the interest rate (𝑖) by increasing the money supply (𝑀𝑆).

• Conversely, monetary contraction occurs as interest rates rise due to a decrease in money supply.

Reactions to Economic Demands

• In response to the COVID-19 pandemic, interest rates were lowered by Federal Reserve statements aimed at maximizing employment and stability.

Diagram of Decreased Interest Rates

• Illustrates the shifts in the LM and IS curves while keeping equilibrium conditions intact after a reduction in interest rates.

Effects of Increased Money Supply

• An increase in the real money supply results in lower equilibrium interest rates (𝑖 ↓).

• Movement along the IS curve is initiated by the lower interest rates, leading to an increase in output (𝑌 ↑).

Interactions in Economic Markets

• Further analysis reflects the balance between goods market equilibrium and money market equilibrium.

Further Analysis of Economic Variables

• Identify how fiscal policy changes influence consumption, investment, government spending, taxes, public saving, and private saving.

Fiscal Consolidation with Monetary Expansion Example

• President Clinton's method of fiscal contraction (higher taxes) paired with monetary expansion effectively addressed budget deficits without triggering a recession.

Fiscal Revenue and Outlays Chart

• Displays the total revenues and outlays as a percentage of GDP over time for illustrative analysis.

Stabilizing Output Through Policy Adjustments

• Moving from point A to A' aims at stabilizing GDP while concurrently lowering interest rates.

Outline for Next Class

• Transition towards the study of the labor market, focusing on the supply side of the economy.

• Upcoming topics will define natural unemployment rates and natural output levels.