IS-LM Model Notes

The Goods Market and the IS Relation

Equilibrium in the goods market is achieved when production (Y) equals the demand for goods (Z). In Chapter 3’s model, the interest rate didn't influence the demand for goods. The equilibrium condition was:

$Y = Z$

Investment, Sales, and the Interest Rate

Investment is affected by:

• Sales level (+)

• Interest rate (-)

Determining Output

Considering the investment relation, the equilibrium condition in the goods market is:

[The specific equation is missing from the provided text. A complete equation would be included here.]

Deriving the IS Curve

The demand for goods increases with output. Equilibrium is where the demand for goods equals output. This illustrates goods market equilibrium.

IS Curve Properties

• An increase in the interest rate leads to a decrease in output.

• The IS curve is downward sloping.

Shifts of the IS Curve

• An increase in taxes shifts the IS curve to the left.

Financial Markets and the LM Relation

The interest rate is determined by the equilibrium between money supply and demand:

M = $YL(i)

Where:

• $M$ = nominal money stock

• $YL(i)= demand for money

• $Y = nominal income

• $i$ = nominal interest rate

Assuming the central bank keeps $M$ constant, $i$ is market-determined. When studying policy mixes, the central bank chooses $i$.

Real Money, Income, and Interest Rate

The LM relation states that in equilibrium, the real money supply equals real money demand:

$\frac{M}{P} = YL(i)$

Where:

• $\frac{M}{P}$ = real money supply

• $Y$ = real income

• $i$ = interest rate

Deriving the LM Curve

At a given interest rate, an increase in income increases the demand for money, leading to an increase in the equilibrium interest rate, given the money supply.

LM Curve Properties

An increase in income leads to an increase in the interest rate. Thus, the LM curve is upward sloping.

Shifts of the LM Curve

An increase in money supply shifts the LM curve down.

IS-LM Model Synthesis

• Goods market equilibrium: higher interest rate → lower output.

• Financial market equilibrium: higher output → higher interest rate.

• The intersection of the IS and LM curves signifies equilibrium in both goods and financial markets.

Fiscal Policy

• Fiscal contraction (or consolidation): Reduces the budget deficit.

• Fiscal expansion: Increases the deficit.

• Taxes affect the IS curve only.

Impact of Increased Taxes

An increase in taxes shifts the IS curve left, leading to decreased equilibrium output and interest rate levels.

Monetary Policy

• Monetary contraction (or tightening): Decreases the money supply.

• Monetary expansion: Increases the money supply.

• Monetary policy affects the LM curve only. An increase in the money supply shifts the LM curve downward.

Assumption: Central bank keeps $M$ fixed.

Effects of Monetary Expansion

Monetary expansion leads to higher output and a lower interest rate.

Summary of Fiscal and Monetary Policy Effects

Policy Mix

• Monetary and fiscal policies are often combined.

• The combination is known as the monetary-fiscal policy mix (or policy mix).

• Consider fiscal contraction ($\downarrow G$or$\uparrow T$) with two monetary policy approaches:</p><ol><li><p>Central bank keeps$M$constant.</p></li><li><p>$i$constant at$i_0$(common; central banks set$i$and allow$M$$ to adjust).

Fiscal Contraction with Constant Interest Rate

Fiscal contraction leads to lower output if the central bank maintains a constant interest rate.

Australian Policy Mix Examples (1986–2012)

1. Hawke–Johnston/Fraser (1986–91): Tight fiscal, tight monetary.

2. Keating–Fraser (1991–96): Easy fiscal, easy monetary.

3. Howard–Macfarlane (1996–2002): Tight fiscal, easy monetary.

4. Howard–Macfarlane/Stevens (2002–2008): Tight fiscal, tight monetary.

5. Rudd/Gillard–Stevens (2008–12): Easy fiscal, easy monetary.

Specific Policy Mixes in Australia

• Hawke–Johnston/Fraser (1986–91): Caused the 1990–91 recession.

• Keating–Fraser (1991–96): Helped Australia recover from the 1991 recession.

• Howard–Macfarlane (1996–2002): Allowed modest output growth.

• Howard–Macfarlane (2002–2008): Enabled growth without hitting capacity constraints.

• Rudd/Gillard–Stevens (2008–12): Addressed the global financial crisis, mining boom further shifted IS curve right.

US Recession of 2001

[Content regarding policy responses to the US Recession of 2001 is not detailed in the provided slides.]

How the IS-LM Model Fits the Facts

In the short run, increasing the federal funds rate decreases output and increases unemployment, with minimal effect on the price level. There's a confidence band indicating the range within which the true value lies with 60% probability.