Lecture 5_ISLM

Lecture 5: Goods and Financial Markets - The IS-LM Model

Overview

• Goods and financial markets are interconnected through the IS-LM model.

• The IS-LM model is fundamental in understanding the economic equilibrium in the short run.

Key Components

• Goods Market: Involves the relationship between investment and savings.

• Financial Market: Involves the demand and supply for money.

Page 1: Introduction to the IS-LM Model

• Depicts interactions between goods and money markets.

• Visualization considers the impact of investment and liquidity on money supply.

Page 2: Review of Money Supply and Demand

• Money Supply (𝑀𝑆) is controlled by the central bank (CB) through open market operations.

• Money Demand (𝑀𝐷) is defined as:𝑀𝐷 = $𝑌 𝐿(𝑖)

• High interest rate (𝑖) increases bond attractiveness, leading to lower money demand.

• Equilibrium condition for money market:𝑀𝑆 = 𝑀𝐷.

• Changes in 𝑀𝑆 allow the CB to influence 𝑖.

Page 3: Contractionary Monetary Policy

• Contractionary Monetary Policy (MP): CB sells bonds, reducing circulation of money.

• Consequences of decreased money supply:

  • Interest rates rise

  • Demand for money decreases.

Page 4: Outline of the IS-LM Model

• History of the IS-LM model and its evolution.

• Derivations involved in the model.

• Examination of the Goods Market and IS Relation.

• Financial Markets and the LM Relation.

• Applications of monetary and fiscal policies in the model.

Page 5: IS-LM Model Continued

• Further discussion on key components:

  • Fiscal policies

  • Monetary policies

  • How they mix in the IS-LM framework.

Page 6: Keynes and the Great Depression

• Keynes published "General Theory of Employment, Interest, and Money" in 1936.

• Key emphasis: Aggregate demand's role in determining output in the short run.

• Model referred to as the Keynesian cross, where output (𝑌) relies on demand (𝑍).

Page 7: Hicks, Hansen, and IS-LM Model

• John Hicks recognized Keynes’ contributions, particularly regarding goods and financial markets.

• Alvin Hansen extended Hicks' ideas in the 1940s, formalizing the IS-LM model.

• The model continues to be relevant after 70 years of development.

Page 8: The Short Run Implications

• The IS-LM model efficiently describes short-run economic conditions.

• Prices are considered sticky and do not change quickly to new economic conditions.

• Unrealistic to assume constant prices over long periods, but acceptable for many economic events.

Page 11: The Goods Market and IS Relation

• Demand (𝑍) = 𝐶 + 𝐼 + 𝐺Where:

  • 𝐶 = Consumption

  • 𝐼 = Investment

  • 𝐺 = Government spending

• Supply equals income (𝑌).

• Investment is not constant; depends on sales levels.

• As 𝑌 increases, investment (𝐼) increases, leading to borrowing dependent on interest rate effects.

Page 12: Real GDP and Investment

• 𝑌 (real GDP) and 𝐼 (investment) trend together; however, 𝐼 tends to fluctuate more.

• Despite its smaller share in GDP, investment significantly affects economic health.

Page 13: The Goods Market Equilibrium

• Equilibrium occurs when total demand (𝑍) equals total output (𝑌).

• It is characterized by the marginal propensity to consume (MPC) and invest (MPI) being less than 1.

Page 15: Effects of Rising Interest Rates

• When interest rates increase, downward shifts in the 𝑍 curve lead to decreased equilibrium output (𝑌).

• Highlighted negative relationship: as interest rates climb, output tends to fall.

Page 16: The IS Curve Dynamics

• The IS curve represents equilibrium, where investment equals savings and taxes account for government borrowing and spending.

• Lower interest rates (𝑖 ↓) result in higher equilibrium output (𝑌 ↑).

Page 23: IS and LM Curves Representation

• Each point on the IS curve shows goods market equilibrium.

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

Page 24: General Equilibrium in Short Run

• Y = C(Y - T) + I(Y, i) + G

• Equilibrium is achieved where IS curve and LM curve intersect, indicating balance in both markets.

Page 26: Fiscal Contraction

• An increase in taxes (𝑇 ↑) to reduce budget deficits affects output negatively, leading to a leftward IS curve shift.

• Consider short-run and long-run implications:

  • Short-run: potential reduction in economic strength

  • Long-run: focus on debt sustainability.

Page 30: Tax Impact on IS Curve

• Increased taxes will reduce goods market equilibrium output, shifting the IS curve leftward.

Page 36: Monetary Policy Changes

• Monetary easing involves lowering interest rates by increasing the money supply (𝑀𝑆).

• Contraction results in increasing interest rates (𝑖 ↑) through decreasing money supply (𝑀𝑆 ↓).

Page 43: Case Study: Fiscal Consolidation and Monetary Expansion

• Historical examination of Bill Clinton’s policies to reduce budget deficits via tax increases and spending cuts while pursuing monetary expansion to stabilize output.

Page 46: Next Class Preview

• Future discussions will focus on the labor market, transitioning from the demand to the supply side of the economy.