EC201 LECTURE WEEK 3 MARTZ

Lecture 3: Goods & Financial Markets: The IS-LM Model (Chapter 5)

Overview of Goods Market and IS Relation

• Equilibrium in the goods market:

  • Exists when production $Y$ is equal to the demand for goods $Z$.

  • Previously, in Chapter 3, the interest rate did not affect demand for goods.

  • Equilibrium condition (5-1):

  • $Y = C(Y − T) + I + G$

    • Where:

    • $C$ = consumption function

    • $I$ = investment

    • $G$ = government spending

    • $T$ = taxes

Investment, Sales, and the Interest Rate

• Two factors affecting investment:

  • Level of sales (positive effect)

  • Interest rate (negative effect)

• Investment relation:

  • $I = I(Y,i)$

Determining Output

• Considering the investment relation:

  • New equilibrium condition in the goods market:

  • $I = I(Y,i)$

  • $Y = C(Y − T) + I(Y,i) + G$

Deriving the IS Curve

• Demand for goods is an increasing function of output.

• Equilibrium requirements:

  • Must be that demand for goods equals output.

• IS Curve Characteristics:

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

  • Thus, the IS curve is downward sloping.

Shifts of the IS Curve

• Effects of an increase in taxes:

  • Shifts IS curve to the left.

• Graphical representation:

  • Interest rate (i) on the vertical axis; output (Y) on the horizontal axis.

  • Original IS: IS (for taxes T) and new IS after tax increase: IS' (for T' > T).

Financial Markets and the LM Relation

• The interest rate is determined by the equilibrium condition of money supply and demand:

  • $M =$ nominal money stock

  • $YL(i) =$ demand for money

  • Variables:

  • $Y$ = nominal income

  • $i$ = nominal interest rate

• Assumption for analysis:

  • Central bank keeps $M$ constant; thus, $i$ is market-determined.

  • In future studies, the central bank's role in choosing $i$ will be examined.

• Key formula (5-2):

  • $M = YL(i)$

Real Money, Real Income, and the Interest Rate

• LM Relation:

  • In equilibrium, the real money supply equals real money demand.

  • Related to $Y$ (real income) and $i$ (interest rate):

  • $\frac{M}{P} = YL(i)$

Deriving the LM Curve

• As income increases, at a given interest rate, the demand for money rises.

• Given the money supply, this increase leads to a higher equilibrium interest rate.

• Graphical understanding:

• The LM curve is upward sloping.

Shifts of the LM Curve

• An increase in the money supply will shift the LM curve down.

Integrating IS and LM Relations

• Equilibrium conditions:

  • An increase in the interest rate causes a decrease in output (IS relation).

  • An increase in output causes an increase in the interest rate (LM relation).

• Intersection of IS and LM curves:

  • Both markets (goods and financial) achieve equilibrium.

• Equations Recap:

  • IS relation: $Y = C(Y - T) + I(Y,i) + G$

  • LM relation: $\frac{M}{P} = YL(i)$

Fiscal Policy, Activity, and the Interest Rate

• Fiscal contraction:

  • Refers to fiscal policy aimed at reducing the budget deficit.

• Fiscal expansion:

  • An increase in the deficit.

• Impact of taxes on the curves:

  • Taxes affect the IS curve but do not change the LM curve.

Effects of an Increase in Taxes

• An increase in taxes leads to a leftward shift of the IS curve.

• Results in a decrease in both equilibrium output and equilibrium interest rate.

Monetary Policy, Activity, and the Interest Rate

• Monetary contraction:

  • Refers to a decrease in the money supply.

• Monetary expansion:

  • An increase in the money supply.

• Implication of monetary policy:

  • It does not affect the IS curve, only the LM curve.

• Example: An increase in the money supply shifts the LM curve down.

  • Current assumption: the central bank keeps $M$ fixed.

• Effects of Monetary Expansion:

  • Results in higher output and lower interest rate.

Summary of Fiscal and Monetary Policy Effects

• Table 5.1 presents shifts and movements resulting from changes in fiscal and monetary policies:

  • Increase in Taxes:

  • IS shifts left, LM unchanged, output decreases, interest rate decreases.

  • Decrease in Taxes:

  • IS shifts right, LM unchanged, output increases, interest rate increases.

  • Increase in Spending:

  • IS shifts right, LM unchanged, output increases, interest rate increases.

  • Decrease in Spending:

  • IS shifts left, LM unchanged, output decreases, interest rate decreases.

  • Increase in Money Supply:

  • IS unchanged, LM shifts down, output increases, interest rate decreases.

  • Decrease in Money Supply:

  • IS unchanged, LM shifts up, output decreases, interest rate increases.

Using a Policy Mix

• Monetary and fiscal policies are interdependent and rarely conducted in isolation.

• This combined approach is known as the monetary-fiscal policy mix or simply policy mix.

• Example Scenario:

  • Fiscal contraction (decreasing government spending $G$ or increasing taxes $T$) with two approaches to monetary policy:

  1. Central bank maintains $M$ constant.

  2. Central bank keeps interest rate $i$ constant at $i_0$ (more common practice).

Effects of Fiscal Contraction

• Leads to lower output (from $Y'' < Y'$) if the central bank keeps the interest rate constant.

Australian Policy Mixes (1986–2012)

1. Hawke–Johnston/Fraser:

   • Tight fiscal, tight monetary policy adversely affects output, resulting in recession (1990-91).

2. Keating–Fraser:

   • Easy fiscal, easy monetary policy aids recovery from recession.

3. Howard–Macfarlane (1996–2002):

   • Tight fiscal, easy monetary policy allows modest growth.

4. Howard–Macfarlane/Stevens (2002–2008):

   • Tight fiscal, tight monetary policy enables continued growth without capacity constraints.

5. Rudd/Gillard–Stevens (2008–2012):

   • Response to global financial crisis leads to fiscal and monetary stimuli, shifting the IS curve positively.

Policy Responses to the US Recession of 2001

• Federal Funds Rate Analysis:

  • Historical trend of interest rates from 1999Q1 to 2002Q4 shows a decline in rates as policy responded to recession impact.

• Government revenues and spending:

  • Ratios to GDP analyzed quarterly from 1999Q1 to 2002Q4, indicating patterns in fiscal policy adjustments during recession.

IS-LM Model and Real-World Applications

• Empirical analysis reveals:

  • An increase in the federal funds rate typically decreases output and increases unemployment with little effect on price levels.

  • This reflects the short-run dynamics within the IS-LM model framework, where monetary policy directly influences economic conditions.