Motivation
- Discuss how are output and the interest rate determined simultaneously in the short run
- Both goods and financial markets are connected. IS-LM model: a framework to think about how output and the interest rate are determined in the short run
In short run:
- Equilibrium in the goods market determines output
- Characterised by the condition that supply equals demand for goods
- Key assumptions: interest rate is given and didn’t affect output
- Equilibrium in the money market determines interest rate
- Characterised by the condition that the supply equals the demand for money
- Key assumptions: output was given
IS Relation
Definition of the demand for goods:
We assume consumption as a function of disposable income
We characterised equilibrium in the goods market as
Thus, (IS relation)
- To consider the simultaneous determination of Y and i, we need the interest rate to affect the equilibrium in the goods market
- Focus on the effects of the interest rate on investment and take as exogenous
- Although can affect consumption, we do not consider it now.
Investment and the Interest Rate
Investmend depends primarily on two factors:
- level of sales: higher sales → higher investment
- interest rate: higher interest rate → lower investment
Thus,
Determination of Output
for any given value of the interest rate, an increase in output generates: and
Equilibrium in the Goods Market
The IS Curve - relation between interest rate and equilibrium output (supply)
Brain teaser:
- As we move down along the IS curve, investment increases and private saving increases
- lower interest rate implies higher investment. Given the level of taxes and that income increases faster than consumption along the IS due to the propensity to consumption being smaller than one, then private saving also increases.
Shift of the IS Curve: when
Shift Directions:
- Shift to the left: any factor that, for a given interest rate, decreases the equilibrium level of output
- Shift to the right: any factor that, for a given interest rate, increases the equilibrium level of output
LM Relation
- Recall that the interest rate is determined when the supply equals the demand for money:
⇒ real money supply equals real money demand (Y = Y*P: nominal GDP = real GDP * GDP deflator)
When CB is conducting monetary policy, there are two choice:
- Choice of the money supply M
- Choice of the interest rate i
Choice of M
For a given money supply, an increase in output generates:
- real money demand
- the interest must increase so the real money demand remains equal to the real money supply
Thus, for a given money supply, an income increase leads to an interest rate increase (LM relation)
Note: if the government want to increase output through government spending, it is equal to increase the real money supply
An increase in money supply (for a given level of prices) causes the LM to shift down
Choice of i
Monetary policy: choosing the level of the interest rate i
- most CBs nowadays, choose the interest rate and adjust the money supply to achieve it
- This will make the interest rate exogenous, denote it as
IS-LM Model
Assume that CB chooses the interest rate
Implications: Fiscal Policy (FP)
- Fiscal Expansion: Increase in G or decrease in T
- Fiscal Contraction: Decrease in G-T or increase in T
Exp. The effects of an increase in Taxes
- IM relation:
- IS relation:
Implications: Monetary Policy (MP)
- Monetary Expansion:
- Decrease in i increase in M
- Monetary Contraction (Tightening):
- Increase in i decrease in M
Exp. The effects of a decrease in i
- IM relation:
- IS relation:
Monetary and Fiscal policy together
Policy Mix 1
- Suppose the economy is in a recession and output is too low
- FP: decrease Taxes, MP: decrease interest rate
Policy Mix 2
- Suppose government is running a large budget deficit and would like to reduce it, but does not want to trigger a recession
- Fiscal can be used to achieve better fiscal “health”, and monetary policy to offset the decrease in output.
Maintaining money supply constant v.s. Maintaining interest rate constant
If all economic shocks arise from exogenous changes in the demand for goods and services. Then all shocks shift the IS curve. Suppose a shock causes the IS curve to shift from IS1 to IS2. The effect undert two policies is shown as below. With a constant money supply, tha change in the interest rate, the change in the interest rate partially offsets the change in output. Wiht a constant interest rate, this offsetting effect is absent, so output flucturates more. Thus, if all shocks are to the IS curve, then the Bank of England should follow a policy of keeping the money supply constant.
If all economic shocks arise from exogenous changes in the demand for money. Then all shocks shift the LM curve. The below figure shows the effects of the two policies. With the money supply held constant, shifts in the LM curve lead to changes in output. With the constant interest rate, the LM curve does not shift in response to money demand shocks because the CB immediately adjusts the money supply to satisfy demand at the given interest rate. There is no effect on output. Thus, if all shocks are to the LM curve, the CB should adjust the money supply to hold the interest rate constant, thereby stabilizing output.
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