Macroeconomics

1
Macroeconomics

• Lecture 6
• The IS-LM model.

2
Outline

• General equilibrium in goods and money markets.
• Economic policy
• fiscal policy
• On the effectiveness of economic policy.

3
The IS-LM model
The IS curve represents combinations of r and Y
at which the goods market (as described by the
Keynesian Cross) is at equilibrium
The LM curve represents combinations of r and Y
at which the market for real money balances is at
equilibrium
The IS-LM model characterises combinations of r
and Y at which the market for real money
balances and the goods market are jointly at
equilibrium.
4
Endogenous
Candidate endogenous
Policy variables
Business cycle
r Y
Behavioural parameters
5
1. EDM, so r up
2. Unplanned I run-down, so Y up
A
3. EDM, so r up
4. Unplanned I run-down, so Y up
4
3
and so on.
2
1
Comparative static analysis.
The stories we tell
The interest rate adjusts fast to clear money
market and then firms adjust output to clear the
goods market more slowly.
6
Active fiscal policy
The policy instruments
The methods of financing

• Deficit financing
• Tax financing
• Get the central bank to print money

spending
financing
Treasury
Deliver public goods
Tax financing
Buy factors of production
Taxes
sell bonds
Deliver public goods
deficit financing
Buy factors of production
Money
Deficit financing via bonds sale does not affect
M.
7
Deficit financed expansion of G
C
A
B
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How large is the impact on Y?
Large crowding out effect fiscal
policy ineffective.
C
Impact in Keynesian Cross model
A
B
crowding out
9
Crowding out
h
k
b
Goods market
money market
large crowding out effect
large k
large b
small h



The Government Spending Multiplier
The effect on Y when G changes and the interest
rate is allowed to adjust to its equilibrium level
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Effectiveness of fiscal policy
Ineffective
Effective
Parameters
Effect
large
small
Crowding out
Keynesian multiplier
small
large
shallow
Slope of IS
steep
steep
Slope of LM
shallow
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The impact of fiscal policy on GDP and its
composition.
Keynesian Cross
Classical
IS-LM
1
1
1
0


-1
0
-
0


The increase in the interest rate crowds out
private investment but not 100.
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Active Fiscal Policy

• Deficit financed expansion of G is effective in
  increasing output (and employment) if the
  crowding out effect is small
• Real money demand insensitive to Y
• Real money demand sensitive to r.
• Investments insensitive to r

13
Tax financed expansion of G
C
D
A
B
Deficit financed expansions are more effective
than tax financed expansions.
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Caveats

• The IS-LM model shows the circumstances under
  which active fiscal policy can, in principle,
  affect the level of activity (in a closed economy
  with a fixed price level), but this does not
  necessarily imply that it, in practice, can be
  used to stabilise the business cycle.
• Automatic stabiliser are important, not the least
  because of restrictions on debt financing of
  public spending.

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What is next?

• Monetary policy and the Keynesian transmission
  mechanism.
• Interest control versus money control.