Macroeconomics by O' Blanchard

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Macroeconomics by O. Blanchard

• Chapter 5
• Goods and Financial markets
• The IS-LM model

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Learning Objectives

• The IS curve
• The LM curve
• Fiscal and monetary policy in the IS-LM model

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Deriving the IS curve

• Def All combinations of r and Y that result
  in the goods market equilibrium.
• The goods market equilibrium
• YC(Y-T)I(Y,i)G

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The equilibrium value of income
E planned expenditure
E Y
E
income, output, Y
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An increase in the demand for goods
E Y
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Deriving the IS curve
E Y
E C I (r2 )G

E C I (r1 )G

Y2
Y1
r1
r2
IS
Y2
Y1
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The IS curve and the Loanable Funds model
(a) The L.F. model
(b) The IS curve
r2
r2
r1
r1
IS
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Shifting the IS curve ?G
E Y
E2

E1
Y2
Y1
r1
IS2
IS1
Y2
Y1
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Exercise Shifting the IS curve

• Use the diagram of the Keynesian Cross or
  Loanable Funds model to show how an increase in
  taxes shifts the IS curve.

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Equilibrium
r interest rate
r1
L (r )
M/P real money balances
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The LM curve

The equation for the LM curve is
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Deriving the LM curve
(a) The market for real money balances
(b) The LM curve
r2
r2
r1
r1
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How the Fed raises the interest rate
r interest rate
r2
r1
L (r )
M/P real money balances
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How ?M shifts the LM curve
(a) The market for real money balances
(b) The LM curve
r2
r2
r1
r1
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Exercise Shifting the LM curve

• Suppose a wave of credit card fraud causes
  consumers to use cash more frequently in
  transactions.
• Use the Liquidity Preference model to show how
  these events shift the LM curve.

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The short-run equilibrium

Equilibrium interest rate
Equilibrium level of income
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An increase in government purchases

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A tax cut
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Expansionary Fiscal Policy

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Contractionary Fiscal policy

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Monetary Policy an increase in M

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Interaction between monetary fiscal policy

• Model up to now, we have studied monetary
  fiscal policy independently, holding other
  exogenous variables constant.
• Real world Monetary policymakers may adjust M
  in response to changes in fiscal policy, or
  vice versa.

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The Feds response to ?G gt 0

• Suppose Congress increases G.
• Possible Fed responses
• 1. hold M constant
• 2. hold r constant
• 3. hold Y constant
• In each case, the effects of the ?G are
  different

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Response 1 hold M constant
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Response 2 hold r constant
r2
r1
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Response 3 hold Y constant
r2
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Estimates of fiscal policy multipliers

• from the DRI macroeconometric model

Estimated value of ?Y / ?G
Estimated value of ?Y / ?T (?T lt0)
Assumption about monetary policy
Fed holds money supply constant
0.60
0.26
Fed holds nominal interest rate constant
1.93
1.19
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CASE STUDY The U.S. economic slowdown of 2001

• - What happened
• Shocks that contributed to the slowdown and their
  consequences according to the ISLM model
• The Policy response and their effect according to
  the ISLM model

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Accommodative monetary policy
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The end of the accommodative monetary policy
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The Feds policy instrument

• The Fed Funds rate or the Money Supply?
• The feds policy and the LM curve

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The Feds policy instrument

• Why does the Fed target interest rates instead
  of the money supply?
• 1) They are easier to measure than the money
  supply
• The Fed might believe that LM shocks are more
  prevalent than IS shocks. If so, then targeting
  the interest rate stabilizes income better than
  targeting the money supply
• Exercise

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How does IS-LM fits the facts?

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The Big Picture
KeynesianCross
IScurve
IS-LMmodel
Explanation of short-run fluctuations
Theory of Liquidity Preference
LM curve
Agg. demandcurve
Model of Agg. Demand and Agg. Supply
Agg. supplycurve