Goods and Financial Markets1: IS-LM

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Goods and Financial Markets1 IS-LM

• Goal link the goods and the financial markets
  into a more general model that will determine the
  equilibrium and the equilibrium in the
  economy (with
  prices)
• The goods market will be represented by the
• curve (standing for investment-savings)
• The financial markets (money market) will be
  represented by the curve (liquidity-money)
  
• 1. The Hicks-Hansen model based on Keynes
  General Theory

2
The goods market - IS curve

• Equilibrium condition
• will provide
  the link to the financial markets
• Determinants of investment
• If
  increase, producers might want to increase their
  productive capacity by investing in capital
  goods.
• If ,
  producers find that borrowing to add new capital
  becomes more expensive

3

• Equilibrium in the goods market becomes
• Y
• Basically
• When i I and Ye
• When i I and Ye
• The ZZ curve shifts now as the interest rate
  changes and a multiplier effect takes place
• If MPI is the marginal propensity to invest out
  of new income, assume that MPC MPI lt 1
• The slope of the ZZ curve is now
  and the interest rate is included in the
  intercept

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Construction of the IS curve
Z
When the interest rate increases, I (Y, i)
drops and the ZZ curve shifts down. The economy
contracts from Ye to Ye. E and E correspond
to 2 combinations of i and Y, such that the good
market is in equilibrium.
i
Y
Ye
Ye
i
i
i
Y
Ye
Ye
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The IS curve

• Y
• Definition All the combinations
  
• i.e. the above equation is satisfied
• Shift of the IS A change in any of the
  
• 
  in the equation will cause IS to shift.
• Shift variables
• (confidence variables)
• (fiscal policy variables)

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Expansionary fiscal policy increase in G
YZ
Z
ZZ (G)
When G increases by ?G, ZZ shifts up and IS
shifts to the right. An increase in T would has
the opposite effect as it is contractionary.
Y
Ye
i
E
i
IS
Y
Ye
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Shifts of IS
Expansionary
i
G T c0 I0
G T c0 I0
Contractionary
IS
Y
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The financial markets - LM curve

• Equilibrium condition1
• supply of money demand for money
• Ms or Ms/P
• (Ms/P is the real money supply)
• It is clear that both LM and IS are relations
  between i and Y
• 1. The bonds market is automatically in
  equilibrium when the money market is in
  equilibrium

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Construction of the LM curve
Ms
i
i
i0
Md(Y0)
M/P
Y0 Y1
Y
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The LM curve

• Ms
• Definition All the combinations of and
  such that the (
  and
• ) are in equilibrium
• Shift of the LM curve a change in the money
  or a change in or an exogenous
  shift in the money demand
• An in the money supply
  ( or a
• in price) is expansionary
• A change in the velocity of money

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Expansionary monetary policy an increase in Ms
Ms
i
LM
i
A
i0
Md(Y0)
M/P
Y0
Y
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Shifts of LM
Contractionary
i
LM
Ms P V
Ms P V
Expansionary
Y
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The IS-LM model

• Y IS curve
• M/P LM curve
• IS is sloped and LM
  is
• sloped, they will intercept
  in E determining Y and i in equilibrium.
• At that point, all three markets
• two financial markets and the goods market, are
  

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The IS-LM graph
i
Y
15

• Problem 4
• IS-LM model
• C 200 .25YD
• I 150 .25Y - 1000i
• G 250 and T 200
• (M/P)d 2Y - 8000i
• M/P 1,600

IS
LM
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• Derive the IS curve Y C I G
• Y 200 .25Y- .25T 150 .25Y - 1000i 250
• 550 .5Y - 1000i
• Y - .5Y 550 - 1000i
• Y (1 - .5) 550 - 1000i
• Y 1/.5 (550 -1000i) multiplier 2
• IS curve Y 1100 - 2000i

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• Derive the LM curve YL(i) M/P
• 2Y - 8000i 1600
• 8000i 2Y - 1600
• LM curve i Y/4000 - .2
• c. Solve IS-LM for equilibrium Y
• Y 1100 -2000i
• 1100 - 2000(Y/4000 - .2)
• 1100 - .5Y 400
• 1.5Y 1500 so Y 1000

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• i Y/4000 - .2
• 1000/4000 - .2
• .25 - .2 .05 so i 5
• Replace equilibrium Y and i into C and I
• C 200 .251000 - .25200 400
• I 150 .251000 - 1000.05 350
• G 250
• So Y 400 350 250 1000

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Fiscal Policy

• Instruments
• Curve affected
• Effect
• Expansionary when (G-T)
• or G or T
• IS shifts to the
• Contractionary when (G-T)
• or G or T
• IS shifts to the

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A fiscal expansion
The economy moves along the LM curve from A to A
i
LM
ie
A
IS
Y
Ye
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Mechanics of fiscal expansion

• Goods market effects
• As G Y too
  immediately
• Then C and I
  also
• Multiplier effect at same i, Y reaches a higher
  level as IS shifts to the right
• Financial markets effects
• As Y the demand for money M
• and the ward shift in Md results in a
  i, but this is a movement along the
  curve to A.

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• Effect on investment
• As i increases, investment is
  . So there are 2 opposite effects on
  investment
• as Y increases I
• as i increases I
• It means that the overall expansion due to the
  increase in G will be by the
  impact of the increase in the interest rate on
  investment.
• There is some of private
  investment due to the increase in government
  spending.

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Expansionary Fiscal Policy
YZ
Z
ZZ (G)
?G
Y
Ye
Y
Ms
i
LM
i
i
i
i
i
IS
Md
Y
M/P
Ye
Ye
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Net effect of increase in G on investment

• 1.
  Using investmt funct
• as Y increases I
• as i increases I
• Net effect is ambiguous
• 2.
  Using equil condition
• as Y increases Sp
• as G increases (T - G)
• Net effect is ambiguous

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• Problem 5 cont.
• A fiscal expansion G increases to 400
• New IS curve Y 700 .5Y - 1000i
• Y 1/.5 (700 - 1000i)
• 1400 - 2000i
• Same LM curve i Y/4000 - .2
• Solve Y 1400 - 2000(Y/4000 - .2)
• 1.5Y 1800 so Y 1200
• Replace in LM and we get i .10 or 10

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• Calculate the corresponding equilibrium for C I
• C 200 .25Y - .25T 200 300 - 50 450
• I 150 .25Y - 1000i 150 300 - 100 350
• Y C I G 450 350 400 1200
• Impact of fiscal expansion
• both Y and i increase.
• C (a function of Y) increases too.
• I increases when Y increases and decreases when
  i increases (ambiguous results overall).
• With these data, I does not change as the two
  effects neutralize each other.

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Monetary policy

• Instrument
• Curve affected
• Effect
• Expansionary when Ms increases
• LM shifts to the
• Contractionary when Ms is cut
• LM shifts to the

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A monetary contraction
i
LM
A
ie

IS
Y
Ye

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Mechanics of a monetary contraction

• Open market of bonds
• Suppose P1 constant - so monetary contraction in
  terms is equivalent to a
  terms one.
• Financial market effects
• As Ms drops, i - money market
  effect.
• Goods market effects
• As i increases, investment I I(Y,i) is
  affected and Y
  .

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• Effect on investment
• Unambiguous as Y drops and
• i increases,
• investment can only .
• Note that the money demand will shift to the left
  as Y drops dampening the extent of the increase
  in the interest rate on the fall of I and
  subsequently on the fall of Y.

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A monetary contraction
Ms
i
Ms
i
IS
LM
i
Md
Ye
Y
M/P
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• Problem 5 cont.
• g. Monetary expansion M/P increases to 1840
• Same IS curve Y 1100 - 2000i
• New LM curve 2Y - 8000i 1840
• i Y/4000 - 1840/8000
• i Y/4000 - .23
• Solve the IS-LM system
• Y 1100 - 2000(Y/4000 - .23)
• Y 1100 - .5Y - 460
• 1.5 Y 1560 so Y 1040

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• Replace in LM
• i 1040/4000 - .23 so i .03 or 3
• Solve for C and I
• C 410 and I 380
• A monetary expansion reduces i
• and increases Y
• Thus C (function of Y) increases
• and I (function of Y and of i) increases
  unambiguously.

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Policy Mix 1

• To maximize the expansionary (or contractionary)
  impact on the economy, use both expansionary
  monetary and expansionary fiscal policy (or both
  contractionary).

LM
i
IS
Y
Rational
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Policy Mix 2

• To dampen the inflationary impact of an
  expansionary fiscal policy, use at the same time
  contractionary monetary policy.

i
LM
IS
Y
Rational