Equilibrium in the IS-LM model

The IS curve represents the r

equilibrium in the market of LM
goods.
Y C(Y T) I(r) G
r1
The LM curve represents the
in the money market.
M P L(r,Y) IS
Y
The intersection determines the combination Y1
unique ofY,rque satisfies the equilibrium in
both markets.

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0
 Analysis of economic policy with
the IS-LM model
Y C(Y T) I(r) G r
LM
M P L(r,Y)

We can use the model

IS-LM to analyze the r1
effects of
Fiscal policy: Gy/oT IS
Monetary policy: M Y
Y1

Slide
1
An increase in purchases of
State
r
LM
It moves to the right
1 r2
for G
1-PMC 2.
r1
causing an increase
of the production and the income 1. IS2
This increases demand IS1
of money, raising the Y
interest rates... Y1Y2
3.
3.…which reduces the investment by
that the final increase in Y
increase in G causes a
is less than G shift of the IS curve to the
1-PMC right equals to ( G)/(1-PMC).
Slide
2
A tax cut r
LM

Consumers save r2
(1PMC) of the cut, for the r1
that the initial growth of
spending is lower with Tque 1. IS2
with a Equal... IS1
2.
The curve shifts Y
Y1 Y2
P MC 2.
1. T
1 PMC fall in T causes a
displacement to the
2. ...then, the effect on right in the curveISequal
Yes, younger for Tque a (-PMC T)/(1 -PMC).
for a Equal.
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3
 Monetary policy: An increase
enM
r
1. M> 0 displaces the LM1
curveLMdown (or to
LM2
the right)
r1
2.…provoking a
fall of the type of r2
interest
3.…what increases the IS
investment Y
Y1 Y2
provoking a
increase of the interest rates are inversely
related to bond prices
profit and rent.
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4
 The interaction between policies
fiscal and monetary
. In the model:
The variables of fiscal and monetary policy
(M,G,T) are exogenous.
. In the real world:
Those who formulate monetary policy can adjust
in response to changes in fiscal policy, or vice versa.
. This interaction can alter the impact of change.
original of the policy.

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5
 The responses of the Central Bank to
G> 0

. Assume that the government increases G.

. Possible responses from the Central Bank:
[Link]
2. Keep constant
[Link] And Constant
. In each case, the effects of Gson
different

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6
 Response 1: It remains
constant
If the government raises G, r
It moves to the LM1
right.
If the BC maintains
r2
constant, thenLM r1
it does not move.
IS2
Resultados:
IS1
Y Y2 Y1 Y
Y1Y2
r r2 r1

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7
 Response 2: it is maintained
constant
If the government raises r
It moves to the LM1
right. LM2
To keep constant
r, the BC increases My r2
move it r1
right.
IS2
Resultados: IS1
Y Y3 Y1 Y
Y1Y2 Y3

r 0

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8
 Response 3: Yes, it remains
constant
If Congress raises G, r LM2
It moves to the LM1
right.
To maintain r3
constant, the BC reduces r2
My LM moves towards r1
the left.
IS2
Resultados: IS1
Y 0 Y
Y1Y2
r r3 r1

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9
Estimates of fiscal policy multipliers
From the DRI macroeconometric model

Value Valor
Hypothesis about the estimated of estimated of
monetary policy Y/ G Y/ T

The BC keeps constant the

money offer 0.60 0.26

The BC keeps constant the

interest rate 1.93 1.19

The government spending multiplier (for a money supply

constant) is 1/(1-PMC) while the tax multiplier is
only (-PMC)/(1-PMC). Slide
10
 Perturbations in the model
IS-LM
Disturbances on IS: exogenous changes
in the demand for goods and services.
Examples:
. A "boom" or "crash" in the market of
values
changes in household wealth
C
. Change in trust or expectations of
the consumers or the entrepreneurs
Iyears old C

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11
 Disturbances in the model
IS-LM
Perturbations on LM: changes
exogenous factors in the demand for money.

Examples:
. A wave of credit card fraud
increases the demand for money.
. More ATMs or the Internet reduce the
demand for money.

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12
EXERCISE:
Analysis of the disturbances with the
IS-LM model
Use the IS-LM model to analyze the effects of
A "boom" in the stock market that enriches the
consumers.
2. After a wave of credit card frauds, the
consumers use cash more frequently in their
transactions.
For each disturbance,
[Link] the IS-LM diagram to show the effects of the disturbance
aboutY, r.
[Link] what happens to C,I, and the unemployment rate.

disturbances and economic policies can potentially affect

all the endogenous variables of the model, not just those that are measured in the
axes. Slide
13
Answers:
The IS shifts to the right because the consumer feels that they can
spend more given the exogenous growth in their wealth, which causes that
Y, they increase.

1b. C increases for two reasons: The stock market 'boom' and the
increase in rent. I falls, because r is greater. u falls, because the
companies hire more workers to produce the amount of
extra production that is demanded.

2a. "(This is a continuation of the class exercise at the end of the

presentation of ch.10). The increase in the demand for money shifts the
LM curve to the left: We are assuming that all the others
exogenous variables, including M and P do not change so an increase in
the demand for money causes an increase in the value of r associated with each
value of Y (this can be easily seen using the diagram of
preference for liquidity). This shifts upwards (i.e., towards the
left) the LM curve. This causes Y to decrease and r to increase.

The drop in income causes a drop in C. The increase in r causes

a fall of I. The fall of Y causes an increase of u.
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14
 PRACTICAL CASE:
The recession in the United States in the year 2001

. During 2001,
. 2.1 million people lost their jobs,
and unemployment increased from 3.9% to 5.8%.
. GDP growth was only 0.8%.
(compared to the average annual 3.9% of
growth in the period 1994-2000.

CHAPTER 11 The Aggregate Demand II Slide

15
 PRACTICAL CASE:
The recession in the United States in the year 2001

. Causes: 1) A fall in the market of

values C
1500
Standard & Poor’s
1200 500

900

600

300
1995 1996 1997 1998 1999 2000 2001 2002 2003
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16
 PRACTICAL CASE:
The recession in the United States in the year 2001

. Causes: 2) 11/9
. The uncertainty has increased.
. Fall in consumer and business confidence
. Result: Lower spending, the IS curve shifts towards
the left
. Causas: 3) Escándalos contables
. Enron, WorldCom, etc.
. They reduced stock prices and discouraged the
investment

CHAPTER 11 Aggregate Demand II Slide

17
PRACTICAL CASE:
The recession in the United States in the year 2001

. Response of fiscal policy: Shifted the

curve to the right
. Tax cuts in 2001 and 2003
. Increase in expenses
. Subsidies to the aviation industry
. Reconstruction of New York
. War in Afghanistan

war means an expansionary fiscal policy that increases demand

aggregated and alleviates or ends recessions. Slide
18
PRACTICAL CASE: The recession in the United States in 2001

. Response of monetary policy (less tight):

Shift the LM curve to the right, causing a
fall in interest rates

7
6
Three-month
T-Bill Rate
5
4
3
2
1
0

Slide
19
 What is the policy instrument?
from the Central Bank?
. The press usually reports on changes in
Central Bank policy as changes in interest rates
interest, as if the Central Bank had direct control
about market interest rates.
. In fact, the Central Bank sets as its objective the type of
interest that banks charge each other for deposits
of a day.
. The Central Bank changes the money supply and shifts
the curveLM to reach its goal.
. The other short-term types generally
they move according to the type set by the Central Bank.
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20
 What is the policy instrument
from the Central Bank?
Why does the Central Bank set as a target the
interest rates instead of the money supply?
They are easier to measure than the supply of
money.
The BC may think that the disturbances
about the LM curve are more common than the
disturbances on the IS curve. If this is
So, then set as a goal the types of
Interest stabilizes the economy better than fixing
as the objective of the money supply.

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21
 IS-LMy the aggregate demand
. So far, we have used the IS-LM model.
to analyze the short term, when the level
prices are supposed to be fixed.

. However, a change in would displace the

Therefore, it would affect the curve.

. The aggregate demand curve

(introduced in Chap. 9) captures this
relationship between P and Y.

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22
Let's derive the curved one
r LM(P2)
Intuition about the slope of the curve
DA: LM(P1)
P (M/P)
LMa la
IS
left
Y2 Y1 Y
r
I

M: it is an exogenous policy variable.

YES
Small feet: Relatively small feet Y2Y1 Y
large and LM curve further to the right

Large feet: Relatively large feet

small and curve LM is more to the
Slide
left. 23
 Monetary policy and the curve
YES
r LM(M1/P1)
The BC can increase the
r1 LM(M2/P1)
aggregate demand:
r2
M The right side
IS
r
Y1 Y2 Y
P
I
Ypara each P1
value of P
YES2
DA1
Y1Y2 Y

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24
 Fiscal policy and the curveDA
r LM
A fiscal policy
expansive Gy/o T ) r2
increases the demand r1 IS2
added
IS1
T C Y1 Y2 Y
P
Turn right
For each P1
value yes2
deP YES1
Y1Y2 Y

CHAPTER 11 Aggregate Demand II Slide

25
 IS-LMyDA-OA
in the short and long term
Remember from Chapter 9: The force that moves the
the economy from the short to the long term is the adjustment
gradual increase in prices.

In balance at Over time,

short term, yes the price level

Y Y Will increase
Y Y It will fall

Y Y It will remain constant

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26
 Los efectos a corto y largo plazo de una
disturbance over IS
r OALP LM(P )
1

A disturbance IS1
negative about the curve IS2
IS displaces IS and DA to
the left Y Y
causing a fall P OALP
deY
P1 OACP1

CP= corto plazo,LP= largo plazo DA1

DA2
Y Y
Slide
27
 The short-term and long-term effects of a
perturbation on IS
r OALP LM(P )
1

In the new eq. to

short term Y Y IS1
IS2
Y Y
P OALP
P1 OACP1

AD1
YES2
Y Y
Slide
28
 The short-term and long-term effects of a
disturbance overIS
r OALP LM(P )
1

In the new eq. to

short term Y Y IS1
IS2
Y Y
Over time, Pcae
gradually, what P OALP
provokes P1 OACP1
Download the OACP.
Increases M/Plo which AD1
lower the curveLM. DA2
Y Y
Slide
29
 The short-term and long-term effects of a
disturbance over IS
r OALP LM(P )
1
LM(P2)

IS1
IS2
Y Y
With time, Pcae
gradually, what P OALP
provokes P1 Short Run Aggregate Supply1
Download the OACP. P2 OACP2
Increases M/Plo which AD1
lower the curveLM. YES2
Y Y
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30
 The short and long-term effects of a
disturbance over IS
r OALP LM(P )
1
LM(P2)

This process continues IS1

until the economy IS2
it reaches its wide eq. Y Y
deadline with
Y Y P OALP
P1 SRAS1

P2 OACP2

other endogenous variables (C, I, AD1

in the short and long term. YES2
Y Y
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31
EXERCISE:
Analyze the short and long-term effects of M
a. Draw the IS-LM diagrams
AD-AS as shown here.
b. Suppose that the BC increases M. r OALP LM(M /P )
1 1
Show the short-term effect
in their graphs.
c. Show what happens in the
transition from short to long IS
deadline.
d. What are the new values?
long-term equilibrium of the Y Y
endogenous variables
compared to the values P OALP
initials?

P1 OACP1

YES1
Y Y
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32
The Great Depression
There is a very strong negative correlation between production and unemployment.
2. Magnitude of the drop in production and the increase in unemployment

240 30
Unemployment
220 (scale 25
right)
200 20

180 15

160 10
PNB Real
140 (scale 5
left)
120 0
1929 1931 1933 1935 1937 1939 Slide
33
 The spending hypothesis: disturbances of
the IS curve

. It argues that the Depression was largely due to

measure to an exogenous drop in demand of
goods and services that were displaced towards the
left the curveIS.
. Evidence:
Production and interest rates fell, and
this is precisely what would provoke a
leftward shift of the IS curve.

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34
 The spending hypothesis: reasons for it
shift of the IS curve

. Crash in the stock market Exogenous C

. Oct-Dec 1929: S&P 500 fell 17%
. Oct 1929-Dec 1933: S&P 500 fell 71%
. Decline in investment
. Correction after overbuilding in the 1920s
. The widespread banking collapse made it more difficult
obtain financing to invest
. Contractionary fiscal policy
. The government increased tax rates and reduced
the spending to combat the increase in the deficit.

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35
 The monetary hypothesis: a disturbance
from the curveLM

. He argues that the Depression was largely due to

a huge drop in the money supply.
. Evidence:
M1 fell by 25% during 1929-33.
. Pero hay dos problemas con esta hipótesis:
. It fell even more, which slightly increased.
during 1929-31.
. Nominal interest rates fell, which is
opposite to the effect that a displacement would cause
to the left of the LM curve.

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36
The monetary hypothesis, again: the effects
from the price drop

. He claims that the Depression was so severe

due to the enormous deflation experienced:
It fell by 25% during 1929-33.
. This deflation was probably caused by
a drop in M, so it is possible that the
money has played an important role
after all.
. In what ways does deflation affect the
economy?
Slide
37
 The monetary hypothesis, again: the
effects of price drop

. The stabilizing effects of deflation:

. P (M/P) It moves to the right Y
. The Pigou effect:
P (M/P)
The wealth of consumers
C
It moves to the right
Y

Slide
38
 The monetary hypothesis, again: the
effects of price drop

. The destabilizing effects of deflation

expected
e

r for each value of i

I because I=I(r)
Planned expenditure and aggregate demand
Rent and production

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39
 The monetary hypothesis, again: the
effects of falling prices
. The destabilizing effects of unexpected deflation:
a theory of debt-deflation
P(if it is unexpected)
Transfer purchasing power from the debtors to the
creditors
Debtors spend less, creditors spend
more
If the propensity to spend of debtors is greater
than that of the creditors, then the aggregate expenditure
the curve shifts to the left, and falls.

Slide
40
Why another depression is unlikely
. Quienes formulan la política económica (o sus asesores) saben ahora
much more than macroeconomics:
. The Federal Reserve knows how to do more than just let things fall too much.
especially during a contraction.
. Those who formulate fiscal policy know how to do more than just increase.
taxes or cutting spending during a contraction.
. The guarantees of deposits make bankruptcy very unlikely.
generalized banking.
. Automatic stabilizers make fiscal policy expansive
during an economic downturn.
.Examples of automatic stabilizers:
Income tax: People pay less taxes
automatically if your rents fall.
Unemployment insurance: They prevent income – and therefore spending –
they fall too much during a recession.
Slide
41
 Resumen

1. The IS-LM model

. A theory of aggregate demand
. Exogenous variables: M, G, T,
Short-term Pexógeno, now long-term
. Endogenous variables: r,
Yendógeno a corto plazo,Pa largo plazo
. CurvaIS: Equilibrium in the goods market
. CurvaLM: Equilibrium in the money market

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42
 Summary

[Link] curveAD
. Show the relationship between Py and the equilibrium of the IS model
LM.
. It has a negative balance because
P (M/P) r I Y
. An expansionary fiscal policy shifts the IS curve to the
right, raises the rent and shifts the AD curve to the right.
. An expansive monetary policy shifts the LM curve to the
right, increases the rent and shifts the AD curve to the right.
. The disturbances on the ISoLM curves displace the
curveAD.

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43