AD in Short Run - Is-LM Model (Lecture 13-16)
AD in Short Run - Is-LM Model (Lecture 13-16)
AD in Short Run - Is-LM Model (Lecture 13-16)
Economic Fluctuations-
Aggregate Demand in the Short Run:
IS-LM Model
IS CURVE LM CURVE
LEARNING OBJECTIVE
Average 4
growth
rate 2
-2
-4
1970 1975 1980 1985 1990 1995 2000 2005
Growth rates of real GDP, consumption, investment
Percent 40
change Investment
from 4 30 growth rate
quarter
s earlier 20
Real GDP
10 growth
rate
0
Consumption
-10 growth rate
-20
-30
1970 1975 1980 1985 1990 1995 2000 2005
Time horizons in Macroeconomics
Long run:
Short run:
➢ https://www.youtube.com/watch?v=Xt_L8WFKvLc&ab_c
hannel=YouWillLoveEconomics
When prices are sticky-Keynesian theory
• monetary policy (M )
Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve
The Keynesian Cross
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
planned expenditure: E = C (Y − T ) + I + G
equilibrium condition:
actual expenditure = planned expenditure
Y = E
Graphing planned expenditure
E
planned
expenditure
E =C +I +G
MPC
1
income, output, Y
Graphing the equilibrium condition
E
planned E =Y
expenditure
Actual
expenditure
45
º
income, output, Y
The equilibrium value of income
E
planned E
expenditure =Y
E =C + I +G
income, output, Y
Equilibrium
income
An increase in government purchases
E
At Y1, E =C +I +G2
there is now an
unplanned drop E =C +I +G1
in inventory…
G
…so firms
increase output,
and income Y
rises toward a
new E1 = E2 =
equilibrium. Y1 Y Y2
Solving for Y
Y = C + I + G equilibrium condition
Y = C + I + G in changes
= C + G because I exogenous
= MPC Y + G because C = MPC Y
E
Initially, the tax
increase reduces E =C1 + I +G
consumption, and E =C2 + I +G
therefore E:
eq’m condition in
Y = C + I + G
changes
= C I and G exogenous
= MPC ( Y − T )
Solving for Y : (1 − MPC) Y = − MPC T
− MPC
Final result: Y = T
1 − MPC
The tax multiplier
Y − 0.8 − 0.8
= = = −4
T 1 − 0.8 0.2
The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
Redefining Investment (I)
Y = C (Y − T ) + I (r ) + G
Deriving the IS curve
E E =Y E =C +I (r )+G
2
r I E =C +I (r1 )+G
E I
Y1 Y2 Y
Y r
r1
r2
I
Y1 Y2 S Y
Why the IS curve is negatively sloped
r S2 S1 r
r2 r2
r1 r1
I (r )
IS
S, I Y Y Y
2 1
Fiscal Policy and the IS curve
• We can use the IS-LM model to see how fiscal
policy (G and T ) affects aggregate demand and
output.
The horizontal Y1 Y2 Y
r
distance of the
IS shift equals r
1
1
Y = G
1− MPC Y IS1 IS2
Y1 Y2 Y
The Theory of Liquidity Preference
r
(M P)
s
The supply of interest
real money rate
balances
is fixed:
(M P) =M P
s
M/P
M P
real money
balances
Money demand
r
(M P)
s
Demand for interest
real money rate
balances:
(M P)
d
= L (r )
In short run, it is L (r )
assumed that price
level is fixed. M/P
M P
real money
balances
Equilibrium
The interest rate r
adjusts interest
(M P)
s
to equate the supply rate
and demand for
money:
M P = L (r )
r1
L (r
)
M/P
M P
real money
balances
How the Central Bank raises the interest rate
r
interest
To increase r, rate
Fed reduces M
r2
r1
L (r )
M/P
M2 M1
real money
P P balances
The LM curve
(M P)
d
= L (r ,Y )
High income leads to high expenditure and more
requirement of money which increases money demand.
The LM curve is a graph of all combinations of r
and Y that equate the supply and demand for real
money balances.
The equation for the LM curve is:
M P = L (r ,Y )
Deriving the LM curve
r2 r2
L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y Y Y
P 1 2
Quantity of real money balances demanded is negatively related to
interest rate and positively related to income.
Why the LM curve is upward sloping
LM1
r2 r2
r1 r1
L (r , Y1 )
M2 M1 M/P Y1 Y
P P
Quantity Equation Interpretation of LM Curve
• MV = PY
• MV(r) = PY
CASE STUDY: Monetary Tightening & Interest Rates
Y = C (Y − T ) + I (r ) + G
r
The LM curve represents 1
money market
equilibrium. IS
Y
M P = L (r ,Y ) Y
1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
Policy analysis with the IS-LM model
Y = C (Y − T ) + I (r ) + G r
LM
M P = L (r ,Y )
1. Consumers save r
(1−MPC) of the tax cut, so LM
the initial boost in
spending is smaller for T
r2
than for an equal G and 2
the IS curve shifts by r1
−MPC 1 IS2
T
1− MPC IS1
Y
2.…so the effects on r Y1 Y2
and Y are smaller for T 2
than for an equal G.
3. Monetary policy: An increase in M
1. M > 0 shifts r
LM1
the LM curve down
(or to the right) LM2
2. …causing the r1
interest rate to
fall r2
3. …which IS
increases Y
Y1 Y2
investment,
causing output &
income to rise.
Interaction between monetary & fiscal policy
If govt raises G, r
the IS curve shifts right. LM1
If govt raises G, r
the IS curve shifts LM1
right. LM2
To keep r constant, Fed r2
increases M r1
to shift LM curve right.
IS2
Results: IS1
Y = Y 3 − Y1 Y
Y 1 Y2 Y 3
r = 0
Response 3: Hold Y constant
r = r3 − r1
IS-LM and aggregate demand
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P (M/P ) IS
LM Y2 Y1 Y
shifts left P
P2
r
P1
I
AD
Y
Y2 Y1 Y
Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase LM(M2/P1)
r1
aggregate demand:
r2
M LM shifts right
IS
r Y1 Y2 Y
P
I
Y at each P1
value
AD2
of P AD1
Y1 Y2 Y
Fiscal policy and the AD curve
r LM
Expansionary fiscal policy
(G and/or T) increases r2
agg. demand: r1 IS2
T C IS1
Y1 Y2 Y
IS shifts right P
Y at each
P1
value of P AD2
AD1
Y1 Y2 Y
Summary
1. Keynesian cross
basic model of income determination
takes fiscal policy & investment as exogenous
fiscal policy has a multiplier effect on income.
2. IS curve
comes from Keynesian cross when planned investment
depends negatively on interest rate
shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services
slide 59
Summary
4. LM curve
comes from liquidity preference theory when
money demand depends positively on income
shows all combinations of r and Y that equate demand for
real money balances with supply
slide 60
Summary
5. IS-LM model
Intersection of IS and LM curves shows the unique
point (Y, r ) that satisfies equilibrium in both the
goods and money markets.
Summary
https://www.youtube.com/watch?v=38c4DFT21n8