AD in Short Run - Is-LM Model (Lecture 13-16)

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MACROECONOMICS

13th - 16th Lecture

Economic Fluctuations-
Aggregate Demand in the Short Run:
IS-LM Model

Instructor: Tamali Chakraborty


IIM Visakhapatnam
LEARNING OBJECTIVE

AGGREGATE DEMAND FROM IS-LM

KEYNESIAN CROSS LIQUIDITY PREFERENCE

GOODS & SERVICE MKT REAL MONEY MKT

INVENTORY MONETARY & NON-


BRINGS MONETARY ASSETS
EQUILIBRIUM BRINGS EQUILIBRIUM

IS CURVE LM CURVE
LEARNING OBJECTIVE

Business cycles and aggregate demand

the IS curve, and its the Keynesian cross


relation to the loanable funds model

the LM curve, and its the theory of liquidity


relation to preference

how the IS-LM model determines income and the


interest rate in the short run when P is fixed
STIMULUS TO DEMAND
Short-run

In the following lectures, we will study the short-run


fluctuations of the economy (business cycles).

We focus on two models:


➢ IS-LM model
➢ AS-AD model
Facts about the business cycle

➢ GDP growth averages 3–3.5 percent per year over the


long run with large fluctuations in the short run
(USA).

➢ Consumption and investment fluctuate with GDP, but


consumption tends to be less volatile and investment
more volatile than GDP.

➢ Unemployment rises during recessions and falls


during expansions.
Growth rates of real GDP, consumption
Percent 10
change Real GDP
from 4 8 growth
rate Consumption
quarter
s earlier 6
growth rate

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:

Prices are flexible, respond to changes in supply or demand.

Short run:

Many prices are “sticky” at some predetermined level.

The economy behaves much differently


when prices are sticky.
Recap of classical macro theory

➢ Output is determined by the supply side:


Supplies of capital, labor, technology.

➢ Changes in demand for goods & services:


(C, I, G ) only affect prices, not quantities.

➢ Assumes complete price flexibility.

➢ Applies to the long run.

➢ https://www.youtube.com/watch?v=Xt_L8WFKvLc&ab_c
hannel=YouWillLoveEconomics
When prices are sticky-Keynesian theory

…output and employment also depend on demand,


which is affected by

• fiscal policy (G and T )

• monetary policy (M )

• other factors, like exogenous changes in


C or I.
The Big Picture

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

A simple closed economy model in which income is


determined by expenditure (due to J.M. Keynes)
Notation:

E = C + I + G = planned expenditure
Y = real GDP = actual expenditure

Difference between actual & planned expenditure


= unplanned inventory investment
Elements of the Keynesian Cross
consumption function: C = C (Y − T )
govt policy variables: G = G , T =T
for now, planned
investment is exogenous: I =I

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

Collect terms with Y Solve for Y :


on the left side of the
equals sign:  1 
Y =    G
(1 − MPC)  Y = G  1 − MPC 
The government purchases multiplier

Definition: the increase in income resulting from a


$1 increase in G.
In this model, the govt
purchases multiplier equals Y 1
=
G 1 − MPC

Example: If MPC = 0.8, then


Y 1 An increase in G
= = 5 causes income to
G 1 − 0.8
increase 5 times
as much!
Why the multiplier is greater than 1

Initially, the increase in G causes an equal increase in Y:


Y = G.
But Y  C
 further Y
 further C
 further Y

So, the final impact on income is much bigger than the


initial G.
An increase in taxes

E
Initially, the tax
increase reduces E =C1 + I +G
consumption, and E =C2 + I +G
therefore E:

C = −MPC At Y1, there is now


T an unplanned
inventory buildup…
…so firms
reduce output,
and income Y
falls toward a
E2 =  E1 =
new
Y2 Y Y1
equilibrium
Solving for Y

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

def: the change in income resulting from


a $1 increase in T :
Y − MPC
=
T 1 − MPC

If MPC = 0.8, then the tax multiplier equals

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)

The investment function is I = I (r ),


where r denotes the real interest rate,
the nominal interest rate corrected for inflation.

The real interest rate is


…the cost of borrowing
So, r  I
The IS curve

def: a graph of all combinations of r and Y that


result in goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:

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

• A fall in the interest rate motivates firms to increase


investment spending, which drives up total planned
spending (E ).

• To restore equilibrium in the goods market, output


(actual expenditure, Y ) must increase.
The IS curve and the loanable funds model
(a) The L.F. model (b) The IS curve

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.

• Let’s start by using the Keynesian cross to see how


fiscal policy shifts the IS curve…
Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, G 1 2
 E  Y E =C +I (r1 )+G1
…so the IS curve
shifts to the right.

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

• Due to John Maynard Keynes.

• A simple theory in which the interest rate is


determined by money supply and money demand.
Money supply

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

Now let’s put Y back into the money demand function:

(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

(a) The market for


(b) The LM curve
real money
r balances r
LM

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

➢ An increase in income raises money demand.

➢ Since the supply of real balances is fixed, there is now


excess demand in the money market at the initial interest
rate.

➢ The interest rate must rise to restore equilibrium in the


money market.
How M shifts the LM curve

(a) The market for


(b) The LM curve
real money
r r
balances LM2

LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P
Quantity Equation Interpretation of LM Curve

• MV = PY

• V depends on interest rate because it determines how


much money people will hold or how much they will
spend.

• Thus velocity is positively related to interest rate.

• MV(r) = PY
CASE STUDY: Monetary Tightening & Interest Rates

• Late 1970s:  > 10%


• Oct 1979: Fed Chairman Paul Volcker announces
that monetary policy would aim to reduce inflation
• Aug 1979-April 1980: Fed reduces M/P 8.0%
• Jan 1983:  = 3.7%

How do you think this policy change


would affect nominal interest rates?
Monetary Tightening & Rates, cont.

The effects of a monetary tightening


on nominal interest rates

short run long run


Quantity theory,
Liquidity preference
model Fisher effect
(Keynesian)
(Classical)

prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%


outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
Equilibrium in the IS-LM model
The IS curve represents
equilibrium in the goods r
market. LM

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 )

We can use the IS-LM model


to analyze the effects of r1
• fiscal policy: G and/or T
• monetary policy: M IS
Y
Y1
1. Fiscal Policy: An increase in government
purchases
1. IS curve shifts right r
1
by G LM
1− MPC

…causing output & r2


income to rise. 2
r1
2. This raises money
demand, causing the
1 IS2
interest rate to rise… IS1
Y
Y1 Y2
3. …which reduces 3
investment, so the final
1
increase in Y is smaller than G
1− MPC
2. Fiscal Policy: A tax cut

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

Model: Monetary & fiscal policy variables (M, G, and T )


are exogenous.

Real world: Monetary policymakers may adjust M in


response to changes in fiscal policy, or vice versa. Such
interaction may alter the impact of the original policy
change.
The Central Bank’s response to G > 0

Suppose the govt. increases G. Possible CB


responses:
1. hold M constant
2. hold r constant
3. hold Y constant

In each case, the effects of the G are different:


Response 1: Hold M constant

If govt raises G, r
the IS curve shifts right. LM1

If Fed holds M constant, r2


then LM curve doesn’t r1
shift.
IS2
Results: IS1
Y = Y 2 − Y1 Y
Y 1 Y2
r = r2 − r1
Response 2: Hold r constant

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

If govt. raises G, r LM2


the IS curve shifts LM1
right.
r3
To keep Y constant, r2
Fed reduces M r1
to shift LM curve left.
IS2
Results: IS1
Y = 0 Y1 Y2
Y

r = r3 − r1
IS-LM and aggregate demand

• So far, we’ve been using the IS-LM model to


analyze the short run, when the price level is
assumed fixed.
• However, a change in P would shift LM and
therefore affect Y.
• The aggregate demand curve captures this
relationship between P and Y.
Deriving the AD curve

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

3. Theory of Liquidity Preference


basic model of interest rate determination
takes money supply & price level as exogenous
an increase in the money supply lowers the interest rate

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

• 6. AD curve. It shows relation between P and the IS-LM


model’s equilibrium Y.
It has negative slope because
P  (M/P )  r  I  Y

• Expansionary fiscal policy shifts IS curve right, raises income,


and shifts AD curve right.

• Expansionary monetary policy shifts LM curve right, raises


income, and shifts AD curve right. IS or LM shocks shift the
AD curve.
Video Links

Limit to Fiscal Policy:

https://www.youtube.com/watch?v=38c4DFT21n8

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