Understanding IS-LM Model: Key Concepts and Policy Implications
School
New York University**We aren't endorsed by this school
Course
ECON-SHU 3
Subject
Economics
Date
Dec 10, 2024
Pages
49
Uploaded by MagistrateUniverse3550
AnnouncementsToday: Chp. 13: AD & Chp. 15 Aggregate SupplyTh: 12/5: Chp. 15 IS-LM-AD-AS: the mother of all models.Tu: 12/10: Chp. 17: Topics in Stabilization PolicyTh: 12/12: Final Exam: in class (comprehensive)Upcoming AssignmentsQuiz tonight on Brightspace on Chps. 12 and 13: IS-LMRecitation Problem Set 10 posted to BrightspaceSample Final Exam will be posted to Brightspace1 / 173
IS-LMModel: Fixed Price, Short Run ModelEquilibrium in the goods market & money (& bond) marketsIS curve:Y=11-b[a-b·T+f-h·r+G]LM curve:MsP=L(r-,Y+) =μ-Lr·r+LY·YYrIS1Y1r1LMM/PrL(r-,Y+)M/Pr11M/P2 / 173
Macro Policy InteractionsSuppose politiciansΔG>0 orΔT<0.What is the Fed’s response?YrIS1LM11Y1r13 / 173
Macro Policy InteractionsSuppose politiciansΔG>0 orΔT<0.What is the Fed’s response?YrIS1IS2LM11Y1r14 / 173
Macro Policy InteractionsSuppose politiciansΔG>0 orΔT<0. What is the Fed’s response?YrIS1IS2LM11Y1r15 / 173
Macro Policy InteractionsSuppose politiciansΔG>0 orΔT<0. What is the Fed’s response?YrIS1IS2LM11Y1r16 / 173
Macro Policy InteractionsSuppose politiciansΔG>0 orΔT<0. What is the Fed’s response?YrIS1IS2LM11Y1r17 / 173
Implication of Monetary Policy Reaction to Fiscal PolicyThe Fed can react quickly to any changes in fiscal policy1.O↵set fiscal policy!Yis constantΔY= 0Fiscal multiplier = 0 sinceΔY= 0 even thoughΔG>02.Accommodate fiscal policy!ris constantΔr= 0M-policy acts to preventr"; no crowding out of investmentΔY=11-b·ΔG= simple Keynesian Multiplier3.KeepMsconstant (neutral M-policy stance)ΔMs= 0)no true fiscal multiplier; ifΔG>0!ΔYdepends on M-PolicyImplication: inSRyou get the economy (ΔY) the CB wantsRecall: inLRY=Yp; excessivegMsby the CB produces⇡Implication: inLRyou get the inflation rate CB produces8 / 173
Macro ShocksNegative Real Shock:a#inC=a+b(Y-T) orf#inI=f-hrNegative shocks to consumer & business confidence!recessionYrIS11Ypr1LM1IS22Y2r29 / 173
Policy Response to a Negative Real Side Shocka#inC=a+b(Y-T) orf#inI=f-hrFiscal Policy:ΔG>0 orΔT<0 return to pt.1 stabilizesY&rYrIS11Ypr1LM1IS22Y2r210 / 173
Policy Response to a Negative Real Side Shocka#inC=a+b(Y-T) orf#inI=f-hrM-Policy:ΔMs>0 to return economy toYPYrIS11Ypr1LM1IS22Y2r211 / 173
Policy Response to a Negative Real Side Shocka#inC=a+b(Y-T) orf#inI=f-hrM-Policy:ΔMs>0 to pt. 3 stabilizesYbut destabilizesrYrIS11Ypr1LM1IS22Y2r2LM23r312 / 173
Macro Shock: Monetary ShockFlight to Safety: fear in financial markets!demand for USD"FromL(r,Y) =μ-Lr·r+LY·Y, money demand"ifμ"YrIS1Ypr1LM1M/PrL1(r,Y)r1M1/P1Krugman: modern recessions are due toMd"; people hoardingM113 / 173
Macro Shock: Monetary ShockFlight to Safety: fear in financial markets!demand for USD"FromL(r,Y) =μ-Lr·r+LY·Y, money demand"ifμ"YrIS1Ypr1LM1M/PrL1(r,Y)r1r1M1/PL2(r,Y)r212Krugman: modern recessions are due toMd"; people hoardingM114 / 173
Macro Shock: Monetary ShockFlight to Safety: fear in financial markets!demand for USD"FromL(r,Y) =μ-Lr·r+LY·Y, money demand"ifμ"YrIS1Ypr1LM1LM22Y2r2M/PrL1(r,Y)r1r1M1/PL2(r,Y)r212Krugman: nearly all recessions are due toMd"; people hoardM115 / 173
Macro Shock: Increase in Money DemandFlight to Safety: increased demand for USD (domestic & global)M-Policy:ΔMs>0 to pt. 1 inIS-LMand pt. 3 in M-MktYrIS1,3Ypr1LM1LM22Y2r2M/PrL1(r,Y)r1r1M1/PM2/PL2(r,Y)r2123Take the easy way out; if people want moreM1, give it to them16 / 173
Macro Shock: Increase in Money DemandFiscal Policy Response:ΔG>0 orΔT<0 to pt. 4 inIS-LMYrIS1IS214Ypr1LM1LM22Y2r2M/PrL1(r,Y)r1r1Ms/PL2(r,Y)r2124L3(r,Y)17 / 173
On Macro ShocksReal side shocks: shocks toIScurve1.Optimal Policy: use Fiscal policy,ΔGorΔTCan stabilize 2 variables,bothY&r, with 1 policy tool2.Using M-policy for real shock!only 1 variable stabilizedMay still prefer M-policy as response is faster than fiscal policyMonetary shocks; shocks toLMcurve1.Optimal Policy: use M-policy:ΔMs&ΔrCan stabilize 2 variables,bothY&r, with 1 policy tool2.Using Fiscal policy for M-shock!only 1 variable stabilizedIn addition, fiscal policy may be too slow to address M-shockIn Sum: use policy that matches the shock; stabilize 2 variablesUse Fiscal policy for Real side shocksM-policy for Monetary shocksMacro Policymaking depends on identifying shocks; empiricalCaveats: it is difficult to know what is happening in real-timeSize, timing & duration of shocks is unknowableSize, timing & duration of policy is unknowable18 / 173
Refinements toIS-LM: Price Adjustment &ADCurveSo far we assumed prices are fixed in short-run,Pso⇡= 0But prices change even in the short runInIS-LM,Pis in real money balances,MsPIfP"!MsP#!like a monetary contraction:EDM$ESBSoLMcurve shifts up,r"h-!I#!AE#b-!Y#Overall:P"!Y#; this describes theAggregate Demandcurve19 / 173
IS-LMwith Price Adjustment: theADcurveYrIS1Y1r1LM1(P1)MPrM/PL(r,Y)r1r11MsP1YP1Y1P120 / 173
IS-LMwith Price Adjustment: theADcurveYrIS1Y1r1LM1(P1)MPrM/PL(r,Y)r1r11MsP1YP1Y1P1P221 / 173
IS-LM!ADcurve."PsoP2>P1YrIS1Y1r1LM1(P1)r2LM2(P2)Y22MPrM/PL(r,Y)r1r11MsP1r2MsP22YP1Y1P1P222 / 173
IS-LM!ADcurve."PsoP2>P1YrIS1Y1r1LM1(P1)r2LM2(P2)Y22MPrM/PL(r,Y)r1r11MsP1r2MsP22YP1Y1P1P2Y2223 / 173
IS-LM!ADcurve."PsoP2>P1YrIS1Y1r1LM1(P1)r2LM2(P2)Y22MPrM/PL(r,Y)r1r11MsP1r2MsP22YP1Y1P1P2ADY2224 / 173
IS-LM!ADcurve."PsoP2>P1YrIS1Y1r1LM1(P1)r2LM2(P2)Y22MPrM/PL(r,Y)r1r11MsP1r2MsP22YP1Y1P1P2ADY22P"alongADfrom pt. 1. to pt.2. In money marketP"!MsP#!real balances fall toMsP2. Initially,EDM!r"to pt. 2. InIS-LM:r"h-!I#!AE#!Y#to pt. 2.25 / 173
Shifts of Aggregate DemandADis a very opportunistic curveADshifts anytime eitherISorLMshifts (except whenΔP)ADshiftsrightwhen eitherISorLMshiftsright:1.a"2.T#3.f"4.G"5.Ms"6.μ#inL(r-,Y+) =μ-Lr·r+LY·Y26 / 173
IS-LM-AD:ΔG>0YrIS11Y1r1LM1(P1)IS22Y2r2ΔG>0, shiftsISright toIS2. TheIS-LM equilibrium is pt. 2 whereY"andr"YPAD11Y1P1AD22Y2Prices have not changed soADshifts right toAD2atP127 / 173
IS-LM-AD:ΔMs>0YrIS11Y1r1LM1(P1)2Y2r2LM2(P1)ΔMs>0, shifts theLMdown toLM2wherer#!I"!AE"!Y"to IS-LM equilibrium at pt. 2YPAD11Y1P1AD22Y2Prices have not changed soADshifts right toAD2atP128 / 173
Chp. 15: Aggregate Supply: IS-LM-AD-ASYrIS11Ypr1LM1(P1)ΔMs>0, shiftsLMtoLM2(P1)at pt. 2. Since prices have notchanged,ADshifts right toAD2at pt. 2. AsAD"sticky price firmsY"& flex price firmsP"to pt. 3.AsP"!MsP#!LM"toLM3(P2).SRequilibrium at pt. 3:"Y&"PYPAD11YpP1SRAS1(P1=Pe)LRASAt pt. 3,Y>Yp!P"due to highAD. InLRsticky price firms"Pe,so fromY=Yp+↵(P-Pe), SRAS"to pt. 4. InLR,ΔY= 0,Δr=0,ΔP>0; this is money neutrality29 / 173
Chp. 15: Aggregate Supply (AS)Y=Yp+↵(P-Pe),where↵>0Slope SRAS =dPdY=1↵>0The termP-Pe= price surprise = forecast errorInShort run,ifP-Pe>0, thenY>Ypandu<uNifP-Pe<0, thenY<Ypandu>uNifP-Pe= 0, thenY=Ypandu=uNInLong run:Y=Yp!u=uN!P=PeverticalLRASInLRY=Ypis thenatural rate hypothesis30 / 173
SRAS Curve:Y=Yp+↵(P-Pe),where↵>0Two models of AS curve:1.Sticky Price Model: 2 kinds of firmsSticky price firmsFlexible price firms2.Imperfect Information Model or the Lucas Island Model31 / 173
AS Curve:Y=Yp+↵(P-Pe),where↵>0Two models of AS curve:1.Sticky Price Model: 2 kinds of firms in the economySticky price firms: some firms setP=Peand stick with itWhenAD"these firms keepP=Peconstant and raiseYFlexible price firms: these firms adjustPquicklyWhenAD"these firms!P"Since both firms exist, whenAD"!Y"&P"Implies theSRASis upward slopingInLRSticky Price firms catch on soP=Pe"soY=Yp2.Imperfect Information Model or the Lucas Island ModelInSRfirms don’t have perfect info!P6=PesoY6=YpInLRfirms adjust bothP&Pe!P=Pe&Y=Yp32 / 173
AS Curve:Y=Yp+↵(P-Pe),where↵>0Suppose all firms were ”Sticky Price”All firms adjust toAD"byY"only,ΔP= 0The slope ofSRAS!0 horizontalSRASIfADincreases!sticky price firms!Y",ΔP= 0Suppose all firms were ”Flexible Price”All firms adjust toAD"byP"only,ΔY= 0The slope ofSRAS! 1 !SRASis vertical and isLRASIfADincreases!flex. price firms!P"soΔY= 0Reality is somewhere between these two extremesAs % of Sticky Price firms"!theSRASis flatterAs % of Flexible Price firms"!theSRASis steeper33 / 173
Shift of AS curve:Y=Yp+↵(P-Pe),where↵>01.WhenY>YP!”inflationary gap”Income and output are higher than normalPeople and firms expect prices to rise (more inflation)!Pe"!Wages"!P"AsPe"!SRAS shifts left & up,Y#towardYpNote: the Sticky Price firms adjustPe"&P"2.WhenY<YP!”recessionary gap”Income and output are lower than normalPeople and firms expect prices to fall (less inflation)!Pe#!Wages#!P#AsPe#!SRAS shifts right & down;Y#towardYpNote: the Sticky Price firms adjustPe#&P#3.SRAS shifts whenYpandLRASshifts34 / 173
IS-LM-AD-AS: permanentMs"SREquilibriumYrIS11Ypr1LM1(P1)ΔMs>0, shiftsLMtoLM2(P1)at pt. 2. Since prices have notchanged,ADshifts right toAD2at pt. 2. AsAD"sticky price firmsY"& flex price firmsP"to pt. 3.AsP"!MsP#!LM"toLM3(P2).SRequilibrium at pt. 3:"Y&"PYPAD11YpP1SRAS1(P1=Pe)LRASAt pt. 3,Y>Yp!P"due to highAD. InLRsticky price firms"Pe,so fromY=Yp+↵(P-Pe), SRAS"to pt. 4. InLR,ΔY= 0,Δr=0,ΔP>0; this is money neutrality35 / 173
IS-LM-AD-AS: permanentMs"SREquilibriumYrIS11Ypr1LM1(P1)2LM2(P1)ΔMs>0, shiftsLM2(P1) at pt. 2YPAD11YpP1SRAS1(P1=Pe)LRASAD22If prices do not changeADshiftsright toAD2at pt. 236 / 173
IS-LM-AD-AS: permanentMs"SREquilibriumYrIS11Ypr1LM1(P1)2LM2(P1)SinceAD"sticky price firmsY"& flex price firmsP"to pt. 3. AsP"!MsP#!LM"toLM3(P3)YPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRequilibrium at pt. 3:"Ydue tosticky price firms;P"due to flexibleprice firms37 / 173
IS-LM-AD-AS: permanentMs"SREquilibriumYrIS11Ypr1LM1(P1)2LM2(P1)LM3(P3)3Y3r3SinceAD"sticky price firmsY"& flex price firmsP"to pt. 3. AsP"!MsP#!LM"toLM3(P3)YPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRequilibrium at pt. 3:"Ydue tosticky price firms;P"due to flexibleprice firms;C",r#h-!I"38 / 173
IS-LM-AD-AS: permanentMs"SREquilibriumYrIS11Ypr1LM1(P1)2LM2(P1)LM3(P3)3Y3r3InSRsinceP"due to flexible pricefirms!MsP#!LM"toLM3(P3)YPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRequilibrium at pt. 3:"Ydue tosticky price firms;P"due to flexibleprice firms.Y",C",I",r#.Note theSRstimulus is smaller nowcompared to IS-LM model (pt. 2)39 / 173
IS-LM-AD-AS: permanentMs"LREquilibriumYrIS11Ypr1LM1(P1)2LM2(P1)LM3(P3)3Y3r3LMshifts toLM4(P4) =LM1(P1)the originalLMcurveYPAD11YpP1SRAS1LRASAD223Y3P3SRAS2P44InLRsticky price firmsPe"&P".SRASY=Yp+↵(P-Pe) shifts upto left (to pt. 4) whenPe"40 / 173
IS-LM-AD-AS: permanentMs"LREquilibriumYrIS11Ypr1LM1(P1) =LM4(P4)2LM2(P1)LM3(P3)3Y3r34WhenP"LMshifts toLM4(P4) =LM1(P1) the originalLMcurveYPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRAS2P44InLR,ΔY= 0,ΔC= 0,Δr= 0,ΔI= 0, onlyΔP>0; this is moneyneutrality41 / 173
IS-LM-AD-AS: permanentMs"LREquilibriumYrIS11Ypr1LM1(P1) =LM4(P4)2LM2(P1)LM3(P3)3Y3r34Overall in SRpt. 3:ΔMs>0,Δr<0,ΔY>0,ΔC>0,ΔI>0,constant Gov’t budget deficit. Allthese results are good!strongtemptation to use expansionary mon-etary policyYPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRAS2P44Overall in LRpt. 4:ΔMs>0,Δr= 0,ΔY= 0,ΔC= 0,ΔI= 0,ΔP>0. None of these results aregood. InLRexpansionary monetarypolicy yields only higher prices &inflation; money neutrality42 / 173
IS-LM-AD-AS: permanentG"SREquilibriumYrIS11Ypr1LM1(P1)ΔG>0, shiftsIStoIS2at pt. 2.Since prices have not changed,ADshifts right toAD2at pt. 2. AsAD"sticky price firmsY"& flex pricefirmsP"to pt. 3. AsP"!MsP#!LM"toLM2(P3).SRequilibrium atpt. 3:"Y&"PYPAD11YpP1SRAS1(P1=Pe)LRASAt pt. 3,Y>Yp!P"due to highAD. InLRsticky price firms"Pe.FromY=Yp+↵(P-Pe), SRAS"to pt. 4. InLR,ΔY= 0,Δr>0,ΔI<0,ΔP>043 / 173
IS-LM-AD-AS: permanentG"SREquilibriumYrIS11Ypr1LM1(P1)2IS2ΔG>0, shiftsIStoIS2at pt. 2YPAD11YpP1SRAS1(P1=Pe)LRASAD22If prices do not changeADshiftsright toAD2at pt. 2.44 / 173
IS-LM-AD-AS: permanentG"SREquilibriumYrIS11Ypr1LM12IS2AsP"due to flexible price firms!MsP#!LM"toLM2(P3)andpt.3YPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3P"due to flexible price firms45 / 173
IS-LM-AD-AS: permanentG"SREquilibriumYrIS11Ypr1LM12IS2LM2(P3)3Y3r3AsP"due to flexible price firms!MsP#!LM"toLM2(P3) and pt.3YPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRequilibrium at pt. 3:Y", due tosticky price firms;P"due to flexibleprice firms,C",r"h-!I#. Againthe stimulus now is smaller than inthe IS-LM model46 / 173
IS-LM-AD-AS: permanentG"LREquilibriumYrIS11Ypr1LM12IS2LM23Y3r3InLRasP"MsPfalls soLMshiftsup toLM3(P4) atYpYPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRAS2P44InLRsticky price firmsPe"&P".SRASY=Yp+↵(P-Pe) shifts topt. 447 / 173
IS-LM-AD-AS: permanentG"LREquilibriumYIS11Ypr1LM12IS2LM23Y3r3LM3(P4)r44InLRasP"MsPfalls soLMshiftsup toLM3(P4) atYpYPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRAS2P44InLRsticky price firmsPe"&P".SRASY=Yp+↵(P-Pe) shifts topt. 448 / 173
IS-LM-AD-AS: permanentG"LREquilibriumYIS11Ypr1LM12IS2LM23Y3r3LM3(P4)r44Overall in SRpt. 3:ΔG>0,Δr>0,ΔY>0,ΔC>0,ΔI<0,ΔPe=ΔP>0 &Δ(G-T)>0YPAD11YpP1SRAS1(P1=Pe)LRASAD223Y3P3SRAS2P44Overall in LRpt. 4:ΔG>0,Δr>0,ΔY= 0,ΔC= 0,ΔI<0,Δ(G-T)>0,ΔP>0.G"isnotneutral inLRbecauseΔr>0&ΔI<0; we saw this in LoanableFunds Model49 / 173