ISIS LMLMISIS--LMLM

Roadmap

1) MARKET I : GOODS MARKET

• goods demand = C + I + G (+NX) = Y = goods supply (set by maximizing firms)

• IS curve

2) MARKET II : MONEY MARKET

• money demand = Ld(Y, r + πe) = Ms/P = money supply (set by the Fed)

• LM curveLM curve

IS-LM EQUILIBRIUM = EQUILIBRIUM IN BOTH MARKETS I and II IS LM EQUILIBRIUM EQUILIBRIUM IN BOTH MARKETS I and II

2

=

Goods Market • IS curve represents the equilibrium in the goods market:

(1) Y = C + I + G + NX C + I + G + NX(1) Y

• Recall the definition of private savings S (hh) = Y – T – C

• Recall the definition of national savings S = S (hh) + T – G

• Combining them

(2) S = Y – C – G

• F (1) d (2) th d d id f th b ittFrom (1) and (2) the demand side of the economy can be written as:

S = I + NX

The IS curve is named as it is because it documents the relationship between Investment

and Saving (holding NX constant). 3

I

Demand side : the IS curve

C is a function of PVLR (Y, Yf, W), tax policy, expectations, etc.

is a function of r, Af, K, and investment tax policy.

G is a function of ggovernment policy ( y (we will discuss this shortly)p y)

NX we will model in the last lecture of the course (for the U.S., NX is small)

• The IS curve relates Y to r. How do interest rates affect Y?

• As r falls, Investment increases (due to firm profit maximization behavior).

• Also Consumpption increases ((substitution effect dominates))

4IS curve is downward sloping in {r, Y} space.

IS Curve: Graphical Derivation

S curve (Y=Y1)I curve rrr

r*r*

YYI,S Y1

5

IS Curve: Graphical Derivation

S curve (Y=Y1)I curve rrr

ISS curve (Y=Y2)

r1 r2

YYI,S Y1 Y2

An increase in current Y leads to more desired S An increase in current Y leads to more desired S, hence the equilibrium r needs to be lower!

6

IS curve

r

r* r*

IS

YYY

Suppose r is set by the Fed at the level of r* (we will explore this in depth later in the course). For a given r, we can solve for the level of output desired by the demand side of the economy.

WWee represent the demand side of the economy represent the demand side of the economy, drawn in {r Y} space as the I drawn in {r,Y} space as the I-S curve S curve. Why IS? Why IS? Because the demand side of the economy can be boiled down to I = S (when NX is zero)

7

What shifts the IS curve

What shifts the IS curve to the right?

Anything that increases C, I or G (or NX when we model it):

• higgher exppected income or wealth higgher PVLR

hi

ggher C • higher conusmer confidence higher PVLR higher C • higher Tr or lower T (if the Ricardian equivalence fails) higher C •• higher expectations about Af higher expectations about A higher MPKf higher MPK higher Ihigher I • higher business confidence higher MPKf higher I • lower δ or mm, or lower tK lower adjusted user cost of K higher I • higher G

Changges in r WILL NOT cause IS curve to shift (causes movement along IS curve)

8

IS shift: Fall in Consumer Confidence

Imagine S decreases

I curve rS curve (Y=Y1)

r

IS

r

S curve (Y=Y1)

r1

rr2

YYI,S Y1

An increase in desired S requires r to decrease if Y is unchanged! An increase in desired S requires r to decrease if Y is unchanged!

9

Money Market LM curve represents the equilibrium in the money market

The Money Market is in Equilibrium whenThe Money Market is in Equilibrium when

Ms/P = Ld(Y, r + πe)

Ms/P = Real Money Supply

L (Y r + πe) = Real Money DemandLd(Y, r + πe) Real Money Demand

The money supply is decided by the Fed and does not change with interest rates

What shifts real money supply: M, P What shifts real money demand: Y, πe

LM curve is named as it is because it documents the relationship between Liquidity andMoney 10

Money Market Equilibrium

Ms/P

r

Md/P = Ld(Y,πe)

M/P

11

LM Curve: Graphical Derivation

M0 /Pr r

r0 r0

Ld(Y0,πe)

YY00

Money Market

12

LM Curve: Graphical Derivation

r M0 /P r

r0

Ld(Y1,πe)

Ld(Y0,πe)

LM(M0)

r0

YY0 Y1

Money Market LM curve

A i i h l l f i ill i h i (f i l )! An increase in the level of transaction will increase the interest rate (for given money supply)!

13

What shifts the LM Curve

LM Curve: represents the relationship of Y and r through the money market

As Y increases - Ld shifts upwards - causing real interest rates to rise (increase in transactions demand increases the demand for money).

What shifts the LM curve to the right?

• Higher nominal money supply higher Ms/P

• Lower pprices

hi

ggher Mss/P

• higher π e higher I and hence lower money demand

14

LM Shift: Increase in Ms Thought experiment: Suppose M increases. What would happen to r if Y was held constant?

r0

M0/P LM(M0)

M1/P

r0

Ld(Y0)

Y00

Money Market LM curve

A i i h i l l ill h LM hif h i hAn increase in the nominal money supply will cause the LM curve to shift to the right.

15

Summing Up

1) MARKET I : GOODS MARKET

• goods demand = C + I + G (+NX) = Y = goods supply (set by maximizing firms) • as the interest rate increases, I and C fall and the demand for goods falls • IS curve is downward slopingp g

2) MARKET II : MONEY MARKET

• money demand = Ld(Y, r + πe) = Ms/P = money supply (set by the Fed) • as output increases, money demand increases and the interest rate has to increase

to bringg the demand back to the su pppp lyy • LM curve is upward sloping

IS-LM EQUILIBRIUM = EQUILIBRIUM IN BOTH MARKETS I and II Q Q

16

IS-LM Equilibrium

r LM = f(M,P,πe)

re

IS = f(G,PVLR,taxesAf )

YYe Y

17

Short Run

• SHORT RUN: equilibrium given by intersection of IS and LM

• When aggregate demand for goods rises, assume that firms are willing to hire more workers in the short run to produce the extra output and meet the exppanded demand

• LONG RUN: also labor market is in equilibrium and full employment: Y* = f((N*,K,A), , )

• In the long run, if there is higher demand, firms will increase prices until theyy hire the opptimal amount of workers and pproduce the ppotential level of output.

18

Labor Market FE Curve: the equilibrium in the labor market (Full Employment)

• Factors Affecting Labor Supply – The Real Wage (w/p) – The Household’s Present Value of Lifetime Resources (PVLR) – The Marginal Tax Rate on Labor Income (t )The Marginal Tax Rate on Labor Income (tn) – The Marginal Tax Rate on Consumption (tc) – Value of Leisure (reservation wage) - non-’work’ status (VL) – Th W ki A P l i (The Working Age Population (pop))

• Factors affecting Labor Demand: – TFP (A) – Capital (K)

Y* is not sensitive to r! 19

What shifts Y*?

• Anything that affects the labor market will affect Y*!

• If N* increases, Y* will shift to the right.

• If N* decreases, Y* will shift to the left.

• For example, Y* will shift right if:

– A iA increases – K increases – population increases – labor income taxes fall (and income effect is small relative to substitution effect)labor income taxes fall (and income effect is small relative to substitution effect) – labor income taxes rise (and income effect is large relative to substitution effect)

20

IS-LM-FE Equilibrium Y* = f(N*,K,A)

r LM = f(M,P,πe)

Money Market

re Labor Market

Goods Market

IS = f(G,PVLR,taxes,Af)

Y* Y

21

Temporary Decrease in A (Step 1) FE

r

re

LM

IS

Y** Y* Y

Firms are not going to be willing to produce Y* anymore for long, hence P will increase! 22

In the Money Market…

Ms/P

r*

Md/P = Ld(Y,πe)

M/P

23

Temporary Decrease in A (Step 2)

r LM

FE

re

IS

Y** Y* Y

In the new long run equilibrium, output is lower, interest rate higher and prices higher! 24

Short Run versus Long run!

• Conventional Definition: – SHORT RUN: Prices are sticky – LONG RUN: LONG RUN: Prices adj Prices adjust st

• Traditional debate in Macroeconomics on the “length” of the Short Run!Run!

– Classical economists: prices adjust fast – Keynesian economists: prices adjust slowly

• Basic Distintion: – Business Cycle: focus on the short run – G th f th lGrowth: focus on the long run

25

Long Run

• The short run equilibrium is an equilibrium in the sense that the aggregate quantity of goods produced is equal to the quantity demanded

• It is not an equilibrium in the sense that to meet the aggregate demand of ggoods,, firms have to pproduce more ((or less)) out pput than their potential level Y*!

• Y* is the level of output that maximizes firms’ profits. Hence, firms are producing more (or less) than what they would like.

• This will induce at some point firms to change prices. If M iincreases, fi firms will start to iincrease priices up to thhe point thhat M/P isill i M/P i the same as before, so that the demand is equal to Y*!

26

Monetary Policy in the Short Run

SHORT RUN: P are fixed

rr LM

re

LM

IS

Y* Y 27As M increase, money holders have more money than what they need and

increase the demand for bonds and decrease r. This increases I and C.

Monetary Policy in the Long Run

LONG RUN: prices adjust and back to the general equilibrium rr LM

re

LM

IS

Y* Y 28In the long-run, monetary policy has no effect!

0

Money Market (Short run / Long run) The effectiveness of Monetary Policy will depend on how sticky prices are

r0

r1

rz

Ms1/P1

Ms0/P0 Ms

1/P0

Ms0/P0 = Ms

1/P1

M1 > M0

P1 > P0

z

1

Md = Ld(Y1) Md = Ld(Y*)

M/P

29

Monetary Neutrality

• Consensus: after some economic disturbance prices will eventually restore the economic general equilibrium

• Disagreement on the speed of this adjustment!

•• Classical economists: prices adjust immediately Classical economists: prices adjust immediately

– Money is Neutral!

• Keynesian economists: prices are sticky

• M i t l l i th l it i

t l i th Money is neutral only in the long run, it is non-neutral in the short run!

30

Fiscal Policy in the Short Run Suppose G increases

r r

r*

Y* = f(N*,K,A)

LM f(M P LM = f(M,P,πee))

As r increases, private I and C are somehow crowded out

IS = f(G0)

Y Y 31*

Fiscal Policy in the Long Run If fi l li d ’t ff t Y* th i ill i d LM hift iIf fiscal policy doesn’t affect Y*, then prices w

Inflationary pressuresY* = f(N*,K,A)

ill rise and LM shifts in….

rr LM = f(M,P,πe)

r*

IS = f(G0)

Y Y *Output is unchanged and G has crowded out C and I (through higher r) 32

A first look at the current recession

How can we can represent thhe current recessiion in thhe IS-LM model?i d l

As a neggative shock to the IS Curve for different reasons:

1) Direct reduction in C and I due to credit crunch

2) Fall in consumer and business confidence

3) FFall in fifinanciiall wealth (NPVLR)3) ll i l h (NPVLR)

33

Fall in private demand: a recession

r

re

LM

IS

Y* Y

34

Fighting the recession: Monetary Policy

r LM

IS

re

Y* Y

Expansionary Monetary Policy by the Fed: Ms increases 35Recall: prices are fixed for now.

When Monetary Policy does not work…

1) Vertical IS Curve

• firms don’t respond much to interest rate changes if they think that the banking system is frozen

• The effect of an expansionary monetary policy is dampened

1)1) Horizontal LM Curve Horizontal LM Curve Liquidity Trap Liquidity Trap

• Nominal interests rates are bounded at zero • LLower bbound on r iis equall to – πe d h F d d i f hd and the Fed cannot reduce it further!! • This is what is happening now in the US and what happened in Japan in

the late 1990s • Read Krugman’s Babysitting the Economy (From Week 1)

36

Vertical IS IS

r LM

re

Y* Y

What if Ms increases? 37

r

Liquidity Trap

Y*

LM

e

Y-πe IS

r

38

Fighting the Recession: Fiscal Policy

r LM

re

IS

Y* Y

If monetary policy does not work fiscal stimulus: G increases 39

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14.02 Principles of Macroeconomics Fall 2009

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