macroeconomics presentation
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ISLM2.pptxThe Goods Market and the IS Relation
The equilibrium condition is given by
Y = C (Y – T) + I + G
Investment, Sales, and the Interest Rate
Investment depends primarily on two factors:
1. The level of sales. Consider a firm facing an increase in sales and needing to
Increase production. To do so, it may need to buy additional machines or build an
Additional plant. In other words, it needs to invest. A firm facing low sales will feel no
such need and will spend little, if anything, on investment.
2. The interest rate. Consider a firm deciding whether or not to buy a new machine.
Suppose that to buy the new machine, the firm must borrow. The higher the interest
rate, the less attractive it is to borrow and buy the machine. At a high enough interest
rate, the additional profits from using the new machine will not cover interest
payments, and the new machine will not be worth buying.
To capture these two effects, we write the investment relation as follows:
I = I(Y, i)
(+, -)
Determining Output
Taking into account the investment relation , the condition for equilibrium in the goods market becomes
Y = C(Y – T) + I(Y, i) + G
Production (the left side of the equation) must be equal to the demand for goods (the right side). This equation is our expanded IS relation.
What Happens to output when the interest rate changes?
For a given value of the interest rate i, demand is an increasing function of output, for two reasons:
1- An increase in output leads to an increase in income and thus to an increase in disposable income. The increase in disposable income leads to an increase in consumption.
2- An increase in output also leads to an increase in investment. This is the relation
between investment and production.
In short, an increase in output leads, through its effects on both consumption and
investment, to an increase in the demand for goods. This relation between demand
And output, for a given interest rate, is represented by the upward-sloping curve ZZ.
Deriving the IS Curve
The increase in the interest rate decreases investment. The decrease in
investment leads to a decrease in output, which further decreases consumption and
investment, through the multiplier effect.
(a) An increase in the interest rate decreases the demand for goods at any level of output, leading to a decrease in the equilibrium level of output.
(b) Equilibrium in the goods market implies that an increase in the interest rate
leads to a decrease in output.
The IS curve is therefore downward sloping.
Shifts of the IS Curve
We have drawn the IS curve taking as given the values of taxes, T, and government spending, G. Changes in either T or G will shift the IS curve.
The IS curve gives the equilibrium level of output as a function of the interest rate.
Now consider an increase in taxes, from T to T. At a given interest rate, say i,
disposable income decreases, leading to a decrease in consumption, leading in turn to
a decrease in the demand for goods and a decrease in equilibrium output: shift to the
left for a given interest rate, increases the equilibrium level of output—a decrease in
taxes, an increase in government spending, an increase in consumer confidence—causes the IS curve to shift to the right. drawn for given values of taxes and spending.
Remember that:
Nominal GDP = Real GDP multiplied by the GDP deflator:
$ Y = YP.
Equivalently:
Real GDP = Nominal GDP divided by the GDP deflator:
$ Y / P = Y.
Financial Markets and the LM Relation
Let’s now turn to financial markets. The interest rate is determined by the equality of the supply of and the demand for money:
M = $Y L(i)
Real Money, Real Income, and the Interest Rate
The equation M = $Y L(i) gives a relation between money, nominal income, and the
interest rate.
Recall that nominal income divided by the price level equals real income, Y. Dividing
both sides of the equation by the price level P gives:
M /P = Y L(i)
The advantage of writing things this way is that real income, Y, appears on the right
side of the equation instead of nominal income, $Y.
To make the reading lighter, we will refer to the left and right sides of
equation simply as “money supply” and “money demand” rather than the more
accurate but heavier “real money supply” and “real money demand.”
Deriving the LM Curve
In deriving the IS curve, we took the two policy variables as government spending, G,
and taxes, T. In deriving the LM curve, we have to decide how we characterize
Monetary policy, as the choice of M, the money stock, or as the choice of i, the interest rate.
If we think of monetary policy as choosing the nominal money supply, M, and, by
implication, given the price level which we shall take as fixed in the short run,
Choosing M/P, the real money stock, equation tells us that real money demand, the
right hand side of the equation, must be equal to the given real money supply, the left-
hand side of the equation.
If real income increases, increasing money demand, the interest rate must increase so
as money demand remains equal to the given money supply. In other words, for a
given money supply, an increase in income automatically leads to an increase in the interest rate.
Although, in the past, central banks thought of the money supply as the monetary
policy variable, they now focus directly on the interest rate. They choose an interest
rate, call it i, and adjust the money supply so as to achieve it.
We shall think of the central bank as choosing the interest rate (and doing what
it needs to do with the money supply to achieve this interest rate). This will make for an extremely simple LM curve, namely, a horizontal line.
Putting the IS and the LM Relations Together
The IS relation follows from goods market equilibrium. The LM relation follows from
financial market equilibrium. They must both hold.
IS relation: Y = C(Y – T) + I(Y, i) + G
LM relation: i = i
Together they determine output. Next figure plots both the IS curve and the LM
curve on one graph. Output is measured on the horizontal axis. The interest rate is measured on the vertical axis.
Any point on the downward-sloping IS curve corresponds to equilibrium in the goods
market. Any point on the horizontal LM curve corresponds to equilibrium in financial
markets.
Point A, with the associated level of output Y and interest rate iQ is the overall equilibrium.
Used properly, it allows us to study what happens to output when the central
bank decides to decrease the interest rate, or when the government decides to increase
taxes, or when consumers become more pessimistic about the future, and so on.
Fiscal Policy
Suppose the government decides to reduce the budget deficit and does so by
increasing taxes while keeping government spending unchanged. Such a reduction in
the budget deficit is often called a fiscal contraction or a fiscal consolidation. (An
increase in the deficit, either due to an increase in government spending or to a
called a fiscal expansion.) What are the effects of this fiscal contraction on
output, on its composition, and on the interest rate?
When you answer this or any question about the effects of changes in policy (or,
more generally, changes in exogenous variables), always go through the following
three steps:
1. Ask how the change affects equilibrium in the goods market and how it affects
equilibrium in the financial markets. Does it shift the IS curve and/or the LM curve, and, if so, how?
2. Characterize the effects of these shifts on the intersection of the IS and the LM
curves. What does this do to equilibrium output and the equilibrium interest rate?
3. Describe the effects in words.
Monetary Policy
Suppose the central bank decreases the interest rate.
Recall that, to do so, it increases the money supply, so such a change in monetary
Policy is called a monetary expansion. Conversely, an increase in the
interest rate, which is achieved through a decrease in the money supply, is called a
monetary contraction or monetary tightening.
Using a Policy Mix
The combination of monetary and fiscal policies is known as the monetary-fiscal
policy mix, or simply the policy mix.
Sometimes, the right mix is to use fiscal and monetary policy in the same direction.
Suppose for example that the economy is in a recession and output is too low. Then,
Both fiscal and monetary policies can be used to increase output.
The initial equilibrium is given by the intersection of IS and LM at point A, with
corresponding output Y. Expansionary fiscal policy, say through a decrease in taxes, shifts the IS curve to the right, from IS to IS.
Expansionary monetary policy shifts the LM curve from LM to LM. The new equilibrium is at A, with corresponding output Y. Thus, both fiscal and monetary policies contribute to the increase in output.
Higher income and lower taxes imply that consumption is also higher. Higher output
And a lower interest rate imply that investment is also higher.
1. A fiscal expansion means either an increase in government spending, or an
Increase in taxes, or both. This means an increase in the budget deficit (or, if the
Budget was initially in surplus, a smaller surplus). Running a large deficit and
increasing government debt may be dangerous. In this case, it is better to rely, at least in part, on monetary policy.
2. A monetary expansion means a decrease in the interest rate. If the interest
rate is very low, then the room for using monetary policy may be limited. In this case,
Fiscal policy has to do more of the job. If the interest rate is already equal to zero, the
case of the zero lower bound then fiscal policy has to do all the job.
3. Fiscal and monetary policies have different effects on the composition of output. A decrease in income taxes for example will tend to increase consumption
relative to investment. A decrease in the interest rate will affect investment more than consumption. Thus, depending on the initial composition of output, policy makers
want to rely more on fiscal or more on monetary policy.
4. Finally, neither fiscal policy nor monetary policy work perfectly. A decrease in
Taxes may fail to increase consumption. A decrease in the interest rate may fail to
investment. Thus, in case one policy does not work as well as hoped for, it is better to
use both.
