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The IS-LM Model

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The IS-LM Model TheThe ISIS --LMLM ModelModel ChapterChapter 8.18.1 –– 8.58.5 0 OutlineOutline InvestmentInvestment andand thethe InterestInterest RateRate NetNet ExportsExports andand thethe InterestInterest RateRate TheThe ISIS CurveCurve TheThe DemandDemand forfor andand SupplySupply ofof MoneyMoney TheThe LMLM CurveCurve PolicyPolicy AnalysisAnalysis withwith ISIS --LMLM 1 8.1.8.1. InvestmentInvestment andand thethe InterestInterest RateRate InvestmentInvestment dependsdepends negativelynegatively onon interestinterest rates.rates. Why?Why? MostMost investmentsinvestments areare financedfinanced throughthrough borrowingborrowing oror withwith fundsfunds fromfrom sellingselling financialfinancial securities.securities. IfIf interestinterest ratesrates areare high,high, thenthen therethere areare highhigh borrowingborrowing costscosts oror highhigh losseslosses inin incomeincome InvestmentInvestment function:function: II == ee -- dRdR e,e, dd == constantsconstants dd == howhow muchmuch investmentinvestment fallsfalls whenwhen thethe interestinterest raterate increasesincreases byby 1%1% 2 InvestmentInvestment andand thethe InterestInterest RateRate ByBy makingmaking investmentinvestment endogenous,endogenous, wewe havehave introducedintroduced aa newnew endogenousendogenous variable:variable: thethe interestinterest rate,rate, RR WeWe focusfocus herehere onon thethe averageaverage interestinterest raterate (which(which representsrepresents thethe behaviorbehavior ofof allall thethe differentdifferent typestypes ofof rates:rates: longlong --term,term, shortshort --termterm securities,securities, etc.)etc.) Note:Note: distinguishdistinguish betweenbetween realreal andand nominalnominal interestinterest rates:rates: RealReal interestinterest raterate (R)(R) == NominalNominal interestinterest raterate (i)(i) –– InflationInflation realreal interestinterest rate:rate: RR HereHere wewe useuse thethe realreal interestinterest rate:rate: RR 3 8.2.8.2. NetNet ExportsExports andand thethe InterestInterest RateRate NetNet exportsexports dependdepend negativelynegatively onon thethe interestinterest rate.rate. Why?Why? IfIf U.S.U.S. interestinterest ratesrates areare higherhigher thanthan ratesrates inin otherother countries,countries, dollarsdollars becomebecome moremore attractive,attractive, whichwhich drivedrive upup thethe priceprice ofof dollars;dollars; U.S.U.S. goodsgoods becomebecome moremore expensiveexpensive andand foreignforeign goodsgoods cheaper,cheaper, thusthus netnet exportsexports fallfall XX == gg –– mYmY ---- nRnR nn –– measuresmeasures thethe decreasedecrease inin netnet exportsexports whenwhen thethe interestinterest raterate risesrises byby 1%1% 4 8.4.8.4. TheThe ISIS CurveCurve YY == CC ++ II ++ GG ++ XX CC == aa ++ b(1b(1 --t)Yt)Y II == ee –– dRdR XX == gg –– mYmY -- nRnR 5 TheThe ISIS CurveCurve TheThe ISIS curvecurve showsshows allall combinationscombinations ofof RR andand YY thatthat satisfysatisfy thethe incomeincome identity,identity, thethe consumptionconsumption function,function, thethe investmentinvestment function,function, andand thethe netnet -- exportexport function.function. ItIt isis thethe setset ofof pointspoints forfor whichwhich spendingspending balancebalance occurs.occurs. WhenWhen thethe curvecurve slopesslopes downwarddownward ---- higherhigher interestinterest raterate reducesreduces investmentinvestment andand netnet exportsexports andand therebythereby reducesreduces GDPGDP throughthrough thethe multipliermultiplier processprocess Shifts:Shifts: anan increaseincrease inin governmentgovernment spendingspending increasesincreases GDPGDP throughthrough thethe multipliermultiplier andand shiftsshifts thethe ISIS curvecurve toto thethe rightright 6 8.3.8.3. TheThe DemandDemand forfor andand SupplySupply ofof MoneyMoney MoneyMoney is:is: CurrencyCurrency issuedissued byby thethe FederalFederal ReserveReserve (coins,(coins, dollardollar bills)bills) togethertogether withwith checkingchecking accountaccount balancesbalances heldheld byby publicpublic inin banksbanks ItIt doesdoes notnot includeinclude largerlarger amountamount ofof wealth,wealth, suchsuch asas mutualmutual funds,funds, bonds,bonds, corporatecorporate stock,stock, etc.etc. 7 TheThe DemandDemand forfor MoneyMoney 1. PeoplePeople wantwant toto holdhold lessless moneymoney whenwhen thethe interestinterest raterate isis highhigh andand moremore moneymoney whenwhen thethe interestinterest raterate isis low.low. 2. PeoplePeople wantwant toto holdhold moremore moneymoney whenwhen incomeincome isis higherhigher andand lessless moneymoney whenwhen incomeincome isis lower.lower. 3. PeoplePeople wantwant toto holdhold moremore moneymoney whenwhen priceprice levellevel isis higherhigher andand lessless moneymoney whenwhen priceprice levellevel isis lower.lower. 8 TheThe DemandDemand forfor MoneyMoney MoneyMoney demanddemand functionfunction MM == (kY(kY –– hR)PhR)P MM –– demanddemand forfor moneymoney RR –– interestinterest raterate PP –– priceprice levellevel k,k, hh –– coefficientscoefficients kk –– howhow muchmuch moneymoney demanddemand increasesincreases whenwhen incomeincome increasesincreases hh –– howhow muchmuch moneymoney demanddemand declinesdeclines whenwhen interest rate raises interest rate raises 9 TheThe SupplySupply ofof MoneyMoney MoneyMoney SupplySupply levellevel –– determineddetermined byby thethe FederalFederal ReserveReserve SystemSystem ForFor now,now, wewe assumeassume thatthat thethe FedFed pickspicks aa certaincertain level,level, MM InIn thethe shortshort --runrun model,model, whenwhen pricesprices areare predetermined,predetermined, incomeincome andand interestinterest ratesrates adjustadjust toto keepkeep thethe demanddemand forfor moneymoney equalequal toto itsits fixedfixed supplysupply 10 8.48.4 TheThe LMLM CurveCurve TheThe LMLM curvecurve showsshows allall combinationscombinations ofof RR andand YY thatthat satisfysatisfy thethe moneymoney demanddemand relationshiprelationship forfor aa fixedfixed levellevel ofof thethe moneymoney supplysupply andand aa predeterminedpredetermined valuevalue ofof thethe priceprice level.level. WhenWhen thethe curvecurve slopesslopes upward:upward: ifif thethe interestinterest raterate increases,increases, moneymoney demanddemand decreases;decreases; therefore,therefore, toto havehave equilibriumequilibrium inin thethe moneymoney marketmarket therethere shouldshould bebe anan increaseincrease inin income.income. So,So, anan interestinterest --raterate increaseincrease isis associatedassociated withwith aa riserise inin income.income. 11 TheThe LMLM CurveCurve Note:Note: RealReal moneymoney == moneymoney supplysupply MM divideddivided byby priceprice levellevel PP M/PM/P == kYkY –– hRhR TheThe demanddemand forfor realreal moneymoney dependsdepends positivelypositively onon realreal GDPGDP andand negativelynegatively onon thethe interestinterest raterate ShiftsShifts :: anan increasesincreases inin moneymoney supplysupply shiftsshifts thethe LMLM curvecurve toto thethe rightright 12 8.5.Policy8.5.Policy AnalysisAnalysis withwith ISIS --LMLM MonetaryMonetary Policy:Policy: changeschanges inin thethe moneymoney supplysupply WhatWhat happenshappens inin thethe economyeconomy whenwhen thethe FedFed increasesincreases thethe moneymoney supply?supply? ImmediatelyImmediately afterafter thethe increase,increase, moremore moneymoney isis inin thethe economyeconomy thanthan peoplepeople demand.demand. ThisThis makesmakes thethe interestinterest raterate fall,fall, soso thethe demanddemand forfor moneymoney increases.increases. TheThe lowerlower interestinterest raterate stimulatesstimulates investmentinvestment andand netnet exports.exports. ThisThis raisesraises GDPGDP throughthrough thethe multipliermultiplier process;process; GDPGDP risesrises andand thethe interestinterest raterate fallsfalls LMLM curvecurve shiftsshifts toto thethe rightright (increase(increase inin realreal money)money) 13 PolicyPolicy AnalysisAnalysis withwith ISIS --LMLM Fiscal Policy: the use of tax rates and government spending to influence the economy Ex. Congress passes a bill that increases government spending or decrease in taxes An increase in government spending increases the interest rate (through the increase in the demand for money) and increases income (through the multiplier) Increasing the interest rate reduces investment and net exports, thereby offsetting some of the increase in income – crowding out 14 PolicyPolicy AnalysisAnalysis withwith ISIS --LMLM TheseThese areare shortshort --runrun resultsresults withwith thethe priceprice levellevel predetermined.predetermined. WhenWhen thethe timetime frameframe isis lengthenedlengthened soso thatthat thethe priceprice levellevel cancan adjust,adjust, thesethese resultsresults willwill bebe modified.modified. 15.
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