Spring Semester 03-04 Akila Weerapana

Lecture 8: The IS Curve and the LM Curve

I. OVERVIEW
In the next few lectures, we will start to put together a simple macro model of an open economy; we can use this model to examine the impact of scal and monetary policy, as well as to study the macroeconomic implications of choosing dierent exchange rate systems. The rst step in the process is to develop a simple model of a closed economy. The model we use is called the IS-LM model. An important feature of the IS-LM model to keep in mind is that it is a short-run model of the economy; the model works with an exogenously given price level and does not by itself describe what determines changes in price levels over time (i.e. ination). The domestic economy applications of the IS-LM model are studied in more detail in Economics 202; in this class, we will restrict our analysis to the basics of scal and monetary policy. We will then expand the model to incorporate the features necessary for analyzing open economy issues.

II. THE IS CURVE

The IS curve describes the combination of interest rates and output that clear the goods and services market in the short run. The goods and services market is said to clear when spending by consumers, rms, the government (and foreigners if an open economy) on goods and services equals the production of goods and services. The basic equation for the IS curve in a closed economy is closely related to the national income accounting identity Y = C +I +G, where Y is GDP. We assume the following relationships describe how the components of GDP change: ), GDP 1. Consumption (C) is assumed to depend on 3 things: consumer condence (C (which is also the sum of all income in the economy) (Y) and taxes (T). We will sum Y, T ) marize this in a relationship of the form C = C (C, We also specify that, in general, consumption increases when consumer condence increases, decreases when taxes increase and increases when income increases and vice versa. ) and the 2. Investment (I) is assumed to depend on two things: investor condence (I i) interest rate (i). We will summarize this in a relationship of the form I = I (I, We also specify that, in general, investment increases when investor condence increases, decreases when the interest rate increases and vice versa. 3. Government Purchases (G) are assumed to be unrelated to both interest rates (i) and income (Y). Why do these relationships make sense? Lets consider them one by one.

Consumption Consumers are likely to spend more money when they are more certain about the future because they are relatively unafraid of drastic events that leave them without money (you can think of this as job security for example). Similarly, the amount of money they are willing to spend today depends on their income and also on the amount of taxes they have to pay to the government: more taxes imply less money available for spending. Investment Depends positively on investor condence because individuals and rms will be unwilling to sink money into building a factory, for example, if they believe that the government will be overthrown in a civil war that decimates the country. Investment has to be nanced either through borrowing or through your own savings; an increase in the interest rate reduces investment by making it more expensive for rms to borrow money and by increasing the opportunity cost for those who use their own funds. Government Purchases Assumed to be determined according to the ideology and beliefs of those in power. Therefore G is independent of output or interest rates. If we combine these relationships together we can derive the IS curve: all the combinations of Y and i that cause the market for goods and services to clear. The market for goods and services clears when all goods and services produced are purchased by consumers, by rms or by the government. Note that when interest rates are high, investment falls and therefore Y must fall as well; the IS curve should show a negative relationship between i and Y. This can be shown graphically as follows. i
6 @ @ @ @ @ @ @ @ @ @ @ @ @ - Y IS Curve

Shifts in vs. Movements Along the IS Curve One important thing to note is that changes in Y caused by changes in i are reected as movements along the IS curve. When interest rates decrease, spending rises and as a result output increases as well. This is reected in a movement to a lower point on the IS curve where interest rates are lower and output is higher. Conversely, when interest rates increase, spending falls and as a result output decreases as well. This is reected in a movement to a higher point on the IS curve where interest rates are higher and output is lower. On the other hand changes in Y that are brought about by factors other than interest rates will cause Y to change, regardless of the level of interest rates in the economy. Changes in consumer condence, investor condence, government purchases etc. will not change the slope but will change the intercepts: in other words, they will cause the IS curve to shift. What direction will the IS curve shift in response to changes in these variables? We can summarize the changes as follows. 1. An increase in government purchases (G) or a reduction in taxes (T ) will increase expenditure on goods and services and therefore increase output as well. This will cause the IS curve will shift out. Conversely, reductions in G or increases in T will shift the IS curve in. ) or investor condence (I ) will also raise ex2. Increases in consumer condence (C penditure, and therefore production of goods and services, shifting the IS curve out. Reductions in consumer or investor condence will reduce expenditure and shift the IS curve in. Remember that you do not have to memorize each of these changes. If you are in doubt as to how a particular change should be reected in the IS curve, you need to only ask two questions. First, is the change in Y a direct result of a change in the interest rate? If so, then it should be simply a matter of moving to a dierent spot on the IS curve. Second, does the change increase or decrease expenditure on domestic goods and services? If the answer is an increase then it should be an outward shift of the IS curve, if the answer is a decrease it should be a shift in of the IS curve. A couple of graphical examples are provided below. EXAMPLE 1 An increase in G will raise spending, and therefore production, of domestic goods and services. This will cause the IS curve to shift outwards.

i
6 @ @ @ @ @ @ @ @ @ @ @ @ Old IS Curve

@ New IS Curve @ @ @ @ @ @ @ @ @ - Y

EXAMPLE 2 A lower tax rate will increase consumer spending on goods and services and therefore cause the IS curve to shift out. i
6 @ @ @ @ @ @ @ @ @ @ @ @ Old IS Curve

@ New IS Curve @ @ @ @ @ @ @ @ @ - Y

III. THE LM CURVE

The IS curve depicts combinations of interest rates and output that clear the market for goods and services. The IS curve by itself does not pin down the interest rate that prevails in the economy. In order to do so, we look at the money market. The LM curve summarizes all the combinations of income and interest rates that equate money demand and money supply. The LM curve in conjunction with the IS curve will help pin down the interest rate in the economy. In this section we categorize as money, currency (coins and dollar bills) issued by the Federal Reserve, travelers checks and checking account balances held in banks by the public and by rms. The ocial terminology for this denition of money is M1.

 When we focus on the demand for money balances we assume that people care about money for the goods and services they can purchase with money. The Demand for Money We can express the demand for money, as a function of the interest rate i, income Y , exogenous factors () and the price level P , i.e. Money Demand= M d (P, Y, i, ) Note the following 1. When interest rates (i) are high, the demand for money is low because money pays no interest - the opportunity cost of holding money rises. 2. When Y is high the demand for money is high, richer people buy more goods and are likely to hold more money. 3. When P is high the demand for money is high because we need more money to buy goods. 4. Some exogenous factors - the presence of ATMs - can reduce the demand for money. Other exogenous factors - doubts about the health of the banking system - can increase the demand for money. The Supply of Money We assume that the nominal supply of money is set by the Federal Reserve. We denote the nominal money supply as M s . How does the Fed increase the money supply? Is it as simple as printing up a bunch of dollar bills and releasing them into the economy? Basically, yes. The Fed uses what are called open market operations, it buys government bonds in exchange for money. Similarly, if the Fed wants to reduce the money supply it sells some of its holdings of bonds in exchange for money. In the newspapers you often read about the Fed conducting monetary policy by changing interest rates. In reality, what they actually do is change the money supply so as to aect interest rates in the economy. How that works will be seen shortly. For now, think of monetary policy as being represented by increases and decreases in the supply of money. Money Market Equilibrium When the money market is in equilibrium, money supply = money demand so M s = M d (P, Y, i, ). The LM curve summarizes all combinations of income and interest rates that equate money demand and money supply. The LM curve is an upward sloping relationship between i and Y. Intuitively we can explain the upward sloping LM curve as follows: Lets consider some combination of income and interest rates that equate money demand with the money supply set by the Fed. Now suppose there is an increase in income. The increase in income causes the demand for money to increase. However, money supply is unaected by the increase in income. The only way that money demand and money supply can be equal again is if interest rates also increase to reduce money demand.

 Similarly, if there is a decrease in income then the demand for money will decrease. However, money supply is again unaected. In order to equilibrate money demand and money supply, interest rates have to decrease as well in order to increase money demand. Graphically, we can draw the LM curve as i
6

- Y @ I @ @ LM Curve

Shifts in vs. Movements Along the LM Curve Once again the most important thing to note is that changes in Y , i are reected as movements along the LM curve. Changes in money supply, changes in the price level or changes in exogenous money demand will shift the LM curve. Any changes (not associated with Y or i) that result in excess money supply would lower interest rates for any level of income (a shift out of the LM curve). The fall in interest rates will raise money demand and help clear the money market. Conversely, any events that result in excess money demand would raise interest rates for any level of income (a shift in of the LM curve). The rise in interest rates will lower money demand and help clear the money market. What factors cause the LM curve to shift out (i.e. cause an excess supply of money) 1. The Fed increases the money supply (expansionary monetary policy). All else equal, money supply increases relative to money demand - excess supply of money. 2. A decrease in the price level. All else equal, money demand goes down relative to money supply - excess supply of money. 3. An exogenous negative shock to money demand - e.g. widespread use of ATM cards. All else equal, money demand goes down relative to money supply - excess supply of money. What factors cause the LM curve to shift in (i.e. cause an excess demand of money) 1. The Fed decreases the money supply (contractionary monetary policy). All else equal, money supply decreases relative to money demand - excess demand for money.

2. An increase in the price level. All else equal, money demand increases relative to money supply - excess demand for money. 3. An exogenous positive shock to money demand - e.g. worry about bank failure. All else equal, money demand increases relative to money supply - excess demand for money. We can illustrate with a few examples Example 1: An Increase in the Money Supply (M) An increase in the supply of money will bring about an excess supply of money. The excess demand can only be cleared if the interest rate falls at each level of income - the LM curve shifts to the right (outward). r
6

Old LM Curve @ @ R @ I @ @ @New LM Curve - Y

Example 2: An Increase in the Price Level An increase in the given price level will raise money demand and cause an excess demand for money. Since money supply is unchanged, this excess money demand can only be cleared if the interest rate rises at all levels of Y - the LM curve shifts to the left (inward). r
6

New LM Curve @ @ R @ I  @ @ @Old LM Curve - Y