Lecture 41.pdf

The IS-LM Model: A Historical Perspective

Module Convenor: Luke Buchanan-Hodgman

Contact: [email protected] Office: Keynes D2.12 Contact Hours: Thursday 10-11

Website: https://sites.google.com/site/buchananhodgman

Learning Objectives

1.

LO1: Understand the IS and LM curves - i.e., equilibrium in

the goods market (IS) and money market (LM)

2.

LO2: The concept of general equilibrium and equilibrium

adjustment (model consistency)

Model Comparison: AS-AD versus IS-LM

Thus far we have dealt explicitly with four models: the APE

model, the AS-AD model and two money market models.

However, the models have been categorised by economists into two

notably distinct sub-genres of theory;

I

Neo-Classical type:

the AS-AD model and the Quantity

Theory of Money are complementary in that both emphasise

the neutrality of demand stimuli if it is inflationary. This

result occurs due to the reaction of the price mechanism to

output gaps.

I

Keynesian:

the APE model and the Keynesian money market

APE and Keynesian money market models: what have we learnt so far?

I Intersection of the money demand and supply schedules, with the bond market behind the scenes, determines theinterest ratein the Keynesian money market

I We assume fixed (ignore) the price level, and so the Fisher Equation -r =i−π- implies that the nominal interest rate,i, equals the real interest rate,r

I The interest rate affects planned investment spending, and by extension real GDP in the goods market

I Real GDP affects a shift in the money demand schedule, thus altering the interest rate thatclearsthe Keynesian money market.

I Notice that real GDP⇐⇒interest rate. Therefore, these markets (goods and money) areinterdependent

Deriving the IS Curve: Goods Market Equilibrium

Y

Y

APE=Y

APE(r= 2%)

APE(r= 4%)

APE(r= 4%)

45◦

Y

APE

Y

Y

2%

4%

IS

Y

Interest

Rate

How do we interpret the IS curve?

I The IS curve plots out the (real) interest rate and real GDP pairs that areconsistent with equilibrium in the APE model.

I Fixing inflation, a change in the (nominal) interest rate by policy-makers equates to a change in the real interest rate. This change in the interest rate shifts the APE schedule, resulting in a change in equilibrium real GDP.

I Intuition: an increase in the interest rate discourages borrowing behaviour. In the context of the APE model, we would strictly refer to the sensitivity of investment spending to changes in the interest rate. Conceptually however, it is clear that this would also impact on consumption. So consumption and investment would fall, shifting the APE schedule down.

Deriving the LM Curve: Money Market Equilibrium

Rm

2%

4%

Ms

Md,2(Y2)

Md,1(Y1)

Rm

r

Y

Y

2%

4%

LM

Y

r

How do we interpret the LM curve?

I First, it is important to recognise that in the IS-LM model the interest rate isendogenous(go back to our discussion in last weeks lectures to see the distinction)

I As with the IS curve, the LM plots out (real) interest rate and real GDP pairs that are consistent with equilibrium but this time in the money market

I A change in real GDP leads to a shift in the money demand schedule in the Keynesian money market.

I With money supply exogenously controlled by the BoE, the interest rate must adjust, via the bond market, to clear the money market

I Notice: although there are, given by the IS and LM curves independently, different{Y,r} pairs that clear either market, due to their respective slopes there can only be one

IS-LM: General Equilibrium

Ye

re

LM

IS E0

IS-LM: Disequilibrium in the Goods Market and Adjustment to Equilibrium

Y1 Ye Y2

r1

re

r2

LM

IS E0

X0

X1

Interpreting Equilibrium Adjustment in the Goods Market: 2 examples

Initial positionX0:

I We are on the LM curve, but not the IS curve. Therefore, we have equilibrium in the money market but

not in the goods market.

I At this interest rate, real GDP is below its equilibrium (i.e., APE>Y). Therefore, real GDP will rise.

I As real GDP increases, demand for money will rise also. This shifts the money demand schedule in the

money market.

I When the money demand schedule shifts, the shadow behaviour in the bond market puts upward pressure

on the interest rate to rise.Result: we arrive back at general equilibriumE0

Initial positionX1:

I We are on the LM curve, but not the IS curve. Therefore, we have equilibrium in the money market but

not in the goods market.

I At this interest rate, real GDP is above its equilibrium (i.e., APE<Y). Therefore, real GDP will fall.

I As real GDP falls, demand for money will fall also. This shifts the money demand schedule in the money

market.

I When the money demand schedule shifts, the shadow behaviour in the bond market puts downward

IS-LM: Disequilibrium in the Money Market and Adjustment to Equilibrium

Y1 Ye Y2

r1

re

r2

LM

IS E0

Z0

Z1

Interpreting Equilibrium Adjustment in the Money Market: 2 examples

Initial positionZ0:

I We are on the IS curve, but not the LM curve. Therefore, we have equilibrium in the goods market but not

in the money market.

I AtZ0, the interest rate is above equilibrium for a given quantity of real GDP.

I At this interest rate, money supply will outstrip money demand. Therefore, agents purchase bonds and the

interest rate falls.

I When the interest rate begins to fall, borrowing behaviour is incentivised and demand increases pushing up

real GDP.Result: we arrive back at general equilibriumE0

Initial positionZ1:

I We are on the IS curve, but not the LM curve. Therefore, we have equilibrium in the goods market but not

in the money market.

I AtZ1, the interest rate is below equilibrium for a given quantity of real GDP.

I At this interest rate, money demand will outstrip money supply. Therefore, agents sell bonds and the

interest rate rises.

I When the interest rate begins to rise, borrowing behaviour is disincentivised and demand falls putting

Learning Objectives

1.

LO1: Understand the IS and LM curves - i.e., equilibrium in

the goods market (IS) and money market (LM)

X