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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 fiscal and monetary policy, as well
as to study the macroeconomic implications of choosing different exchange rate systems.
The first 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. inflation).
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 fiscal and monetary
policy. We will then expand the model to incorporate the features necessary for analyzing
open economy issues.
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 confidence because individuals and firms 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 financed either through borrowing or through your own savings;
an increase in the interest rate reduces investment by making it more expensive for firms
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 firms
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.
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IS Curve
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EXAMPLE 2
A lower tax rate will increase consumer spending on goods and services and therefore cause
the IS curve to shift out.
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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 affect
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 unaffected 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 unaffected. 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
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LM Curve
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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).
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Old LM Curve
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