IS-LM Revisited

Simple Income Determination

Properties of IS & LM Curves
Equilibrium Output & Interest Rates
Economic Policy
(1) Simple Income Determination
* Eco 1002
* Goods Market (IS)
* Exogenous Interest Rate & Prices
* Endogenous Income (GDP)
(2) IS-LM Model
* Eco 2101 (Keynesian Short-Run)
* (1) + Money Market
* Endogenous Income & Interest Rate (Fixed P)
Endogenous Policy
Simple Income Determination
(Eco 1001)
Behavioral Assumptions:
Consumption = C (y, r)
y = disposable income = Y T
r = interest rate
MPC = where 0 < C
y
< 1
Investment = I(r)

Government Purchases = G
Exogenous: r, P, Fiscal Policy: G, T
Endogenous: Y
Linear Examples
y
C y C = c c /
0 / < = c c
r
I r I
Equilibrium:

Some Basic Results:

(interest rates and GDP)



(Gov. Spending Multiplier)


(Tax Multiplier)
E G r I r y C Y + + = ) ( ) , (
1
1
1
/ >

=
y
C
dG dY
0
1
/ <

+
=
y
r r
C
I C
dr dY
0
1
/ <

=
y
y
C
C
dT dY
IS-LM Model (Eco 2101)
Goods & Money Market Equilibrium
IS-LM Model
Exogenous: P, Fiscal Policy: G, T
Monetary Policy: M
s

Endogenous: Y and r

IS and the Goods Market
Goods Market Equilibrium:
Y = C(y,r) + I(r) + G (IS equation)
where y = Y T = disposable income
0< C
y
< 1
I
r
< 0
G and T are exogenous policy
variables
Properties of IS curve:
Slope*:

Government spending multiplier:
(shifts right)

Tax Multiplier:
(shifts left)
0
1
<

+
=
y
r r
IS
C
I C
dr
dY
1
1
1
>

=
y
C dG
dY
0
1
<

=
y
y
C
C
dT
dY
LM and the Money Market
Real Money Demand = L(Y,r)



Money Market Equilibrium:

M
s
= P*L(Y,r) (LM equation)

M
s
is an exogenous policy variable.

0 / > = c c
Y
L Y L
0 / < = c c
r
L r L
Properties of LM curve
Slope*:


Real Money Supply:

(shifts right)
0 > =
Y
r
LM
L
L
dr
dY
0
1
) (
< =
r
s
PL M d
dr
The Simple IS-LM Model - (Y,r) which
solves:

(IS)

(LM)


G r I r y C Y + + = ) ( ) , (
) , ( * r Y L P M
s
=
Policy in IS-LM Model
Exogenous: P
Endogenous: Y, r
Policy Variables: G, Ms, T
Fiscal Policy
(1) Government Expenditures (dG)


but less than 1/(1-C
y
)!
0
) / )( ( ) 1 (
1
) ( ) 1 (
*
>
+ +
=
+ +
=
r Y r r y r r Y r y
r
L L I C C I C L L C
L
dG
dY



Crowding-out effect!
Effectiveness of G:
If (IS Flat)

or (LM verticle)

then . (Complete crowding-out!)
(2) Taxes (dT): dY/dT = ?, dr/dT = ?
0
) ( ) 1 (
*
>
+ +

=
r r Y r y
Y
I C L L C
L
dG
dr

r r
C I ,
0
r
L
0
dG
dY
Monetary Policy (dM
s
):









0
) ( ) 1 (
*
>
+ +
+
=
r r Y r y
r r
s
I C PL PL C
C I
dM
dY
0
) ( ) 1 (
1
*
<
+ +

=
r r Y r y
y
s
I C PL PL C
C
dM
dr
Effectiveness of monetary policy:
If (IS vertical)

or (LM flat)

Then

(Ineffective Monetary Policy)

0 ,
r r
C I

r
L
0
s
dM
dY
Liquidity Trap and Interest Rate
Insensitivity
Great Depression
Year UR i t r = i - t
1930 8.9 3.6 -2.6 6.2
1931 16.3 2.6 -10.1 12.7
1932 24.1 2.7 -9.3 12.0
1933 25.2 1.7 -2.2 3.4
1934 22.0 1.0 7.4 -6.6
1935 20.3 0.8 0.9 -0.1
1936 17.0 0.8 0.2 0.6
2008-09 Recession
Jan 2007 Jan 2010, Federal funds rate
cut from 6% to 1%.
i UR
Jan 2007 5.25% 4.6%
Jan 2008 3.94% 5%
Jan 2009 0.15% 7.7%
Jan 2010 0.12% 10%
Business Cycles in IS-LM
Shocks to Consumer confidence ():
C = C(Y,r,) where C

> 0
dY*/d > 0
dr*/d > 0
Shocks to money demand (o):
L = L(y,r,o) where L
o
> 0
dY*/do < 0
dr*/do > 0
Endogenous Policy
Monetary/Fiscal Policy responds to economic
conditions to achieve goal.
Objective: dY = 0 (output stability) OR
dr = 0 (interest rate stability)
Exogenous: Policies - M
s
or G, or T
Shocks or o
Endogenous: Policies - M
s
or G, or T
Example: An increase in G and Feds objective
is to keep r constant (prevent crowding out).
Step 1: Set dr = 0
Step 2: Treat dY and dM
s
as endogenous, dG
as exogenous.
Step 3: Use Cramers Rule to solve for
dY/dG and dM
s
/dG.
Suppose instead Fed wanted to keep output
stable (dY = 0). Find dr/dG and dM
s
/dG.
Evaluation of Simple Keynesian IS-
LM Models
Provided reasonable explanation of
business cycles.
Guides policymakers on stabilizing
economic fluctuations.
Can be applied easily to think about
current events.
Shortcomings
Criticisms of IS-LM Model:
(1) Emphasis on aggregate demand.
(2) Static Model.
(3) Lack of solid microeconomic
foundations.
Lucas Critique on Policy Evaluation
Examples: Consumption, Phillips Curve
Modern Macro
Dynamics
Expectations (rational)
Microeconomic Foundations

Most modern macro models (New Classical
and New Keynesian) have these features.