IS-LM 2: Examples

See Mankiw 12.1 & 12.3

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The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets.

The LM curve represents money market equilibrium.

Recap: Equilibrium in IS -LM

The IS curve represents equilibrium in the goods market.

Y C Y T I r G ( ) ( )

( , )M P L r Y ISY

rLM

r1

Y1

2

Policy & Shocks in ISLM

• Fiscal policy: change G and/or T

• Monetary Policy: Change M

• Shocks to the economy– Great Depression– Crisis of 2008

3

Fiscal Policy and Crowding out

• Shift in the IS curve: G is in defn of IS

• Shift along the LM curve: G is not in defn of LM

• IS shifts to right: for any interest rate output will rise– Remember multiplier

• Crowding out– Final Y is less then if we

looked at goods market only

– GYLrIY– Public expenditure replaces

private investment

r

y

LM

IS1

IS0

4

warning: v simple cons function

IS1

FP & Crowding out

1. IS curve shifts right

Y

rLM

r1

Y1

G

1by

1 MPC

IS2

Y2

r2

1.2. This raises money

demand, causing the interest rate to rise…

2.

3. …which reduces investment, so the final increase in Y

G

1is smaller than

1 MPC

3.

5

IS1

1.

A tax cut

Y

rLM

r1

Y1

IS2

Y2

r2

Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G…

and the IS curve shifts by

T

1

MPC

MPC1.

2.

2.…so the effects on r and Y are smaller for T than for an equal G.

2.

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Balanced Budget Multiplier

• The expression for the multiplier is from a very simple model

• But the general idea that tax multiplier is smaller than expenditure multiplier is true

• Why? Savings• This implies that balanced budget multiplier

is greater than zero.• In the very simple model it is 1

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r

Y

LM1

IS

LM2

An Increase in Money Supply

• Money supply affects LM direclty

• Shift in LM along IS

• LM shift: for any output level interest rates will fall

• New eqm. has lower r and higher Y

• There is a crowding out effect her also.

– r less than if we looked at money market only

– Y rises and puts extra demand for money

• M r > I > Y> L> r

8

Interaction between monetary & fiscal policy

• Model: – Monetary & fiscal policy variables

(M, G, and T ) are exogenous.

• Real world: – Monetary policymakers may adjust M

in response to changes in fiscal policy, or vice versa.

– Such interactions may alter the impact of the original policy change.

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If Gov raises G, the IS curve shifts right.

IS1

Change G & M: Extra effect

Y

rLM1

r1

Y1

IS2

Y2

r2To keep r constant, CB increases M to shift LM curve right.

3 1Y Y Y

0r

LM2

Y3

Results: No Crowding out

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IS1

Change G & M: No effect on Y

Y

rLM1

r1

IS2

Y2

r2To keep Y constant, CB reduces M to shift LM curve left.

LM2

Results: •complete CO•Why? Inflation•Example German unification

Y1

r3

If Gov raises G, the IS curve shifts right.

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Estimates of fiscal policy multipliersfrom the DRI macroeconometric model of US

Assumption about monetary policy

Estimated value of Y / G

Fed holds nominal interest rate constant

Fed holds money supply constant

1.93

0.60

Estimated value of Y / T

1.19

0.26

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Shocks to the Ecomomy: IS• Exogenous changes in the demand for goods

& services.

• Examples: – Housing boom or crash

change in households’ wealth C

– Note that this implies a more complicated consumption function (see later)

– change in business or consumer confidence or expectations I and/or C

– Expectations are not in the simple model (so far)

13

LM Shocks

• Exogenous changes in the supply/demand for money.

• Examples:– A wave of credit card fraud increases demand

for money.– More ATMs or the Internet reduce money

demand– Leaving the euro

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Example: Irish Housing Mkt

15

IS1

Y

rLM1

r1

Y1

IS2

Y2

r2

• Decline in house prices affects consumers wealth.

• C falls (need more complicated C fn)

• IS shifts left, causing

• r and Y to fall.• Policy response?• Caveat: SOE

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Example: US recession of 2001

Causes: 1) Stock market decline CCauses: 2) 9/11

– increased uncertainty– fall in consumer & business confidence– result: lower C & I

Causes: 3) Corporate accounting scandals– Enron, WorldCom, etc. – reduced stock prices, discouraged investment

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Example: US 2001

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IS1

Y

rLM1

r1

Y1

IS2

Y2

r2

• Multiple reasons for decline in C & I

• IS shifts left• Make sure you

understand why?• Hint: this is a

typical exam question.

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• The Policy Response

• Fiscal policy:– tax cuts in 2001 and 2003 (T down)– spending increases (G up)– Shift IS curve to right (why?)

• Monetary policy– Increase in M– shifted LM curve down (why?)

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US Recession 2001

IS2

Policy Response 2001

Y

rLM2

IS1

LM1

• Economy starts at A• Shock: IS1 IS2

• AB• FP: IS2 IS1

• MP: LM1LM2

• BC

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A

B C

Great Depression

• The biggest economic crash in modern times

• Bigger than the crisis now• Policy makers learned a lot from great

depression• Three questions

1. What was the cause?2. What was the policy response?3. What should have been the policy response?

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The Great Depression

Unemployment (right scale)

Real GNP(left scale)

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

bill

ions

of

1958

dol

lars

0

5

10

15

20

25

30

perc

ent o

f la

bor

forc

e

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IS Shocks

• Stock market crash exogenous C – Oct 1929–Dec 1929: S&P 500 fell 17%– Oct 1929–Dec 1933: S&P 500 fell 71%

• Drop in investment– Correction after overbuilding in the 1920s.– Widespread bank failures made it harder to obtain

financing for investment.– Parallels with recent history

• Contractionary fiscal policy– Politicians raised tax rates and cut spending to combat

increasing deficits.

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Monetary Shocks (LM)

• Asserts that the Depression was largely due to huge fall in the money supply.

• Milton Friedman: “Monetarist” Approach

• Evidence: M fell 25% during 1929–33.

• But, two problems with this hypothesis:– P fell even more, so M/P actually rose slightly during

1929–31.

– nominal interest rates fell, which is the opposite of what a leftward LM shift would cause.

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The effects of falling prices• Strictly speaking ISLM not much use for analyzing

deflation.– We will return to this later

• The destabilizing effects of unexpected deflation:debt-deflation theory

P (if unexpected) transfers purchasing power from borrowers to lendersborrowers spend less,

lenders spend moreif borrowers’ propensity to spend is larger than

lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

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Another Depression is unlikely• Policymakers (or their advisers) now know

much more about macroeconomics:

– The Fed knows better than to let M fall so much, especially during a contraction.

– Fiscal policymakers know better than to raise taxes or cut spending during a contraction.

• Federal deposit insurance makes widespread bank failures very unlikely.

• Automatic stabilizers make fiscal policy expansionary during an economic downturn.

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The 2008–09 financial crisis & recession

• 2009: Real GDP fell, u-rate approached 10% in US

• Important factors in the crisis:– subprime mortgage crisis

– bursting of house price bubble, rising foreclosure rates

– falling stock prices

– failing financial institutions

– declining consumer confidence, drop in spending on consumer durables and investment goods

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Change in U.S. house price index and rate of new foreclosures, 1999–2009

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Consumer sentiment and growth in consumer durables and investment spending

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29

30

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The Policy Response

• US– Tax cuts

– Obama “Stimulus”

– Fed “Quantitative Easing”

• Combination makes situation better

• Ireland– Tax rises

– Cuts in expenditure

– No change in money supply

• Combination makes situation worse

• Why do this?

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The US

r

y

LM0

IS1

IS0

33

• Start at A• The shock:

– IS0 IS1

– AB• The stimulus:

– IS1 IS2

– BC• Q easing:

– LM0 LM0 – CD

IS2

LM1A

BC

D

Ireland

r

y

LM0

IS2

IS0

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• Start at A

• The shock: – IS0 IS1

– AB

• Austerity: – IS1 IS2

– BC

IS1

A

CB

D

Conclusions

1. IS curve is equilibrium in the goods market– rIY

2. LM curve is equilibrium in Money market– YLr

3. Simultaneous equilibrium – Unique stable

4. Fiscal and Monetary policy– Crowding out– Quantitative easing– Shocks– examples

What’s Missing

Three Big Things missing from the model

1.Expectations or forward looking behaviour– Hint of this in consumption out of wealth

2.No price adjustment– Very simplistic approach to supply side

3.Ignore openness of economy– Most countries are SOE

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