intermediate macroeconomics chapter 6 the neoclassical is-lm model
TRANSCRIPT
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Intermediate Macroeconomics
Chapter 6
The Neoclassical IS-LM Model
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Intermediate Macroeconomics
The Neoclassical IS - LM Model
• IS-LM Model• The IS Curve• The LM Curve• IS-LM Equilibrium• Fiscal and Monetary Policy
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Intermediate Macroeconomics
1. IS – LM ModelIntroduce variable interest rate
Simple Model
Chapter 4 Keynesian Chapter 5
IS - LM Chapter 6
Income Fixed Variable Variable
Interest Rates Fixed Fixed Variable
Prices Fixed Fixed Fixed
Consumption Autonomous Function of
Income Function of
Income
Investment Autonomous Autonomous Function of
Interest Rate
Money Supply Not Included Not Included Autonomous
Money Demand Not Included Not Included Function of Income and Interest Rate
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Intermediate Macroeconomics
1. IS – LM ModelIntroduce variable interest rate
• IS (Goods) Sector, Investment:
I = I0 - b · i
Solve for: iIS = f(Y)
• LM (Money) Sector, Money Demand:
Md = k · Y - h · i
Solve for: iLM = f(Y)
• Equilibrium
iIS = iLM
Solve for Y
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Intermediate Macroeconomics
1. IS – LM Model IS – LM Curves
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National Income, Y
Inte
rest
Rat
e, i
IS Curve
LM Curve
Equilibrium Incomeand Interest Rate
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Intermediate Macroeconomics
1. IS – LM Model Fiscal and monetary policy
• Fiscal Policy (spending and taxes)– shifts IS curve– increase in spending or cut in taxes
shifts IS curve to the right
• Monetary Policy (money supply)– shifts LM curve– increase in money supply shifts LM
curve to the right
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Intermediate Macroeconomics
2. IS curveInvestment
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Planned Investment
Inte
rest
Rat
e
Planned investment is a negative function of the interest rate
Slope = - b
As the interest rate declines planned investment increases.
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Intermediate Macroeconomics
2. IS CurveThe “goods” market
Given:
AE = C + I + G + NX
C = C0 + c · YD
I = I0 - b · i
G = G0
NX = NX0
YD = Y – t · Y + TR0
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Intermediate Macroeconomics
2. IS CurveDerive the IS curve (1 of 3)
• Given:AE = C + I + G + NX
C = C0 + c · YD
I = I0 - b · i
G = G0
NX = 0
YD = Y – T0 – t · Y + TR
• Step 1. Restate Aggregate Demand:AE = C0 + c · (Y – T0 – t · Y + TR) + I0 - b · i + G0
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Intermediate Macroeconomics
2. IS CurveDerive the IS curve (2 of 3)
Step 2. State the Goods Market equilibrium condition:
Y = AE
Step 3. Substitute AE from Step 1 into Step 2:
Y = C0 + c · (Y – T0 – t · Y + TR) + I0 - b · i + G0
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Intermediate Macroeconomics
2. IS CurveDerive the IS curve (3 of 3)
Step 4. Solve for Interest Rate as a function of Income:
Y = C0 + c · (Y – T0 – t · Y + TR) + I0 - b · i + G0
b · i = C0 + I0 + G0 + c · (Y – T0 – t · Y + TR) - Y
b · i = C0 + I0 + G0 – T0 + c · TR – [1 – c(1-t)] · Y
i = 1 · (C0 + I0 + G0 – c · T0 + c · TR) - 1- c(1-t) · Y b b
intercept slope (negative)
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Intermediate Macroeconomics
2. IS CurveGraph
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National Income, Y
Inte
rest
Rat
e, i
Intercept = 1 * (C0 + I0 + G0 - c T0 + c TR) b
Slope = - 1 - c (1 - t) b
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Intermediate Macroeconomics
2. IS CurveShift in the IS curve
A change in the intercept causes the IS curve to shift.
Intercept = 1 * (C0 + I0 + G0 - c T0 + c TR) b An increase in government spending or
decrease in taxes increases the value of the intercept and causes the IS curve to shift up (or to the right).
The size of the shift depends on the sensitivity of investment to the interest rate, b.
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Intermediate Macroeconomics
2. IS CurveFiscal policy effectiveness and IS curve shift
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0.02
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0.1 4
0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
National Income, Y
Inte
rest
Rat
e, i
IS Curve
LM Curve
Small shift in IS Curve.b is large.Investment is very sensitive to changes in the interest rate
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0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
National Income, Y
Inte
rest
Rat
e, i
LM Curve
IS Curve
Large shift in IS Curve.b is small.Investment is not sensitive to changes in the interest rate
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Intermediate Macroeconomics
2. IS CurveFiscal policy effectiveness and IS curve shift
• Small shift in IS curve– Classical view, fiscal policy ineffective– Increase in government spending raises
interest rate, which crowds out (reduces) investment spending. Net increase in aggregate spending may be small
• Large shift in IS curve– Keynesian view, fiscal policy effective.– Increase in government spending may raise
the interest rate but has no effect on investment. Get big bang for buck.
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Intermediate Macroeconomics
2. IS CurveSlope of the curve
Effectiveness of fiscal policy also depends on the slope of the IS curve
Slope = - 1 - c (1 - t) b
Keynesian: small b, steep curve fiscal policy more effective
Classical: large b, flat curvefiscal policy less effective
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Intermediate Macroeconomics
2. IS CurveFiscal policy effectiveness and IS curve slope
0
0.02
0.04
0.06
0.08
0.1
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0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
National Income, Y
Inte
rest
Rat
e, i
IS Curve
LM Curve
Flat IS Curve.b is large.Investment is very sensitive to changes in the interest rate
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0.02
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0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
National Income, Y
Inte
rest
Rat
e, i
LM Curve
IS Curve
Steep IS Curve.b is small.Investment is not sensitive to changes in the interest rate
Small increase inNational Income
Larger increase inNational Income
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Intermediate Macroeconomics
2. IS CurveFiscal policy effectiveness and IS curve slope
• Flat IS curve– Classical view, fiscal policy ineffective– Increase in government spending raises
interest rate, which crowds out (reduces) investment spending. Net increase in aggregate spending may be small
• Steep IS curve– Keynesian view, fiscal policy effective.– Increase in government spending may raise
the interest rate but has little effect on investment. Get big bang for buck.
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Intermediate Macroeconomics
3. LM CurveMoney Supply and Money Demand
• Money Supply:– assumed to be a some fixed level
• Money Demand:– negative function of interest rate. People
hold more money when interest rates decline.
– positive function of income. People hold more money as their income increases.
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Intermediate Macroeconomics
3. LM CurveDerive the LM Curve (1 of 2)
• Given:
Money Demand: Md = k · Y - h · i
Money Supply: Ms = M
• Step 1. State the money market equilibrium condition:
Ms = Md
• Step 2. Substitute equations for Md and Ms into equilibrium condition:
M = k · Y - h · i
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Intermediate Macroeconomics
3. LM CurveDerive the LM Curve (2 of 2)
Step 3. Solve for Interest Rate as a function of Income:
M = k · Y - h · i
h · i = - M + k · Y
i = - 1 · M + k · Y h h
intercept slope (positive)
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Intermediate Macroeconomics
3. LM CurveGraph
-0.04
-0.02
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National Income, Y
Inte
rest
Rat
e, i
Intercept = - 1 M h
Slope = k h
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Intermediate Macroeconomics
3. LM CurveShift in the LM curve
A change in the intercept causes the LM curve to shift.
Intercept = - 1 M hAn increase in money supply, M, reduces the
value of the intercept (more negative) and causes the LM curve to shift down (or to the right).
The size of the shift depends on the sensitivity of money demand to the interest rate, h.
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Intermediate Macroeconomics
3. LM CurveMonetary policy and LM curve shift
0
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0.08
0.1
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0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
National Income, Y
Inte
rest
Rat
e, i
IS Curve
LM Curve
Small shift in LM Curve.h is large.Money demand is very sensitive to changes in the interest rate
0
0.02
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0.08
0.1
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0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
National Income, Y
Inte
rest
Rat
e, i
LM Curve
IS Curve
Large shift in LM Curve.h is small.Large change in interest rate required to change money demand
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Intermediate Macroeconomics
3. LM CurveMonetary policy and LM curve shift
• Small shift in LM curve– Keynesian view, monetary policy ineffective– Increase in money supply is met by an
increase in money demand without a significant decline in the interest rate. No stimulus to investment spending.
• Large shift in LM curve– Classical view, monetary policy effective.– Increase in money supply leads to a large
decline in the interest rate in order to increase money demand. Increases investment spending.
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Intermediate Macroeconomics
3. LM CurveSlope of the LM curve
Effectiveness of monetary policy also depends on the slope of the LM curve
Slope = k h
Keynesian: large h, flat curvemonetary policy less effective
Classical: small h, steep curve monetary policy more effective
Note: little debate over change in money demand with change in income, k.
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Intermediate Macroeconomics
3. LM Curve Monetary policy and LM curve slope
0
0.02
0.04
0.06
0.08
0.1
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0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
National Income, Y
Inte
rest
Rat
e, i
IS Curve
LM Curve
Steep LM Curve.h is small.Money demand is insensitive to changes in the interest rate
0
0.02
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0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0
National Income, Y
Inte
rest
Rat
e, i LM Curve
IS Curve
Flat LM Curve.h is large.Money demand is very sensitive to changes in the interest rate
Smaller increase inNational Income
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Intermediate Macroeconomics
3. LM CurveMonetary policy and LM curve slope
• Flat LM curve– Keynesian view, monetary policy ineffective– Increase in money supply has little or no effect
on the interest rate. Money demand adjusts to match money supply. No change in interest rate means no change in investment and aggregate spending
• Steep LM curve– Classical view, monetary policy effective.– Increase in money supply lowers the interest
rate, which increases investment spending.
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Intermediate Macroeconomics
4. IS - LM EquilibriumSolve the model (1 of 2)
Step 1. Apply IS - LM equilibrium condition
iIS = iLM
Step 2. Substitute IS (step 4) and LM (step 3) solutions for interest rate:
1 · (C0 + I0 + G0 + c · TR – c · T0) - 1 – c(1-t) · Y b b
= - 1 · M + k · Y h h
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Intermediate Macroeconomics
4. IS - LM EquilibriumSolve the model (2 of 2)
Step 3. Solve for Income, Y
Y = h (C0 + I0 + G0 + c · TR – c · T0) [1-c(1-t)] · h + b · k
+ b M [1-c(1-t)] · h + b · k
Autonomous Spending Money Multiplier Multiplier
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Intermediate Macroeconomics
5. Fiscal and Monetary Policy Fiscal Policy
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IS Curve
LM Curve
1
2
1 – Increase in government spending (expansionary fiscal policy) National income rises with increase in spending (C and G)2 – Increase in income leads to increase in money demand. Interest rate rises to maintain balance between money supply and money demand. Investment spending declines with higher interest rate. Aggregate spending and national income decline.
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Intermediate Macroeconomics
5. Fiscal and Monetary Policy Monetary Policy
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IS Curve
LM Curve
1
2
1 – increase in money supply (expansionary monetary policy). interest rate falls to maintain balance between money
demand and money supply.2 – lower interest rate stimulates investment spending. increase in national income with higher spending also
raises money demand which leads to an increasein the interest rate.
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Intermediate Macroeconomics
5. Fiscal and Monetary PolicyExpansionary fiscal policy
• Investment negatively related to interest rate (investment curve downward sloping)
• Aggregate expenditures negatively related to interest rate (downward sloping)
• Fiscal policy change shifts the IS curve only. Increase in government spending or cut in taxes shifts IS curve to the right
Keynes Classical
Investment and interest rate
Insensitive (inelastic)
b is small
Sensitive (elastic)
b is large
IS curve intercept shift, 1/b
Large Small
IS curve slope,
- [1-c(1-t)]/b
Steep Flat
Crowding out of investment
Small Large
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Intermediate Macroeconomics
5. Fiscal and Monetary Policy SummaryExpansionary monetary policy
• Money demand negatively related to interest rate and positively related to income
• LM curve upward sloping. An increase in income requires an increase in interest rate to maintain constant money demand.
• Monetary policy change shifts the LM curve only. Increase in money supply shifts LM curve to the right
Keynes Classical
Money demand and interest rate
Sensitive (elastic)
h is large
Insensitive (inelastic)
h is small
LM curve intercept shift, 1/h
Small Large
IS curve slope,
k/h
Flat Steep
Change in investment
Small Large