Chapter 4 -The IS-LM Model

Fundamental inflexibility assumptions: W -- inflexible P -- inflexible i -- flexible Overriding theme -- The interest rate changes as a result of monetary policy (money supply) as well as other factors.

The IS Curve
Re-translation of Simple Keynesian model at equilibrium (Investment = Saving). A plot of equilibrium output for various interest rates within the market for goods and services.

Properties of the IS Curve

Downward sloping, i C, I Y* Shift variables consist of the shift variables of the EP curve, except for the nominal interest rate (i). Increases in autonomous expenditure which shift the EP curve upward, simultaneously shift

 Decreases in autonomous expenditure which shift the EP curve downward, simultaneously shift the IS curve leftward. The steepness or flatness of the IS curve describes the elasticity or responsiveness of C and I to the nominal interest rate. -- Steep IS curve: inelastic. -- Flat IS curve: elastic.

Considering Additional Behavior (Curve #2)

Extra behavior -- decisions to hold money and financial assets. The Demand for Money -- The decision of how much of total wealth should be held as money (I.e. currency and checkable deposits).

Fundamental Aspects -The Demand for Money

Group all assets into two categories -- money and bonds. Advantage of holding money -convenience for making desired transactions. Disadvantage of holding money -interest that could be earned by holding bonds instead.

 Major advantage of holding money implies that we demand money in real units. The Demand for Money (L) -liquidity preference. For a given level of real wealth, the demand for money covers the entire financial asset holding decision (Walras Law).

The Demand for Money in Real Terms (L) -- Causes

Output or Income (Y) Y L The interest rate (i) i L Financial Innovation (FI) FI L

The Supply of Real Money (Ms/P) -- Causes

The Nominal Money Supply (MS) -the Federal Reserves variable for monetary policy. MS (MS/P) The (Inflexible) Price Level (P) P (MS/P)

The LM Curve
Depicts equilibrium in the money market (L = M), as well as the Bond Market (by Walras Law). A plot of the equilibrium interest rate for various levels of output or income, within the money market for a given level of the nominal money supply.

Properties of the LM Curve

Upward sloping, Y L i* Shift variables consist of the shift variables of the money demand and supply curves (except for Y). Increases in the real money supply (MS or P) shift the LM curve rightward.

 Decreases in the real money supply (MS or P) shift the LM curve leftward. The steepness or flatness of the LM curve describes the elasticity or responsiveness of money demand (L) to the nominal interest rate. -- Steep LM curve: inelastic. -- Flat LM curve: elastic.

Economic Policy: IS-LM Model

Equilibrium output (Y*) takes place where the IS and LM curves intersect (equilibrium interest rate, i*, as well). Keynesian property of model Y* < YN, (sluggish economy) Y* > YN, (accelerating inflation) Y* = Y (desired state)

Types of Policy: IS-LM Model

Fiscal Policy -- Change G0, T0, t, or other components of autonomous goods and services expenditure Shift the IS curve. Monetary Policy -- Change the nominal money supply (MS) Shift the LM curve.

Expansionary and Contractionary Policy

Expansionary (Y* < YN) -- shifts the appropriate curve rightward. Contractionary (Y > YN) -- shifts the appropriate curve leftward.

Policy Effectiveness
An effective policy is one that obtains a large output response for a given change - Policy effectiveness depends upon the steepness or flatness of the IS and LM curves.

Decomposition of Policy
Fiscal and monetary policies change interest rates as well as output. This property implies that, for a given policy, Total Effect = Primary Effect + Secondary Effect.

 Primary Effect -- Effect of a policy due to factors other than how it changes i*. Secondary Effect -- Effect of a policy due to how it changes i*. Policy Effectiveness -- based upon size of the secondary effect.