Topic 4; IS-LM model (2017)Apunte Inglés
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G O O D S A N D F I N A N C I A L M A R K E T S : TH E I S - L M M O D E L ( S H O R T R U N )
THE GOODS MARKET AND THE IS RELATION
Equilibrium in the goods market exists when production, Y, is equal to the demand for
goods, Z. This condition is called the IS relation. In the simple model developed in Topic 2,
the interest rate did not affect the demand for goods. The equilibrium condition was given
Investment depends primarily on two factors:
The level of sales (+) need to increase production (Y)
The interest rate (-) cost of borrowing to buy K (i). Interest rate is the cost of
borrowing/lending in respect to "tomorrow"→ opportunity cost. Usually you
borrow, and you have to pay an interest rate. Also, if you use the resources instead
of saving it, you'll also have the opportunity cost, because you'll lose the money
that you'd win if you had saved the money.
I=I(Y,i) Investment is not a constant anymore, but is a function of income(+) and interest rate().For an investor, the relevant interest rate is the real interest rate.
More general, the opportunity cost: you pay it if you borrow, you forgo it if you invest your own funds in physical capital rather than buying bonds Recall: r=i;when Equilibrium condition in the goods market becomes: Y C(Y T) I (Y, i) G For a given value of the interest rate, i, demand is an increasing function of output, for two reasons: • • An increase in output leads to an increase in income and also to an increase in disposable income, and therefore an increase in C (we studied this relation in topic 2) An increase in output also leads to an increase in investment.
So, when income changes, there is going to be a change in investment and in consumpiton.
Note two characteristics of ZZ: • • Because it’s assumed that the consumption and investment relations are not linear, ZZ is, in general, a curve rather than a line.
ZZ is drawn flatter than a 45-degree line because it’s assumed that an increase in output leads to a less than one-for-one increase in demand (empirical evidence supports this assumption) For each interest rate there is a different value for investment, and this means that there's also a different value for demand. So, if the interest rate is higher, we are going to invest less. And if the interest rate is lower, you'll invest more. So, a shift in the interest rate will change the aggregate demand.
For a given value of the interest rate we can represent ZZ 1. An increase in the interest rate decreases investment and therefore the demand for goods at any level of output. Downward shift of the ZZ curve. Lower equilibrium level of output.
2. Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is therefore downward sloping.
The IS curve shows the combinations of Y and i which are compatible with the equilibrium in the goods markets. Any point in the IS curve represents a equilibrium in a different market. When the interest rate goes down, people consume more, so there is more investment, and when interest rate goes up, people consume less and save more, making the output smaller.
The IS curve relates output and interest rate for a given level of taxes, T, and government spending, G. Changes in either T or G will shift the IS curve.
• • An increase in G or a decrease in T shifts IS to the right A decrease in G or an increase in T shifts IS to the left If we increase taxes and/or decrease the government expenditure, consumers will hae less money to expend, and we will have a whole new set of equilibrium, thet will be smaller than the former one.
We are assuming that G and T are exogenous, but in reality they aren't FINANCIAL MARKETS AND THE LM RELATION In the financial markets, the interest rate is determined by the equality of the supply of money and the demand for money: M=$YL(i). The financial market is in nominal terms, so demand for money is a demand of nominal income, not a real one, but the goods market, the IS curve, is in real terms, so we have to make sure that our units are the same. Nominal income→ $Y=YP; Real Income→ $Y/P=Y Real money supply = real money demand The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i, (same variables as for the goods market equilibrium and the IS relation). M=$YL(i); M/P=($Y/P)*L(i); M/P=Y*L(i) An increase in income leads, at a given interest rate, to an increase in the demand for money. Given the money supply, this increase in the demand for money leads to an increase in the equilibrium interest rate. Income; Interest rate Equilibrium in the financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is therefore upward sloping.
* For a given amount of money in the economy in real terms, with the LM curve → were the supply of money meets the demand in the money market Equilibrium in financial markets implies that, for a given real money supply, an increase in the level of income, which increases the demand for money, leads to an increase in the interest rate. This relation is represented by the upward-sloping LM curve An increase in the money supply shifts the LM curve down A decrease in the money supply shifts the LM curve up LM AS INTEREST RATE RULE If central bank follows an interest rate rule, given changes in the aggregate demand, it adjusts the supply of money to achieve the interest rate the central bank wants. The central banks focus on reaching certain interest rates, because it's the variable that affects the investment. Their instrument is the money supply → they set a target and try to reach it.
PUTTING THE IS AND THE LM RELATIONS TOGETHER Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. This is represented by the IS curve.
Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate. This is represented by the LM curve.
Only at the intersection of the two curves, are both goods and financial markets in equilibrium. Goods market and financial markets only converge in one point → Equilibrium EN each of the markets behind we have different policies fiscal (goods market) and monitary (financial policy) Fiscal contraction, or fiscal consolidation, refers to fiscal policy that reduces the budget deficit (increase in T or decrease in G or both: (G-T) Fiscal expansion, refers to fiscal policy that increases the budget deficit (decreases T or increases G or both: (G-T) Taxes or government expenditure affect the IS curve, not the LM curve.
Effects on the composition of demand of a fiscal contraction, or fiscal consolidation, through increase in taxes, T . Assume G constant Consumption → Y , T (Y-T) Consumption Investment ? →Y Investment ; i Investment(opportunity cost is lower if i)→ contradiction, depends on the components, we cannot say without having more information what's going to happen We have a new equilibrium, with a lower interest rate, but also a higher income, so it looks like a positive outcome. (Figure 5.9) Monetary contraction, or monetary tightening, refers to a decrease in the money supply.
Monetary expansion refers to an increase in the money supply.
Monetary policy does not affect the IS curve, only the LM curve. For example, an increase in the money supply shifts the LM curve down.
Effects on the composition of demand of a monetary expansion, M (remember: P fixed) Consumption → Y , T no change→ (Y-T) Consumption Investment → Y → Investment I → investment DEFICIT REDUCTION: GOOD OR BAD FOR INVESTMENT? Reducing the budget deficit leaves more savings available for investment and therefore increases investment? In the goods market equilibrium, total saving equals investment, and there we have a public and a private part. So, true if private saving does not change, does not adjust to changes in public deficit.
But fiscal contraction reduces Y: Consumption and Saving reduces. A fiscal contraction may decrease investment. Or, looking at the reverse policy, a fiscal expansion—a decrease in taxes or an increase in spending—may actually increase investment.
In this analysis we are not taking into account the effect of the interest rate on changes on I and S Policy mix: The combination of monetary and fiscal polices is known as the monetary-fiscal policy mix, or simply, the policy mix. Sometimes, the right mix is to use fiscal and monetary policy in the same direction. Sometimes, the right mix is to use the two policies in opposite directions—for example, combining a fiscal contraction with a monetary expansion.
Goverments lots of times decide to make a combination of policies to reach their goals.
IS-LM AND THE LIQUIDITY TRAP As interest rate decreases, people want to hold more money and less bonds. As interest rate becomes equal to zero, people want to hold a certain amount they need for transactions, but they are willing to hold even more money (and fewer bonds) because they are indifferent between money and bonds.
Liquidity trap: people are willing to hold more money (more liquidity) at the same interest rate. Expansionary monetary policy is powerless.
When the interest rate is equal to zero, the economy falls in a liquidity trap. The central banks can increase liquidity (increase in money supply), but this liquidity falls into a trap: the additional money is willingly held by people at an unchanged interest rate, zero. If at zero interest rate the demand for goods is still low, there is nothing the monetary policy can do to increase output.
In this situations what is efficient is to have a fiscal policy, change government expenditure, taxes… Introducing dynamics formally would be difficult, but we can describe the basic mechanisms in words.
• • • • Consumers are likely to take some time to adjust their consumption following a change in disposable income.
Firms are likely to take some time to adjust investment spending following a change in their sales.
Firms are likely to take some time to adjust investment spending following a change in the interest rate.
Firms are likely to take some time to adjust production following a change in their sales.
In the short run, an increase in the interest rate leads to a decrease in output and to an increase in unemployment. It has little effect on the price level in the short run, but larger in the medium run.
In the short run, an increase in the interest rate leads to a decrease in output.
In the short run, an increase in the interest rate has little effect on the price level.
Assumption that price level is fixed, central in IS-LM model, good in short run ...