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					Macroeconomics

     Lecture 6
 The IS-LM model
                    Outline
• General equilibrium in the market for
  goods & services and the market for real
  money balances.
• Economic policy
  – Fiscal policy
• On the effectiveness of fiscal policy.
              The IS-LM model
 The IS curve represents combinations of R and Y at which
the goods market (as described by the Keynesian Cross) is at
                       equilibrium:

      IS : Y  c0  c1 (1  t )Y  T   i0  i1 R  G
The LM curve represents combinations of R and Y at which
  the market for real money balances is at equilibrium:

      MS
 LM :     L0  L1Y  L2 R
      P
The IS-LM model characterises combinations of R and Y
      at which the market for real money balances
    and the goods market are jointly at equilibrium.
  IS : Y  c0  c1 (1  t )Y  T   i0  i1 R  G
       MS
  LM :     L0  L1Y  L2 R                   Endogenous
       P
                             P    “Candidate endogenous”
Policy variables
      G                                    Business cycle
    T                        R                   c0
     t                       Y                   i0
    MS

                   L1   L2       i1   c1
               Behavioural parameters
R                                 LM 0
                                  1. EDM, so R up
                                  2. Unplanned I run-down, so Y up
                     A            3. EDM, so R up
R0
                                  4. Unplanned I run-down, so Y up
                      4
                 3                          and so on….
                 2                  IS 0
             1
                     Y0                     Y
The stories we tell…        Comparative static analysis.

     The interest rate adjusts fast to clear money market and then
     firms adjust output to clear the goods market more slowly.
                Active fiscal policy
  The policy instruments:          G T and t               D  G  T  tY
                           1. Deficit financing (sell bonds to private sector)
 The methods of financing: 2. Tax financing
                           3. Get the central bank to print money
                              (sell bonds to the central bank)
         spending                Treasury             financing
Deliver
public goods                                                      Tax financing
Buy factors
                                                     Taxes
of production
Deliver                                            sell bonds
public goods                                                     deficit financing
Buy factors
of production                                       Money
    Deficit financing via bonds sale to the private sector does not affect MS.
     Deficit financed expansion of G
R                      LM 0

R1                 C
             A
R0

                               IS1
                        IS 0

             Y0   Y1
                               Y
     How large is the impact on Y?
                                              Large crowding out
R     IS 0                          LM 0      effect = fiscal policy
                               C                   ineffective.

                                             Impact in Keynesian
                           A          B
R0                                           Cross model

                                               IS1



                       Y0      Y2    Y1
                                               Y
                 G

             1c1 (1t )
                                           crowding out
                  Crowding out
                                        
                  M   D           M    D
           L1                 L2               i1
  Y               L1Y            L2 R           I  i1R
 MPG             money market
                                                         Goods
                                                         market

                                                           large
         large             small             large
           L1     +         L2       +         i1    =   crowding
                                                         out effect
           The Government Spending Multiplier
   The effect on Y when G changes and the interest rate
        is allowed to adjust to its equilibrium level

                             1
 Y
 G IS LM       
                   1  c1 (1  t )          i1L1
                                              L2
        Active Fiscal Policy
• Deficit financed expansion of G is
  effective in increasing output (and
  employment) if the crowding out effect is
  small:
  – Real money demand insensitive to Y
  – Real money demand sensitive to R.
  – Investments insensitive to R
            Comparison

• IS-LM model

• Keynesian Cross

• Classical model
   The impact of fiscal policy on GDP and its composition.


G  0                                                  Keynesian
                                               Classical Cross IS-LM

                                         G       1          1   1
          G0                             C
                             C  0               0      ++      +
                   C0                     I      -1     0       -

I  0     I0
                                          Y      0      ++      +




    The increase in the interest rate crowds out private investment
    but not 100%.
            Tax financed expansion of G

           R       IS (G1 , T1 )                LM 0

                                            C             G  T
           R2                          D
                                   A
           R0                                    B


                                                        IS (G1 , T0 )

                                                 IS 0

                                   Y0 Y2 Y1              Y
Deficit financed expansions
are more effective than
tax financed expansions.               G
                    Caveats

• The IS-LM model shows the circumstances
  under which active fiscal policy can, in
  principle, affect the level of activity (in a closed
  economy with a fixed price level), but this does
  not necessarily imply that it, in practice, can be
  used to stabilise the business cycle.
   – Crowding out?
   – Saving/consumption?
• Automatic stabilisers continue to be important.
            What is next?
• Monetary policy and the Keynesian
  transmission mechanism.

• Interest control versus money control.
      Effectiveness of fiscal policy
   Effect      Parameters          Effective   Ineffective

                     i1 L1
Crowding out                       small        large
                      L2
Keynesian             1
multiplier      1  c1 (1  t )    large        small

                 1  c1 (1  t )
Slope of IS                       steep        shallow
                       i1
                     L1
Slope of LM                        shallow      steep
                     L2

				
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posted:10/2/2011
language:English
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