Macroeconomic Analysis (ECM402) Engelbert Stockhammer Lecture 4 - ISLM

Macroeconomic Analysis (ECM402)
ML– SIl edo M
Engelbert Stockhammer
Lecture 4 - ISLM
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 1 of 31
Competing views on the money supply and
interest rates
• Exogenous money supply: Central Banks control the
money supply (through the money multiplier).
• CB control “high powered money”
• Commercial bank have to keep reserves on deposits
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• CB controls the money supply by varying the required

reserve ratio
• Endogenous money supply: Central Banks set the interest
rate (and the money supply adjust endogenously)
• Commercial banks extend credit
• When credit is given, money (deposits) is created
• CB sets the base (short-run) interest rate
• Commercial banks mark up this interest rate
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• If the Central Bank sets the interest rate ...
• Is the interest rate exogenous?
• Not necessarily
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 Taylor Rule : CB should increase interest rates when

inflation rises and low them when
unemployment/output gap risis
 iCB = f(P,Y)
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What does the BoE say about monetary
policy making?
• “Monetary policy is typically implemented by setting
the short-term interest rate, with the central bank
allowing the supply of narrow money to expand or
contract as required to meet the needs of
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households and companies at that rate.”

• “But by far the largest role in creating broad money
is played by the banking sector.”
• BoE Quarterly Bulletin 2007 Q3, p. 376
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BoE Quarterly Bulletin 2007 Q3, p. 378
• Monetary policy is a key driver of changes in the supply of

money. (...) But that is not the only factor affecting the
stock of money in the economy.
• In practice, the borrowing decisions of households and
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companies depend on the retail interest rates they face,

rather than the policy rate. (...) The quantity of bank
lending, and hence broad money creation, will also depend
on banks’ lending criteria covering factors such as the
creditworthiness of borrowers and loan to value ratios for
secured borrowing.
• Changes in either spreads or lending criteria could
therefore lead to changes in money growth without any
change in the official interest rate.
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Lecture 4 – The ISLM model

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5-1 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.
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In the simple model developed in Chapter 3,

the interest rate did not affect the demand
for goods. The equilibrium condition was
given by:
Y = C (Y − T ) + I + G
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Investment, Sales, and the Interest Rate
Investment depends primarily on two factors:

 The level of sales (+)
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 The interest rate (-)
I = I (Y ,i)
( + ,− )
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Determining Output
Taking into account the investment relation, the

equilibrium condition in the goods market becomes:
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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.
 An increase in output also leads to an increase in
investment.
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Determining Output
Note two characteristics of ZZ:
 Because it’s assumed that the consumption and

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investment relations in Equation (5.2) are 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.
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Determining Output
Figure 5 - 1
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Equilibrium in the Goods

Market
The demand for goods
is an increasing
function of output.
Equilibrium requires
that the demand for
goods be equal to
output.
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Determining Output
Note two characteristics of ZZ:
 Because it’s assumed that the

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consumption and investment

relations in Equation (5.2) are
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.
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Deriving the IS Curve
Figure 5 - 2
The Derivation of the IS
Curve
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(a) An increase in the

interest rate
decreases the
demand for goods
at any level of
output, leading to
a decrease in the
equilibrium level of
output.
(b) Equilibrium in the

goods market
implies that an
increase in the
interest rate leads
to a decrease in
output. The IS
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Shifts of the IS Curve
We have drawn the IS curve in Figure 5-2, taking as given the

values of taxes, T, and government spending, G. Changes in
either T or G will shift the IS curve.
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To summarize:
 Equilibrium in the goods market implies that an increase in
the interest rate leads to a decrease in output. This relation
is represented by the downward-sloping IS curve.
 Changes in factors that decrease the demand for goods,
given the interest rate, shift the IS curve to the left. Changes
in factors that increase the demand for goods, given the
interest rate, shift the IS curve to the right.
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Figure 5 - 3
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An increase in taxes
shifts the IS curve to
the left.
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5-2 Financial Markets and the LM Relation
The interest rate is determined by the equality of the supply of

and the demand for money:
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M = $ Y ( Li )
M = nominal money stock

$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate
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Real Money, Real Income, and the Interest Rate
The equation M = $ Y ( Li ) gives a relation between money,

nominal income, and the interest rate.
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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:
M
= YL( i )
P
From chapter 2, recall that Nominal GDP = Real GDP
multiplied by the GDP deflator:
$Y = Y P
Equivalently: $Y
= Y
P
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Deriving the LM Curve
Figure 5 - 4 a) An increase in income leads, at a b) Equilibrium in the
given interest rate, to an financial markets
The Derivation of the
increase in the demand for implies that an
LM Curve
money. Given the money supply, increase in income
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this increase in the demand for leads to an increase in

money leads to an increase in the interest rate. The
the equilibrium interest rate. LM curve is therefore
upward sloping.
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Deriving the LM Curve
Figure 5-4(b) plots the equilibrium interest rate, i,

on the vertical axis against income on the
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horizontal axis.
This relation between output and the interest rate

is represented by the upward sloping curve in
Figure 5-4(b). This curve is called the LM curve.
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Shifts of the LM Curve
Figure 5 - 5
Shifts of the LM curve
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An increase in money
causes the LM curve
to shift down.
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Shifts of the LM Curve
■ 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
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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.
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• How does the LM curve look if the CB is setting
interest rates rather than the money supply?
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5-3 Putting the IS and the LM Relations
Together
I S r en l : Ya = tC i( Y o − T ) + I ( Y , i ) + G
M
L M r n e : l a = Yt i ( Loi )
P
Figure 5 - 6
ML– SIl edo M
The IS–LM Model

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
point A, which is on
both curves, are both
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Deriving the ISLM equilibrium
• YIS = m.A – m.b1.i

• iLM = f0 + f1.Y
• Y = m.A – m.b1.(f0 + f1.Y)]
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• Y = m.A – m.b1.f0 – m.b1.f1.Y

• Y (1+ m.b1.f1) = m.A – m.b1.f0
• Y = m.A/(1+ m.b1.f1) – m.b1.f0/(1+ m.b1.f1)
• YISLM = (m.A – m.b1.f0 ) / (1+ m.b1.f1)
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
So what about the multiplier?
• The simple multiplier

• YIS = m.A – m.b1.i
• What happens to Y if A changes?
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• dY/dA = ?
• dY/dA = m
• YISLM = (m.A – m.b1.f0 ) / (1+ m.b1.f1)
• Now, what happens to Y if A changes?
• dY/dA = m / (1+ m.b1.f1)
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
Together
Fiscal Policy, Activity, and the Interest Rate
Fiscal contraction, or fiscal consolidation, refers to

fiscal policy that reduces the budget deficit.
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An increase in the deficit is called a fiscal expansion.
Taxes affect the IS curve, not the LM curve.

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Together
Fiscal Policy, Activity, and
the Interest Rate
Figure 5 - 7
The IS–LM Model
ML– SIl edo M
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
point A, which is on
both curves, are both
goods and financial
Copyright © 2009 markets in
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Together
Monetary Policy, Activity, and the Interest Rate
Monetary contraction, or monetary tightening, refers to a

decrease in the money supply.
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An increase in the money supply is called monetary expansion.
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.
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Together
Monetary Policy, Activity, and the Interest Rate
Figure 5 - 8
The Effects of a
Monetary Expansion
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A monetary expansion
leads to higher output
and a lower interest
rate.
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5-4 Using a Policy Mix
Table 5-1 The Effects of Fiscal and Monetary Policy

Shift of LM Movement Movement in
Shift of IS in Output Interest Rate
Increase in taxes Left None Down Down
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Decrease in taxes Right None Up Up

Increase in spending Right None Up Up
Decrease in spending Left None Down Down
Increase in money None Down Up Down
Decrease in money None Up Down Up
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5-4 Using a Policy Mix
The combination of monetary and fiscal

polices is known as the monetary-fiscal
policy mix, or simply, the policy mix.
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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.
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The U.S. Recession of 2001
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Figure 1 The U.S. Growth Rate, 1999:1 to 2002:4

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Figure 2 The Federal Funds Rate, 1999:1 to 2002:4

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Figure 3 U.S. Federal Government Revenues and

Spending (as Ratios to GDP), 1999:1 to 2002:4
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Figure 4 The U.S. Recession of 2001

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What happened in 2001 was the following:

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 The decrease in investment demand led to a sharp

shift of the IS curve to the left, from IS to IS’.
 The increase in the money supply led to a downward

shift of the LM curve, from LM to LM’.
 The decrease in tax rates and the increase in spending

both led to a shift of the IS curve to the right, from IS’’
to IS’.
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5-5 How Does the IS-LM Model Fit the
Facts?
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.
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 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.
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Facts?
Figure 5 - 9
The Empirical Effects of
an Increase in the
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Federal Funds Rate

In the short run, an
increase in the federal
funds rate leads to a
decrease in output
and to an increase in
unemployment, but it
has little effect on the
price level.
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Facts?
The two dashed lines and the tinted space between the dashed lines
represents a confidence band, a band within which the true value of
the effect lies with 60% probability:
 Figure 5-9(a) shows the effects of an increase in the federal
funds rate of 1% on retail sales over time. The percentage
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change in retail sales is plotted on the vertical axis; time,

measured in quarters, is on the horizontal axis.
 Figure 5-9(b) shows how lower sales lead to lower output.
 Figure 5-9(c) shows how lower output leads to lower

employment: As firms cut production, they also cut
employment.
 The decline in employment is reflected in an increase in the

unemployment rate, shown in Figure 5-9(d).
 Figure 5-9(e) looks at the behavior of the price level.

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Key Terms
 IS curve
 LM curve
 fiscal contraction, fiscal consolidation
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 fiscal expansion
 monetary expansion
 monetary contraction, monetary tightening
 monetary–fiscal policy mix, policy mix
 confidence band
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Macroeconomic Analysis (ECM402)

ML– SIl edo M

• CB controls the money supply by varying the required

 Taylor Rule : CB should increase interest rates when

households and companies at that rate.”

• Monetary policy is a key driver of changes in the supply of

companies depend on the retail interest rates they face,

Lecture 4 – The ISLM model

Equilibrium in the goods market exists when

In the simple model developed in Chapter 3,

Investment depends primarily on two factors:

 The interest rate (-)

Taking into account the investment relation, the

For a given value of the interest rate i, demand is an

Note two characteristics of ZZ:

 Because it’s assumed that the consumption and

investment relations in Equation (5.2) are linear,

 ZZ is drawn flatter than a 45-degree line because

Equilibrium in the Goods

Note two characteristics of ZZ:

 Because it’s assumed that the

consumption and investment

 ZZ is drawn flatter than a 45-

(a) An increase in the

(b) Equilibrium in the

We have drawn the IS curve in Figure 5-2, taking as given the

The interest rate is determined by the equality of the supply of

M = nominal money stock

The equation M = $ Y ( Li ) gives a relation between money,

The LM relation: In equilibrium, the real money supply is equal

this increase in the demand for leads to an increase in

Figure 5-4(b) plots the equilibrium interest rate, i,

This relation between output and the interest rate

■ Equilibrium in financial markets implies that, for a given real

interest rate. This relation is represented by the upward-

■ An increase in the money supply shifts the LM curve

The IS–LM Model

• YIS = m.A – m.b1.i

• Y = m.A – m.b1.f0 – m.b1.f1.Y

• The simple multiplier

Fiscal contraction, or fiscal consolidation, refers to

An increase in the deficit is called a fiscal expansion.

Taxes affect the IS curve, not the LM curve.

Monetary contraction, or monetary tightening, refers to a

An increase in the money supply is called monetary expansion.

Table 5-1 The Effects of Fiscal and Monetary Policy

Decrease in taxes Right None Up Up

The combination of monetary and fiscal

Sometimes, the right mix is to use fiscal and

Sometimes, the right mix is to use the two

Figure 1 The U.S. Growth Rate, 1999:1 to 2002:4

Figure 2 The Federal Funds Rate, 1999:1 to 2002:4

Figure 3 U.S. Federal Government Revenues and

Figure 4 The U.S. Recession of 2001

What happened in 2001 was the following:

 The decrease in investment demand led to a sharp

 The increase in the money supply led to a downward

 The decrease in tax rates and the increase in spending

 Consumers are likely to take some time to adjust their

 Firms are likely to take some time to adjust investment

 Firms are likely to take some time to adjust investment

 Firms are likely to take some time to adjust production

Federal Funds Rate