Money and Banking Chapter 21 IS-LM

Chapter 21 CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Explain this equation , I . Provide the equation for and explain its importance . Describe the cross diagram and explain its use . Describe the ( IS ) curve and its characteristics . Describe the liquidity ( curve and its characteristics . Explain why equilibrium is achieved in the markets for goods and money . Explain the model biggest drawback . URL books 435

Aggregate Output and Cross Diagrams LEARNING OBJECTIVES . What does this equation mean , I ?

Why is this equation important ?

What is the equation for and why is it important ?

What is the cross diagram and what does it help us to do ?

Developed in 1937 by economist and Keynes disciple John Hicks , the model is still used today to model aggregate output ( gross domestic product , gross , etc . and interest rates in the short run . It begins with John Maynard Keynes recognition that ) where aggregate output ( supplied ) Yad aggregate demand consumer expenditure I investment ( on new physical capital like computers and factories , and planned inventory ) government spending net exports ( exports minus imports ) explained that a ( where disposable income , all that income above a a autonomous consumer expenditure ( food , clothing , shelter , and other necessaries ) URL books 0791 ) 436

marginal propensity to consume ( change in consumer expenditure from an extra dollar of income or disposable income it is a constant bounded by and ) Practice calculating in Exercise . EXERCISES . Calculate consumer expenditure using the formula a ( I ' Il ) 200 200 400 400 200 200 300 200 300 350 300 300 450 300 300 525 300 300 375 300 300 303 300 300 600 100 1000 600 100 1000 850 . You can plot a consumption function by drawing a graph , as in Figure A consumption function , with consumer expenditure on the vertical axis and disposable income on the horizontal . Autonomous consumer expenditure a will be the intercept and will be the slope . Figure URL books 437

Consumer Expenditure , billions ) 1000 800 600 400 200 a 200 200 400 600 800 Disposable income , billions ) Investment is composed of fixed investment on equipment and structures and planned inventory investment in raw materials , parts , or goods . For the present , we will ignore and and , following Keynes , changes in the price level . Remember , we are talking about the short term here . Remember , too , that Keynes wrote in the context of the gold standard , not an inflationary free floating regime , so he was not concerned with price level changes . The simple model that results , called a cross diagram , looks like the diagram in Figure A cross diagram . Figure cross diagram URL books 438

Aggregate Demand , Yad ( billions ) 900 200 800 500 I 300 200 a 200 200 400 600 800 . Aggregate Output , The line simply represents the equilibrium , The other line , the aggregate demand function , is the consumption function line plus planned investment spending Equilibrium is reached via inventories ( part of I ) inventory levels will be higher than firms want , so they cut production . If , inventories will shrink below desired levels and firms will increase production . We can now predict changes in aggregate output given changes in the level ofl and and the marginal propensity to consume ( the slope of the component of Yai ) 10 . Suppose I increases . Due to the upward slope of , aggregate output will increase more than the increase in I . This is called the expenditure multiplier and it is summed up by equation 11 . 12 . So if a is 200 billion , I is 400 billion , and is , be 13 . billion 14 . If I increases to 600 billion , 800 billion . URL books ( 439

15 . If the marginal propensity to consume were to increase to , would increase to 16 . 800 800 billion because Ym would have a much steeper slope . A decline in to , by contrast , would flatten Yen and lead to a lower equilibrium 17 . billion 18 . Practice calculating aggregate output in Exercise . 19 . Calculate aggregate output with the formula ( a I ) 200 500 1400 300 500 1600 400 500 1800 500 500 2000 500 500 2500 200 500 200 500 500 200 500 200 500 1000 200 600 1600 200 700 1800 200 800 2000 200 400 1200 200 300 1000 200 200 800 Stop and Think Box During the Great Depression , investment ( I ) fell from 232 billion to 38 billion ( in 2000 ) What happened to aggregate output ?

How do you know ?

Aggregate output fell by more than 232 billion 38 billion 194 billion . We know that because investment fell and the marginal propensity to consume was , so the fall was more than 194 billion , as expressed by the equation ( a I ) URL books To make the model more realistic , we can easily add to the equation . An increase in exports over imports will increase aggregate output by the increase in times the expenditure multiplier . Likewise , an increase in imports over exports ( a decrease in ) will decrease by the decrease in times the multiplier . Government spending ( also increases . We must realize , however , that some government spending comes from taxes , which consumers view as a reduction in income . With taxation , the consumption function becomes the following ( means taxes . The effect of is always larger than that of because expands by the multiplier , which is always , while is multiplied by , which never exceeds . So increasing , even if it is totally funded by , will increase . Remember , this is a analysis . Nevertheless , Keynes argued that , to help a country out , government should cut taxes because that will cause to rise , Or , in more extreme cases , it should borrow and spend ( rather than tax and spend ) so that it can increase without increasing Tand thus decreasing Stop and Think Box As noted in Chapter 11 The Economics of Financial Regulation , many governments , including that of the United States , responded to the Great Depression by increasing tariffs in what was called a neighbor policy . Today we know that such policies beggared everyone . What were thinking ?

They were thinking that tariffs would decrease imports and thereby increase ( exports minus imports ) and . That would make their trading partner decrease , thus them by decreasing their . It was a simple idea on paper , but in reality it was dead wrong . For starters , other countries retaliated with tariffs of their own . But even if they did not , it was a losing strategy because by making neighbors ( trading partners ) poorer , the policy limited their ability to import ( decreased the country exports ) and thus led to no change in . Figure The of aggregate demand sums up the discussion of aggregate demand . Figure The ( URL books 441

KEY TAKEAWAYS The equation , I tells us that aggregate output ( or aggregate income ) is equal to aggregate demand , which in turn is equal to consumer expenditure plus investment ( planned , physical stuff ) plus government spending plus net exports ( exports imports ) It is important because it allows economists to model aggregate output ( to discern why , for example , changes ) In a taxless Eden , like the Gulf Cooperation Council countries , consumer expenditure equals autonomous consumer expenditure ( spending on necessaries ) a ) plus the marginal propensity to consume ( times disposable income ( income above a . In the rest of the world , a ( where taxes . particularly the marginal propensity to consume variable , is important because it gives the aggregate demand in a cross diagram its upward slope . books , 442

A cross diagram is a graph with aggregate demand ( Yad ) on the vertical axis and aggregate output ( on the horizontal . It consists of a line where , and a , curve , which plots I with the slope given by the expenditure multiplier , which is the reciprocal of minus the marginal propensity to consume ( a I ) The diagram helps us to see that aggregate output is directly related to a , I , exports , and and indirectly related to and imports . wiki John Hicks URL books 443

The Model LEARNING OBJECTIVES . What are the IS and curves ?

What are their characteristics ?

What do we learn when we combine the IS and the curves on one graph ?

Why is equilibrium achieved ?

What is the model biggest drawback ?

The cross is great , as it goes . Note that it has nothing to say about interest rates or money , a major shortcoming for us students of money , banking , and monetary policy ! It does , however , help us to build a more powerful model that examines equilibrium in the markets for goods and money , the IS ( and the ( liquidity ) curves , respectively ( hence the name of the model ) Interest rates are negatively related to I and to . The reasoning here is straightforward . When interest rates ( i ) are high , companies would rather invest in bonds than in physical plant ( because fewer projects net present value or ) or inventory ( because it has a high opportunity cost ) so I ( investment ) is low . When rates are low , new physical plant and inventories look cheap and many more projects are ( i has come down in the denominator of the present value formula ) so I is high . Similarly , when i is low , as we learned in Chapter 18 Foreign Exchange , the domestic currency will be weak , all else equal . Exports will be facilitated and imports will decline because foreign goods will look expensive . Thus , will be high ( exports imports ) When i is high , by contrast , the domestic currency will be in demand and hence strong . That will hurt exports and increase imports , so will drop and perhaps become negative ( exports imports ) Now think of Yad on a cross diagram . As we saw above , aggregate output will rise as I and do . So we know that as i increases , Yad decreases , Plotting the interest rate on the vertical axis against aggregate output on the horizontal axis , as below , gives us a downward sloping curve . That the IS curve ! For each interest rate , it tells us at what point the market for goods ( I and , get it ?

is in equilibrium . For all points to the right of the curve , there is an excess supply of URL books 444 goods for that interest rate , which causes to decrease inventories , leading to a fall in output toward the curve . For all points to the left of the IS curve , an excess demand for goods persists , which induces to increase inventories , leading to increased output toward the curve . Obviously , the IS curve alone is as insufficient to determine i or as demand alone is to determine prices or quantities in the standard supply and demand price model . We need another curve , one that slopes the other way , which is to say , upward . That curve is called the curve and it represents equilibrium points in the market for money . Recall from our discussions of liquidity preference in Chapter The Economics of Fluctuations and Chapter 20 Money Demand that the demand for money is positively related to income because more income means more transactions and because more income means more assets , and money is one of those assets . So we can immediately plot an upward sloping curve . To the left of the curve there is an excess supply of money given the interest rate and the amount of output . That cause people to use their money to buy bonds , thus driving bond prices up , and hence i down to the curve . To the right of the curve , there is an excess demand for money , inducing people to sell bonds for cash , which drives bond prices down and hence i up to the curve . Figure in I ( zu ( URL books 445

Interest Rate , i . Aggregate Output , When we put the IS and curves on the graph at the same time , as in Figure diagram equilibrium in the markets for money and , we immediately see that there is only one point , their intersection , where the markets for both goods and money are in equilibrium . Both the interest rate and aggregate output are determined by that intersection . We can then shift the IS and curves around to see how they affect interest rates and output , i and . In the next chapter , well see how manipulate those curves to increase output . But we still won be done because , as mentioned above , the model has one major drawback it works only in the short term or when the price level is otherwise . Stop and Think Box URL books 446

Does Figure 215 Real gross private domestic investment , make sense ?

Why or why not ?

What does Figure Net exports , mean ?

Why is Figure Federal government expenditures , not a good representation of ?

Figure Real gross private domestic investment , Real Gross Private Domestic Investment ( Source US . Department of Commerce Bureau of Economic Analysis ( Billions Dollars ) 1985 2000 Shaded areas Indicate as by the . 2007 Federal Reserve Louis ! Figure exports , URL books 447

Net Exports of Goods Services ( Source US . Department of Commerce Bureau of Economic Analysis ( of Dollars ) 1940 1950 1970 1930 Shaded areas Indicate as by the . 2007 Federal Reserve Bank of Louis Figure 21 . government expenditures , URL books ell ) 448

Federal Government Current Expenditures ( Source US . Department of Commerce Bureau of Economic Analysis ( Billions of Dollars ) 1940 1950 1960 1970 1980 1999 2000 Shaded areas indicate as determined by the . 2007 Federal Reserve Bank of Louis Figure Real gross private domestic investment , makes perfectly good sense because it depicts I in the equation I , and the shaded areas represent , that is , decreases in . Note that before almost every recession in the twentieth century , I dropped . Figure Net exports , means that in the United States is considerably negative , that exports imports by some 800 billion , creating a drain on ( Figure Federal government expenditures , is not a good representation of because it ignores state and local government expenditures , which are in the United States , as Figure State and local government expenditures , shows . Figure and local government expenditures , URL books

State 84 Local Government Current Expenditures ( Source Department of Commerce Bureau of Economic Analysis 500 1950 1960 2000 Shaded areas indicate as determined by the . 2007 Federal Reserve Bank of Louis KEY TAKEAWAYS The IS curve shows the points at which the quantity of goods supplied equals those demanded . On a graph with interest ( i ) on the vertical axis and aggregate output ( on the horizontal axis , the IS curve slopes downward because , as the interest rate increases , key components of , I and , decrease . That is because as , the opportunity cost of holding inventory increases , so inventory levels fall and projects involving new physical plant become rarer , and I decreases . Also , high a strong domestic currency , all else constant , which is bad news for exports and good news for imports , which means also falls . The curve traces the equilibrium points for different interest rates where the quantity of money demanded equals the quantity of money supplied . It slopes upward because as increases , people want to hold more money , thus driving i up . The intersection of the IS and curves indicates the equilibrium interest rate ( i ) and output ( the point where the market for goods and the market for money are both in equilibrium . URL books 450 2010

At a money for bonds ( to buy bonds ) thus driving bond prices up and interest rates down toward equilibrium . At a I points to the left of the curve , an excess supply of money exists , inducing people to give up I points to the right of the curve , an excess demand for money exists , inducing people to give up bonds for money ( to sell bonds ) thus driving bond prices down and interest rates up toward equilibrium . At a I points to the left of the IS curve , there is an excess demand for goods , causing inventory levels to fall and inducing companies to increase production , thus leading to an increase in output . At a I points to the right of the IS curve , there is an excess supply of goods , creating an inventory glut that induces firms to cut back on production , thus decreasing toward the equilibrium . The model biggest drawback is that it does consider changes in the price level , so in most modern situations , it applicable in the short run only . URL books 451

Suggested Reading , Robert , Edward Nelson , Robert Lucas , David Colander , Warren Young , et al , The Model Its Rise , Fall , and Strange Persistence . Raleigh , Duke University Press , 2005 . Young , Warren , and . and Modern . New York Springer , 2001 . URL books 452