QUOTE OF THE DAY

How does output affect the interest rate?

How does the interest rate affect output?

How are output and the interest rate determined

simultaneously?

If the Fed decides to raise the interest rate, what will

happen to US economy and to HK economy?

How do QEs work to fight recessions?

SO FAR INTEREST RATE PLAYS NO ROLE IN THE

GOODS MARKET!

Describe roles of banks and understand how the supply and demand of money
change with and without the presence of banks.

Define and derive equilibrium interest rate in the financial markets.

Explain factors that determine the demand for money and write down the
money demand function.

LEARNING OBJECTIVES

Ch4: Financial Markets

PREVIOUSLY

THE ISLM MODEL

ECON 2123: Macroeconomics

The Hong Kong University of Science and Technology

Prof. Fei DING

M
P
YL i

$YL(i )

not every pair will make LHS = RHS.

M
P

YL i

a) At a given interest rate, an increase in b) Equilibrium in the financial markets implies

income leads to an increase in the
that an increase in income leads to an
equilibrium interest rate.
increase in the interest rate. The LM curve
is therefore upward sloping.

LM: LIQUIDITY MONEY

Endogenous: Y and i

Nominal money stock M is exogenous short run real

money stock M/P is also exogenous. Why?

Income: $Y = YP, or Y = $Y/P

Price level P: GDP deflator or CPI

Convert to real Ms = real Md :

Recall money market equilibrium: M

LM: LIQUIDITY MONEY

Y; Financial market

i
Start from the financial market (LM) first.

Focus on the equilibrium in the short run.

Goods market

IS-LM: a framework to analyze both markets at the

same time to define the grand equilibrium.

The equilibrium of an economy both goods and

financial markets should be at their equilibria.

People trade both goods and financial assets.

WHAT IS THE IS-LM MODEL?

Apply the IS-LM model to predict and explain effects of fiscal and monetary
policy, both separately and together.

Define and derive the grand equilibrium using the IS-LM Model.

Explain and derive the IS relation and the LM relation.

LEARNING OBJECTIVES

Ch5: Goods and Financial Markets:

The IS-LM Model

Md

M/P

M/P

M/P

i1

i1

Supply

i2

Supply'

i2

A CONTRACTIONARY MONEY POLICY

An increase in money
causes the LM curve to
shift down.

Shifts of the LM curve

Figure 5 - 5

AN EXPANSIONARY MONEY POLICY

LM

LM'

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an equilibrium

This statement holds for

any level of income Y.

An increase in the supply of

money leads to a decrease
in the interest rate.

The Effects of an Increase

in the Money Supply on the
Interest Rate

Figure 4 - 4

Ms'

RECALL: EXPANSIONARY MONEY POLICY

How would a change in monetary policy affect

the LM curve?

Higher economic activities puts pressure on

interest rates. (moving along the curve)

Change output (income) new equilibrium

interest rate, given by the intersection of real
money supply and real money demand.

Each point on the LM curve

in the money market

THE LM CURVE

10

The LM curve shifts down when which of the

following occurs?
1) an increase in taxes
2) an increase in output
3) an open market sale of bonds by the central
bank
4) an increase in consumer confidence
5) none of the above

REFRESH

For each interest rate, the LM curve illustrates

the level of output where
1) the goods market is in equilibrium.
2) inventory investment equals zero.
3) money supply equals money demand.
4) all of the above
5) none of the above

REFRESH

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15

13

Example: monetary expansion

14

Changes in factors that increase the supply (or

decrease the demand) for money, given Y, shift the LM
curve down (shift out).

Example: monetary contraction

Changes in factors that decrease the supply (or

increase the demand) for money, given Y, shift the LM
curve up (shift in).

SHIFTS OF THE LM CURVE

How would the arrival of Octopus cards affect

the LM curve of Hong Kong?

THE LM CURVE

C(Y

T)

I goes down

LHS > RHS

(b) 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.

(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. (through investment)

Figure 5 - 2
The Derivation of the IS Curve

THE IS CURVE

What should happen to Y to make LHS = RHS again?

i2 > i 1

Suppose (Y1, i1) constitutes an equilibrium. Would

(Y1, i2 > i1) also constitute an equilibrium?

All the equilibrium (Y, i) pairs form the IS curve.

equilibrium values

I (Y , i ) G

Endogenous variables: Y and i

are such that LHS = RHS.

Goods market equilibrium now becomes

IS: INVESTMENT SAVING

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19

( , )

I (Y , i )

The demand for goods is

an increasing function of
output, but less than
one-for-one. Equilibrium
requires that the demand
for goods be equal to
output.

Equilibrium in the
Goods Market

Figure 5 - 1

Determining Output

C(Y

IS: INVESTMENT SAVING

Interest rate: i leads to investment

T)

I (Y , i ) G

Business volume (level of sales): output leads to

investment

But investment depends on

Interest rate would not affect the demand for goods.

Investment was assumed to be exogenous.

Y = Z = C(Y T) + I + G.

Recall: goods market equilibrium is defined as

IS: INVESTMENT SAVING

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17

an equilibrium in the

an equilibrium in the

23

3)

2)

1)

True
False
Uncertain

Q2: In the financial market, when we change the

interest rate to derive the corresponding equilibrium
level of output, we can derive the LM curve.

24

Q1: In the goods market, when we change output level

and derive the corresponding equilibrium level of
interest rate, we can derive the IS curve.

REFRESH

Change output (income) Y new equilibrium interest rate,

given by the intersection of real money supply and real
money demand.

Each point on the LM curve

money market

Change interest rate new equilibrium output Y, given by

the intersection of (new) demand ZZ and the 45-degree line
in goods market.

Each point on the IS curve

goods market

THE IS CURVE VS. THE LM CURVE

IS curve to the left

IS curve to the right

Example: fiscal expansion

Shifting up ZZ

Changes in factors that increase the demand for

goods, given the interest rate, shift the IS curve to
the right (shift out).

Example: fiscal contraction

Shifting down ZZ

Changes in factors that decrease the demand for

goods, given the interest rate, shift the IS curve to
the left (shift in).

SHIFTS OF THE IS CURVE

An increase in taxes reduces

demand, and thus reducing
equilibrium output at any
given interest rate. The IS
curve shifts to the left.

Shifts of the IS Curve

Figure 5 - 3

Example: Increasing taxation leads to

How would changes in exogenous variables (C,

T, G) affect the IS curve?

SHIFTS OF THE IS CURVE

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21

In the short run, a

reduction of the
budget deficit may
decrease investment.

T IS shifts in
Y and i I ?

An increase in taxes shifts the IS curve to the left and leads to a decrease in the
equilibrium level of output and the equilibrium interest rate.

The Effects of an Increase in Taxes

Figure 5 - 7

FISCAL CONTRACTION: (GT)

An increase in taxes shifts the IS curve to the left and

The Effects of an Increase in Taxes

Figure 5 - 7

FISCAL CONTRACTION: (GT)

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27

C(Y

LM relation:

T)

M
P
YL(i )

I (Y , i ) G

25

IS to the left (Y at same i)

Fiscal contraction

LM down (i at same Y)
LM up (i at same Y)

Expansion
Contraction

Ms affects IS or LM or both?

Monetary policy: Central bank chooses Ms

IS to the right (Y at same i)

Fiscal expansion

G and T affect IS or LM or both?

26

Fiscal policy: Government chooses GT (<=> 0)

POLICY APPLICATIONS

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 markets in equilibrium.

The ISLM Model

Figure 5 - 6

IS relation: Y

ISLM: THE GRAND EQUILIBRIUM

But Greece does not have its own currency

Note: a fiscal contraction in combination with a monetary

expansion can reduce budget deficit without sacrificing output.

We will see the good side of austerity (saving) in longer time frames.

YES, in the short run.

So, is austerity the wrong prescription for Greece?

So what a government does to reduce what it needs to pay at the

same time decreases what it is able to pay.

A monetary expansion
is more investment
friendly, i.e.,
increasing investment.

Y , i

A monetary expansion leads to

higher output and a lower
interest rate.

The Effects of a
Monetary Expansion

Figure 5 - 8

MONETARY EXPANSION: MS

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32

Point D is an EQ in the goods market.

Fiscal contraction leads to lower output (Y ), which means a smaller

pie and less tax revenues.

above the LM.

further reducing Y @ same i

higher I

higher demand

I ?)

To sum up: A fiscal contraction may decrease investment. Or,

looking at the reverse policy, a fiscal expansiona decrease in taxes
or an increase in spendingmay actually increase investment.

However, S is affected by a fiscal contraction because Y .

Recall: S = c0 + (1 c1) (Y T).
If S by more than (T-G)
I

Investment = Private saving + Public saving

I = S + (T G)
Given private saving, if T-G goes up investment must go up:
Given S, T-G going up implies that I goes up.

A deficit reduction may decrease rather than increase investment.

Deficit Reduction: Good or Bad for Investment?

C for sure, investment I ambiguous (Y and i

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29

offsetting some decline in Y

lower money

IS shifts to the left, new EQ moves along the LM curve to A.

Lower i

Money market channel: lower Y (income)

demand lower i

At point D, money demand < > money supply ???

But NOT in the money market

further reducing C and I

Lower Y

Goods market channel: Higher taxes lower disposal

income lower consumption lower demand lower Y

But the IS-LM model shows

the public debt of Greece is unsustainable.

FISCAL CONTRACTION: AN INCREASE IN T

Austerity
fiscal contraction, cutting spending and increasing
taxes, so budget deficit (G-T) .

Problem

Fiscal Contraction: Good or Bad for Greece and for the Euro?

no change in output if investment is independent of the

interest rate

Focus box: The US recession of 2001

At the same time enhancing the impact on Y.

Monetary expansion can be used to cancel

the increase in i,

But the increase in i would partially offset the

effect (as I decreases).

Fiscal expansion can be used to stimulate Y.

Fiscal and monetary policy can be used in the

same direction.

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35

no change in the interest rate if investment is independent

of the interest rate

an increase in investment and a rightward shift in the IS

curve

a reduction in the interest rate and ambiguous effects on

investment

a leftward shift in the IS curve

MIXING FISCAL AND MONETARY POLICY

5)

4)

3)

2)

1)

An increase in the money supply must cause which of

the following?

REFRESH

below the IS.

lower i @

higher money demand

offsetting some

higher investment I

Up

Down

LM shifts out (down)

LM shifts in (up)

Monetary contraction

Down

Up

Down

Up

Up

Down

Movement
in Output

I )

Monetary expansion

IS shifts in (left)

Decrease in money

Fiscal contraction

None
None

Increase in money

None

IS shifts out (right)

Left

Decrease in spending

None

None

None

Shift of LM

Fiscal expansion

Right

Increase in spending

Left
Right

Decrease in taxes

Shift of IS

The Effects of Fiscal and Monetary Policy

Increase in taxes

Table 5-1

POLICY SHOCKS

C and I increase for sure (Y and i

33

Up

Down

Down

Up

Up

Down

34

Movement in
Interest Rate

LM shifts down, new EQ moves along the IS curve to A.

Higher Y (income)
decline in i

Goods market channel: lower i

higher demand higher Y

At point C, demand for goods < > supply for goods ???

But NOT in the goods market

Point C is an EQ in the money market.

Money market channel: higher money supply

the same Y

MONETARY EXPANSION: MS

Figure 4 The U.S. Recession of 2001

The U.S. Recession of 2001

Spending (as Ratios to GDP), 1999:1 to 2002:4

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T , G , (G-T)

Figure 3 U.S. Federal Government Revenues and

Expansionary fiscal policy

The U.S. Recession of 2001

The Fed increased

money supply to
fight recession.

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

Expansionary monetary policy

The U.S. Recession of 2001

38 of 33

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

The U.S. Recession of 2001

37

Outcome 1

Outcome 2

STEP 3: POLICY MIX POSSIBLE OUTCOMES

STEP 2: FISCAL EXPANSION

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43

STEP 1: MONETARY CONTRACTION

Monetary contraction and fiscal expansion

increase equilibrium output and interest rate
simultaneously.

True or false or uncertain?

Fiscal and monetary policy can also be used in

the opposite direction.

MIXING FISCAL AND MONETARY POLICY

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Because the interest rate influences both investment and

money demand, it is the variable that links the two parts of
the IS-LM model.

Tell us how output affects the interest rate: through money

demand.

The LM relation follows from the condition that the supply of

money must be equal to the demand for money.

Tell us how the interest rate affects output: through

investment.

The IS relation follows from the condition that the supply of

goods must be equal to the demand for goods.

ISLM: THE GRAND EQUILIBRIUM

The LM curve (which stands for liquidity and

money) plots the relationship between the
interest rate and the level of income that
arises in the equilibrium of the money market.

The IS curve (which stands for investment

saving) plots the relationship between the
interest rate and the level of income that
arises in the equilibrium of the goods and
services market.

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47

Expansionary monetary policy can offset the

negative impact on Y. (Greece cannot do it! )

Cutting G and increasing T improve the budget

deficit, but the downside is?

Example: When the economy has a large budget

deficit (like in Greece),

Fiscal and monetary policy can also be used in

the opposite direction.

MIXING FISCAL AND MONETARY POLICY

So the answer should be

It depends.

Outcome 3

STEP 3: POLICY MIX POSSIBLE OUTCOMES

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51

52

Take the for firms to adjust production following a change in

their sales.

Take time for firms to adjust investment spending following

a change in the interest rate.

Take time for firms to adjust investment spending following

a change in sales.

Take time for consumers to adjust their consumption

following a change in income.

But the model ignored dynamics.

Short answer: Yes!

DOES THE IS-LM MODEL FIT THE FACTS?

Credit cards and ATMs, doubts about the health of

the banking system, etc.

LM: exogenous changes in money demand can shift

the LM curve, how?

IS: increase or decrease in consumer/investor

confidence will raise or reduce total demand and thus
shift the IS curve.

Other exogenous changes can also shift the IS or LM

curve.

ANYTHING ELSE CAN SHIFT THE CURVES?

49

For example, the changes in G or T (fiscal policy), or the

changes in the money supply (monetary policy).

Only changes to variables exogenous to the IS-LM

model can shift the IS or LM curve.

Changes move along the curve.

(Y, i) are endogenous variables in the IS-LM model.

50

Interest rate changes do not shift the IS or LM curve!

ISLM: THE GRAND EQUILIBRIUM

Changes in monetary policy that reduce the money supply

shift the LM curve up (shift in).

Changes in monetary policy that raise the money supply

shift the LM curve down (shift out).

The LM curve is drawn for a given monetary policy.

Changes in fiscal policy that reduce the demand for goods

and services shift the IS curve to the left (shift in).

Changes in fiscal policy that raise the demand for goods

and services shift the IS curve to the right (shift out).

The IS curve is drawn for a given fiscal policy.

ISLM: THE GRAND EQUILIBRIUM

4-3 and 4-4, but need to know everything from

lecture slides.

Ch2 Appendix

Mid-term exam covers Ch1-5 except

Problem set 2 due on Monday, Oct. 12.

Textbook, Chap. 6 (for next time)

Textbook Chap. 5

Assigned reading:

SEE YOU NEXT TIME

ANSWER

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55

1)
2)
3)
4)
5)

None of the above.

Smaller increase in Y & larger decrease in i.

Larger increase in Y & larger decrease in i.

Smaller increase in Y & smaller decrease in i.

Larger increase in Y & smaller decrease in i.

Two identical economies, one has higher MPC than the

other. If the money supply increases by the same
amount for both economies, the higher MPC economy
will experience

QUESTION

The Central Bank can control the slope of the LM curve by

adjusting Ms. .

LM AS AN INTEREST RATE RULE

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