LM Curve • IS-LM Examples

• LM Curve

• IS-LM Examples

• Fiscal and Monetary policies

• Keynesians vs. Monetarists

• IS-LM Examples

People are worried and thus

1. they want to save more and spend less

2. they want to spend money slower

Profitability of investments decrease and thus 3. firms want to invest less

and savers want to invest less at home

4. currency depreciates (looses value)

IS curve

S

I

Real i

Y

LY

Li

Real i

Y

LM curve

S = I + G – T + NX Ms/P = Li +LY

LMIS

S

I

Real i

Y

LY

Li

Real i

Y

S = I + G – T + NX Ms/P = Li +LY

LMIS

1. PEOPLE WANT TO SAVE MORE

Real GDP

Real

interest

rate

IS1

IS0

LM0

E1

E0

People want to ↑↑↑↑ S

S

I

Real i

Y

LY

Li

Real i

Y

S = I + G – T + NX Ms/P = Li +LY

LMIS

2. VELOCITY OF MONEY DECREASES

Real GDP

Real

interest

rateLM1

IS0

LM0

E0

Velocity of M ↓↓↓↓

E1

S

I

Real i

Y

LY

Li

Real i

Y

S = I + G – T + NX Ms/P = Li +LY

LMIS

3. SMALLER PROFITABILITY OF INVESTMENTS

Real GDP

Real

interest

rate

IS1

IS0

LM0

E1

E0

Smaller Profitability of I

S

I

Real i

Y

LY

Li

Real i

Y

S = I + G – T + NX Ms/P = Li +LY

LMIS

4. CURRENCY DEPRECIATION (NX↑↑↑↑)

Real GDP

Real

interest

rate

IS0

IS1

LM0

E0

E1

Currency Depreciation

People are worried and thus

1. they want to save more and spend less

Y ↓ + i ↓

2. they want to spend money slower

Y ↓ + i ↑

Profitability of investments decrease and thus 3. firms want to invest less

Y ↓ + i ↓

and savers want to invest less at home

4. currency depreciates (looses value)

Y ↑ + i ↑

People are worried and thus

1. they want to save more and spend less

Y ↓ + i ↓

2. they want to spend money slower

Y ↓ + i ↑

Profitability of investments decrease and thus 3. firms want to invest less

Y ↓ + i ↓

and savers want to invest less at home

4. currency depreciates (looses value)

Y ↑ + i ↑

• LM Curve

• IS-LM Examples

• Fiscal and Monetary policies

• Keynesians vs. Monetarists

FISCAL Policy MONETARY Policy

S

I

Real i

Y

LY

Li

Real i

Y

LMIS

(G-T) ↑ : EXPANSION : Ms↑

increases Y

(G-T) ↓ : CONTRACTION : Ms↓

decreases Y

S

I

Real i

Y

LY

Li

Real i

Y

S = I + G – T + NX Ms/P = Li +LY

LMIS

FISCAL EXPANSION

Real GDP

Real

interest

rate

IS0

IS1

LM0

E0

E1

Fiscal Expansion

S

I

Real i

Y

LY

Li

Real i

Y

S = I + G – T + NX Ms/P = Li +LY

LMIS

MONEARY EXPANSION

Real GDP

Real

interest

rate

LM1

IS0

LM0

E1

E0

Monetary Expansion

• LM Curve

• IS-LM Examples

• Fiscal and Monetary policies

• Keynesians vs. Monetarists

Md / P = real money demand is determined by

Transactions motive — positively related to YPrecautionary motive — positively related to YSpeculative motive — negatively related to i

In equilbrium: Ms / P = Md / P = Li + LY

i

Li

Md= f(i, Y)

P – +

Keynes

Liquidity trap

How do Monetarists differ from Keynesians:

Other assets besides money and bonds: equities and real goods

rm

not constant: e.g. if rb

↑, rm

↑, then rb

– rm

may stay unchanged,

and so Md

stays almost unchanged:

Interest rates may have little effect on Md

Md= f(YP, rb – rm, re – rm, πe – rm)

P + – – –

i i

Li Li

Md= f(i, Y)

P – +

Modern Quantity TheoryKeynes

FRIEDMANLiquidity trap

Keynesians vs. Monetarists

KEYNES FRIEDMAN

Liquidity trap

Li

i

Li

i

LMLM

Keynesians and the Liquidity Trap

Y

Real i LM1IS0

E0 = E1

Short Run

Equilibrium

E1

Short Run

Equilibrium

LM0

Y

Real i IS0 LM0IS1

LM curve has

a flat part, thus

an increase of Ms,

that shifts LM

to the right,

does not have any

impact on GDP.

On the other hand,

Fiscal policy

Expansion works

great. Since it has a

limited impact on

interest rates, I is

not crowded out.

Monetarists

Y

Real i LM1IS0

E1

Short Run

Equilibrium

E1

Short Run

Equilibrium

LM0

Y

Real i IS0 IS1

LM curve is steep,

thus an increase of Ms

increases GDP.

On the other hand,

Fiscal policy Expansion

does not work – Since it

only increases

the interest rate,

an increase of

government purchases

results in private

investment I

being crowded out by it.

LM0

Keynesians vs. Monetarists

Y

Real i IS0 LM0IS1

Y

Real i IS0 IS1 LM0

Fiscal expansion works great. It is not worth the debt or it does not work at all !!!

(as i and I do not change) (as i increases and G crowds-out I )

Y

Real i LM1IS0 LM0

Monetary expansion may not work! It does work, but…

(as i and I do not change) …only temporary (before inflation comes)

Y

Real i LM1IS0

LM0

• Fiscal and Monetary policies

• Keynesians vs. Monetarists

• Spending Multipliers

Problem (Multiplier - Fiscal policy)

(a) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T , NX = constants and I = constant

Solve for equilibrium output and the value of the multiplier.

(b) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T , NX = constants and I = b0

+ b1

Y – b2

i

Where b1

+c1

<1. Solve for equilibrium output and the value of the multiplier.

(c) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T , NX = constants and I = b0

+ b1

Y – b2

i

Where b1

+c1

<1. Suppose also that the LM relation is:

Ms / P = d1

Y – d2

i

Solve for equilibrium output and the value of the multiplier.

Problem (Multiplier - Fiscal policy)

(a) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T , NX = constants and I = constant

Solve for equilibrium output and the value of the multiplier.

(b) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T , NX = constants and I = b0

+ b1

Y – b2

i

Where b1

+c1

<1. Solve for equilibrium output and the value of the multiplier.

(c) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T , NX = constants and I = b0

+ b1

Y – b2

i

Where b1

+c1

<1. Suppose also that the LM relation is:

Ms / P = d1

Y – d2

i

Solve for equilibrium output and the value of the multiplier.

Problem (Multiplier - Fiscal policy)

(a) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T, NX = constants and I = constant

Solve for equilibrium output and the value of the multiplier.

Solution (a)

Z = c0

+ c1

(Y –T) + G + I + NX = Y

Y = 1/(1 – c1

) [ c0

+ c1

(–T) + G + I + NX ]

= multiplier

Solution (a)

Z = c0

+ c1

(Y –T) + G + I + NX = Y

Y = 1/(1 – c1

) [ c0

+ c1

(–T) + G + I + NX ]

= multiplier

Problem (Multiplier - Fiscal policy)

(b) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T , NX = constants and I = b0

+ b1

Y – b2

i

Where b1

+c1

<1. Solve for equilibrium output and the value of the multiplier.

Solution (b)

Z = c0

+ c1

(Y –T) + G + b0

+ b1

Y – b2

i + NX = Y

Y = 1/(1 – c1

– b1) [ c

0+ c

1(–T) + G + b

0 – b

2i + NX ]

= multiplier (parameter of business confidence

increases multiplier)

… => Bussines cycle has bigger ups and downs

Problem (Multiplier - Fiscal policy)

(c) Suppose that the economy is characterized by the following equations:

C = c0

+ c1

YD

; G , T , NX = constants and I = b0

+ b1

Y – b2

i

Where b1

+c1

<1. Suppose also that the LM relation is given by:

Ms / P = d1

Y – d2

i

Solve for equilibrium output and the value of the multiplier.

Solution (b)

Z = c0

+ c1

(Y –T) + G + b0

+ b1

Y – b2

i + NX = Y

Y = 1/(1 – c1

– b1) [ c

0+ c

1(–T) + G + b

0 – b

2i + NX ]

= multiplier (parameter of business confidence

increases multiplier)

Solution (c)

Z = c0

+ c1

(Y –T) + G + b0

+ b1

Y – b2

i + NX = Y

Y = 1/(1 – c1

– b1

+ b2

d1

/ d2

)[ c0

– c1T + G + b

0 + b

2Ms / (d

2P) + NX ]

{INVESTMENTS are crowded-out}

= multiplier (parameter b2

decreases multiplier)

(parameter (d1

/d2) decreases multiplier)

Z = c0

+ c1

(Y –T) + G + b0

+ b1

Y – b2

( d1

Y – Ms / P ) / d2

+ NX = Y

=> i = – Ms / (d2

P) + ( d1

/ d2

)Y