ISLM: The Engine RoomISLM: The Engine Room

Chapter 7Chapter 7

A curve in (i, Y) space comprising all points where theA curve in (i, Y) space comprising all points where thegoods market is in equilibrium. goods market is in equilibrium.

Y = C + Y = C + I + GI + GEarlier, we definedEarlier, we defined: : C = C = CC + b + bY and I = I = II - fi - fi Thus,Thus, Y = ( Y = (CC + b + bY) + ( II – fi) + G – fi) + GLet A = C C + + II + G, we have + G, we have

Y = Y = A + b bY – fi – fi fi = fi = A – Y + b bY Solving for i we getSolving for i we get i = i = AA/f /f – Y(1 – b)/f (This is an equation of a straight line with intercept equal to

AA/f and slope equal to /f and slope equal to – (1 – b)/f [Negative slope]

The The ISIS Curve Curve

1.1. ISIS curve response to a collapse in investor curve response to a collapse in investor confidence (confidence (II).).

2.2. IS IS curve response to a collapse in consumer curve response to a collapse in consumer confidence (confidence (CC).).

3.3. ISIS curve response to a change in government curve response to a change in government spending (G).spending (G).

ApplicationsApplications(fig. 7.2)(fig. 7.2)

CCT = = CC – bY – bYD

YYD = Y(1 – t)= Y(1 – t)

CCT = = CC + bY(1 – t) + bY(1 – t) Using the equilibrium condition in the goods marketUsing the equilibrium condition in the goods market

YY = C = CT + + II + G + G (with the after–tax C function) and (with the after–tax C function) and

solving for i we getsolving for i we get

i = i = AA/f /f – [1– b(1– t)]Y/f Now the slope is Now the slope is – [1– b(1– t)]/f (the IS curve

becomes steeper; fig. 7.3)

How do taxes affect the IS How do taxes affect the IS curve?curve?

1.1. The tax rate increases from 35% to 43%.The tax rate increases from 35% to 43%.

2.2. The tax rate increases in an economy The tax rate increases in an economy struggling to recover from a prolonged struggling to recover from a prolonged recession (recession (examplesexamples: tax increases in : tax increases in Japan in 1996, doubling of tax rates in Japan in 1996, doubling of tax rates in the U.S. during the great depression, and the U.S. during the great depression, and state taxes in 1990-91.)state taxes in 1990-91.)

ApplicationsApplications(fig. 7.4 and 7.5)(fig. 7.4 and 7.5)

A curve in (i, Y) space comprising all points where the money market A curve in (i, Y) space comprising all points where the money market is in equilibrium. is in equilibrium.

Money supply = Money demandMoney supply = Money demand

Earlier (chapter 4), we defined: Earlier (chapter 4), we defined: Money demand = kY – hiMoney demand = kY – hi

M/PM/P = = kY – hikY – hiSolving for i we getSolving for i we get i = (k/h)Y i = (k/h)Y – (1/h)M/P (This is an equation of a straight line with intercept equal to – (1/h)M/P and slope equal to (k/h) and slope equal to (k/h) [positive

slope]Fig. 7.6Fig. 7.6

The The LMLM Curve Curve

1.1. A change in the nominal money A change in the nominal money stock, M.stock, M.

2.2. A change in the price level, P.A change in the price level, P.

Factors that shift the LM curveFactors that shift the LM curve(fig. 7.7)(fig. 7.7)

Survival guide to ISLM-ADAS analysisSurvival guide to ISLM-ADAS analysis Make all moves in (i,Y) space first.Make all moves in (i,Y) space first. Go to (P,Y) space and adjust AD to make Y Go to (P,Y) space and adjust AD to make Y

consistent with Y in the (i,Y) space.consistent with Y in the (i,Y) space. Has P changed? If ‘no’, go to step 4. If ‘yes’, Has P changed? If ‘no’, go to step 4. If ‘yes’,

go to (i,Y) space and adjust LM.go to (i,Y) space and adjust LM. Close the goods markets (and the labor Close the goods markets (and the labor

market, to be incorporated in chapter 8). How market, to be incorporated in chapter 8). How do the final values of C and I compare with do the final values of C and I compare with the initial values?the initial values?

Analyze the implications of your results.Analyze the implications of your results.

ISLM – ADAS policy applicationsISLM – ADAS policy applications

Initial state of the economy: Low GDP growth rate YInitial state of the economy: Low GDP growth rate Y00..

Assume government spending increases from GAssume government spending increases from G00

to Gto G11 (spending on infrastructure, defense, …). (spending on infrastructure, defense, …).

Step 1Step 1: As G increases, the IS curve [(i,Y) space] shifts to : As G increases, the IS curve [(i,Y) space] shifts to the right (intercept increases).the right (intercept increases).

Step 2Step 2: In the (P,Y) space, the AD curve shifts to the right : In the (P,Y) space, the AD curve shifts to the right (upward).(upward).

Step 3Step 3: P did not change we go to step 4.: P did not change we go to step 4.

Step 4Step 4: The equilibrium in the goods market is consistent : The equilibrium in the goods market is consistent with Ywith Y1 1 in the (i,Y) and (P,Y) spacesin the (i,Y) and (P,Y) spaces

We know that CWe know that C11 > C > C0 0 since Ysince Y11 > Y > Y0 0 but what about but what about

investment, I?investment, I?

ISLM – ADAS policy experiment IISLM – ADAS policy experiment I(fig. 7.10)(fig. 7.10)

Recall that Recall that I = I = II - fi - fi

So So II00 = = II - fi - fi00

But the new interest rate is higher as a But the new interest rate is higher as a result of higher government borrowing.result of higher government borrowing.

So ISo I11 < I < I00

Step 5Step 5: An increase in G causes an : An increase in G causes an increase in the rate of growth of Y and increase in the rate of growth of Y and a decrease in private capital investment a decrease in private capital investment (crowding out effect).(crowding out effect).

ISLM – ADAS policy experiment IIISLM – ADAS policy experiment II

The Fed increases money growth.The Fed increases money growth. Step 1Step 1: LM curve shifts to the right.: LM curve shifts to the right.Step 2Step 2: We adjust the AD curve in the (P,Y) space to : We adjust the AD curve in the (P,Y) space to

ensure that Y is consistent with Y in the (i,Y) space.ensure that Y is consistent with Y in the (i,Y) space.Step 3Step 3: P has not changed.: P has not changed.Step 4Step 4: Shift (upward) the expenditure line in the goods : Shift (upward) the expenditure line in the goods

market. Is Cmarket. Is C11> C> C00? Yes (since Y? Yes (since Y11> Y> Y00).).

Is IIs I11> I> I00? Yes (since interest rate ? Yes (since interest rate ii11 < < ii00).).

Step 5Step 5: An increase in money supply leads to a : An increase in money supply leads to a decrease in interest rate, and increase in decrease in interest rate, and increase in investment, consumption, and Y.investment, consumption, and Y.

ISLM – ADAS policy experiment IIIISLM – ADAS policy experiment IIICountry K has been struggling to come out of a recessionCountry K has been struggling to come out of a recession and the budget deficit is very high. Policymakers decide to and the budget deficit is very high. Policymakers decide to increase taxes (T = tY).increase taxes (T = tY). Step 1Step 1: IS curve pivots clockwise. : IS curve pivots clockwise. CC and and II fall. fall. Step 2Step 2: We adjust the AD curve in the (P,Y) space to ensure that Y is : We adjust the AD curve in the (P,Y) space to ensure that Y is

consistent with Y in the (i,Y) space.consistent with Y in the (i,Y) space.Step 3Step 3: P has not changed.: P has not changed.Step 4Step 4: Shift (down) the expenditure line in the goods market. Is C: Shift (down) the expenditure line in the goods market. Is C11> >

CC00? No (since Y? No (since Y11< Y< Y00) and ) and C C is loweris lower)) Is IIs I11> I> I00? (i? (i11 < i < i0 0 but but II11 < < IIoo (investor confidence is lower). If the (investor confidence is lower). If the

macroeconomic outlook is dismal and investors expect further tax macroeconomic outlook is dismal and investors expect further tax increases (investment) I will not rise (liquidity trap; U.S. economy in increases (investment) I will not rise (liquidity trap; U.S. economy in 2008; Japan and Argentina in early 2000s).2008; Japan and Argentina in early 2000s).

Step 5Step 5: Y, C, I and interest rates (i) fall.: Y, C, I and interest rates (i) fall.

Policy Challenges in ChinaPolicy Challenges in China

Bao ba (guaranteed 8%) growth policyBao ba (guaranteed 8%) growth policy Low MPC (small multiplier)Low MPC (small multiplier) IS curves for the Western and Central IS curves for the Western and Central

regions in Chinaregions in China

ISLM – ADAS policy experiment IV:ISLM – ADAS policy experiment IV:Fine tuningFine tuning

Country K increases G and M (to avoid Country K increases G and M (to avoid crowding out private investment)crowding out private investment)

Step 1Step 1: As G increases, IS curve shifts up (right). As M : As G increases, IS curve shifts up (right). As M increases, LM curve shifts to the right. increases, LM curve shifts to the right.

Step 2Step 2: We adjust the AD curve in the (P,Y) space to : We adjust the AD curve in the (P,Y) space to ensure that Y is consistent with Y in the (i,Y) space.ensure that Y is consistent with Y in the (i,Y) space.

Step 3Step 3: P has not changed.: P has not changed.Step 4Step 4: We Adjust the expenditure line in the goods : We Adjust the expenditure line in the goods

market to be consistent with Ymarket to be consistent with Y11. Is C. Is C11> C> C00? Yes, ? Yes, since Ysince Y11> Y> Y00

Is IIs I11> I> I00? In this example, no change in the interest ? In this example, no change in the interest rate, i so Irate, i so I11 = I = Ioo (assume investor confidence is the (assume investor confidence is the same). same).

Step 5Step 5: Y and C increase.: Y and C increase.

The Global IS CurveThe Global IS Curve

Y = C + Y = C + I + G + (EX – IM)I + G + (EX – IM)i = [i = [AA/f + /f + (EX – IM)/f](EX – IM)/f] – Y(1 – b)/f

The intercept: The intercept: AA/f + /f + (EX – IM)/f (EX – IM)/f An increase in exports causes the IS curve to shift An increase in exports causes the IS curve to shift

upward (right).upward (right). A recession in a large foreign economy causes A recession in a large foreign economy causes

foreign national income to fall and causes foreign foreign national income to fall and causes foreign demand for domestic country’s exports to decline demand for domestic country’s exports to decline (contagion).(contagion).

Effects of the home currency depreciation or Effects of the home currency depreciation or devaluation (China and U.S.).devaluation (China and U.S.).