ISLM model - Lecture notes 3-5 PDF

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ISLM model notes...

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IS Curve [Goods] Equilibrium:

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Increase in Y increases consumption and investment Investment in this model is endogenous Equilibrium conditions cause the condition Y = Z(Y) to be met Only for changes in G and T o Increase in G, decrease in T, IS shifts to the right o Decrease G, Increase T, IS shifts to the left

Affect of interest rates:  An increase in interest: o Opportunity cost of investment increases, I falls o Direct affect of fall in demand, I o Triggers a fall in Y, fall in consumption and I [multiplier effect]  Vice-versa also occurs Shifts in the IS curve:  Changes in G or T will shift the whole curve  i.e. Increase in taxes: o disposable income falls, consumption falls, demand for goods falls o equilibrium output falls at any given interest rate o IS curve shifts in (to the left)  Any exogenous shock (change in G, consumer confidence, etc) that for given interest rate i reduces Y causes IS curve to shift in o We look at the effect on both interest rates and demand (Z and i)

LM Curve [Finance] Equilibrium:

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The RBA sets interest rate i and moves money supply (M) to achieve i o Increase in M, decrease in P, LM curve shifts down o Decrease in M, increase in P, LM shifts up

Shifts in LM  Changes in i will shift the LM curve: [interest rate target] o decreasing i by the Reserve Bank, an expansionary monetary policy, shifts LM curve down o increasing i by the Reserve Bank, a contractionary monetary policy, shifts LM curve up

IS-LM

Equilibrium in the Goods and Financial Markets 

When supply of goods = demand of goods

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And, the supply of real money = demand for real money

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Each point on either curve relates to when that market is in equilibrium o When both curves intersect, both markets are in equilibrium

Fiscal Policy

A fiscal contraction, decreases G and or increases T o Reduces budget deficit  A fiscal expansion, increases FG and or decreases T o Increases deficit Effect on model: (IS)  Start at point A. Output Y and interest rate i' such that supply of goods equals demand for goods  Taxes increase from T to T'  Increase in taxes lowers disposable income, lowers consumption and so output (reinforced by multiplier effect)  IS curve shifts to left from IS to IS' Effect on model: (LM)  Start at point A. Output Y and interest rate ¯i such that supply of money equals demand for money  Taxes increase from T to T'  Position of LM curve unchanged --> movement along curve 

Monetary Policy Monetary contraction -- increase in i Monetary expansion, decrease in i Affects the position of the LM curve, not the IS curve Effect on model:  Position of LM curve changes. Shifts down for decrease and shifts up for increase in interest rates  Position of IS curve unchanged, movement along  See changes in Y   

Effectiveness of the model:  Slope of the IS curve determines how effective the model is  The flatter the slope, the larger change in Y o IS curve is steep when investment demand is very interest-insensitive o If so, a given decrease in i leads to a small increase in investment demand I and a small increase in output Y

Monetary / Fiscal Policy Interactions Which policy mix of expansionary and contractionary policies will guide the economy? o Both monetary and fiscal policies can interact to assist with redirecting the macroeconomy o They can operate in opposite directions as well Germany and France Recessions  Both France and Germany went into recession in late 2001 o After the dot com bubble  Policy responses o Germany  Contractionary fiscal policies  Expansionary monetary policy by the European Central Bank (ECB) o France  Much less contractionary fiscal policy  Same expansionary monetary policy by the ECB 

Historic Australian Policy Mixes

Howard-Macfarlane policy mix I (1996-2002)  Large amounts of Fiscal Debt  Large CAD so increasing national debt o Fiscal contraction through a succession of budgetary surpluses, G...