ISLM ClosedEconomy

UOL Summer Camp 2017 - Macro
Aggregate Demand
Models
[Models 1]
 Before we continue, we should mention that our objective
is to build a model for the macroeconomy
 Models built to explain macroeconomic phenomena
 The important phenomena are
 Long-run growth (supply side economics, last topic of the
summer camp)
 Business cycles (main focus for the summer camp and the
questions on past exams)
 A macroeconomic model captures the essential features of
the world needed to analyze a particular macroeconomic
problem
 Macroeconomic models should be simple, but they need
not be realistic
[Models 2]
 In the following sections (Aggregate demand, Money and
banking, Monetary and fiscal policy, Aggregate demand and
aggregate supply), we are going to develop the IS-LM and
aggregate demand & supply models
 The IS-LM model present two markets that interact
- Money: Provide an equilibrium for the quantity of money and the interest
rate. This equilibrium is affect by output or income (goods market)
Goods market Market for money
- Goods: In this market the production of goods is determined. Output is

affected by interest rates, which are determined in the money market
 The IS-LM model will be extended to consider the
possibility of having an open economy (i.e. an economy that
makes transactions with the rest of the world). The model
develop will be the IS-LM-BP
Aggregate Demand
The Goods Market

The Goods Market

 A simple closed-economy model in which income is
determined by expenditure (due to J. M. Keynes)
 Depending on the textbook, aggregate demand is
sometimes called planned expenditure. Begg et. al (2014)
used aggregate demand, we are going to use planned
expenditure
 Notation:
 I = planned investment
 PE = C + I + G = planned expenditure
 Y = real GDP = actual expenditure
 Difference between actual & planned expenditure =
unplanned inventory investment (i.e. sales do not meet
their expectations, then inventories accumulate)
The Goods Market
(1) Consumption function: C  C (Y - T )

Remember, this is a function. It says that total consumption depends on (Y-T), which is
disposable income. An example of this function: C = a + b(Y-T), where b>0 and b=Marginal
Propensity to Consume (MPC). Mathematically, MPC  C Y  b
(2) Gov. policy variables: G  G , T T
(3) Investment: I  I (r )
(1-3) Planned expenditure: PE  C (Y - T ) + I (r ) + G

Planned expenditure is the amount households, firms, and the government would like to spend
on goods and services.
Equilibrium condition: actual expenditure = planned expenditure

Y  PE
The Consumption Function

C  C (Y - T )
The Investment Function

I  I (r )
 There are different interest rates. Interest rates can differ according to
their maturity, or according to their risk characteristics
 Typically, the government affect the shortest and most secure interest
rate in the economy. When this rate is increased, all the other rates
also go up (the opposite is also true)
 The IS-LM world assumes one real interest rate
Nominal Interest Rates of US Government Bonds with Nominal Long Term Bond Yields,
different maturities 1919–2011
The Investment Function

I  I (r )
US - Investment and The Interest Rate Spread
Spread: the difference between BAA and AAA corporate bonds. Note that the data shows the % deviation
with respect to each trend
The Goods Market: Equilibrium

Planned expenditure depends
positively on income (slope is “b”
in the example of the previous
slide)
In equilibrium, planned
expenditure is equal to
expenditure and is equal to
PE income
planned Y
expenditure (1) What happens if Y>PE? (to
C +I + G
the right of the equilibrium
Actual point) Inventories are
production
accumulated (sales were below
Planned sales expectations). This induce firms
(or demand)
Y to lay off workers and reduce
Equilibrium
production. Until when? Until
output Y=PE
The Goods Market: Equilibrium

PE
planned Y
(2) What happens if Y<PE? (to
expenditure the left of the equilibrium point)
C +I + G Inventories are reduced. This
induce firms to hire more
workers and increase
production. Until when? Until
Y=PE
Y
Equilibrium
output
The intersection of the two curves represent the equilibrium. This

equilibrium for production does not indicate that the economy is
producing at the level of potential output (the economy could be
produce more or less than the potential output). The way to
interpret the model is that this is a model for the short run, where
output is determine by aggregate demand (or PE)
Fiscal Policy & The Goods Market
PE FISCAL POLICY
PE =C +I +G2 If we increase
government
PE =C +I +G1
expenditures we can
increase PE and
output
ΔG
The key question is:
How big is the
change in Y for a $1
Y increase in G?
PE1 = Y1 ΔY PE2 = Y2
Impact of Government Expenditures: Multiplier
Y  C + I + G equilibrium condition
DY  DC + DI + DG in changes
 DC + DG because I exogenous
 MPC �DY + DG because ΔC = MPC ΔY
Collect terms with ΔY Solve for ΔY :

on the left side of the
equals sign: � 1 �
DY  � ��DG
(1 - MPC) �DY  DG 1 - MPC �
�
The Multiplier
Definition: the spending multiplier is the increase in
income resulting from a $1 increase in G, I or C autonomus
Example: If MPC = 0.8, then
DY 1 DY 1
   5
DG 1 - MPC DG 1 - 0.8
Initially, the increase in G causes an equal increase in Y

But #Y g #C
g further #Y
g further #C
g further #Y
Aggregate Demand
Government
Government
 Resources: Taxation
 Lump-sum tax: It is a tax that does not depend in any way on the actions
of the economic agent who is being taxed
 Sales tax or Value Added Tax (VAT): taxation over consumption
 Income tax (proportional tax): taxation over income
 Typical consumption function (without taxes): C  c0 + c1Y
 Sales tax:  1 - tVAT  C   1 - tVAT   c0 + c1Y 
 Income tax: C  c0 + c1  1 - tIT  Y
 Other sources of income for the government: debt and
printing money. The IS-LM model is a static model, then
debt cannot be modeled (it would require more than
one period). Typically in the IS-LM model printing
money is not part of government resources, and its
effects are confined to the money market
Government
 Expenditures: in the IS-LM world, expenditures typically
are assumed exogenous. In other words, there is no
theory of why governments spend the level G
 An exception is the case of a balance budget. If the
budget is balanced, then income = expenditures, or the
government is not saving, nor borrowing
 Then, if there is a proportional tax, or an income tax:
C  c0 + c1  1 - t IT  Y
G  t IT Y
Government
 The multiplier for the case of an income tax, a balanced
budget, and a closed economy is
Y  C + I + G   c0 + c1  1 - t IT  Y  + I +  t IT Y 
Y  1 - c1  1 - t IT  - t IT    c0 + I 
1 1
Y  0 
c + I   c0 + I 
1 - c1  1 - t IT  - t IT 1- M
 What are the effects of an increase in the tax rate?

M
 -c1 + 1  0
t IT
 The multiplier: 1
1- M 
Money and Banking
Back to the IS-LM model: the

Money Market
The Money Market

 Due to John Maynard Keynes
 A simple theory in which the interest rate is determined
by money supply and money demand
 Caveat: we discuss about interest rates in the context of
an static model (1 period)
 Simplification: assume
that the Fed controls
the money supply
(there is no MB, M1,
M2, etc; but recall
M=mMB)
 Prices are fixed (we
are in the short-run)
The Money Market
How to interpret the

shape of the money
demand? Think about a
portfolio choice problem.
You can invest in money
and bonds (or deposits).
Only bonds pay “r”.
In this case, the interest rate is the “opportunity cost of holding money”
The Money Market: Equilibrium

Monetary Policy & Money Market
Note: the demand

for money not
only depends on
the interest rate, it
can also depend
on income, hence
L(r,Y)
The Money Market

 Following Begg et. al (2014), the money market
equations are given by
Interest rate that could be earned by
LS investing wealth elsewhere
LD   +  Y -   r - rd    0,   0,   0
Interest rate on deposits
LS  LD   +  Y -   r - rd 
Equilibrium: for given levels of LS, Y and rd, there is only one level of
r that ensures the equilibrium in the money market
Index
 Introduction to macroeconomics
 Aggregate demand
 Money and banking
 Monetary and fiscal policy
 Aggregate demand and aggregate supply
 Inflation
 Unemployment
 Exchange rates and the balance of payments
 Open economy macroeconomics
 Business cycles
 Supply-side economics and economic growth
The IS-LM Model

 In the previous sections (Aggregate demand, Money and
banking, Monetary and fiscal policy, Aggregate demand and
aggregate supply) we developed the foundations for the IS-
LM model
 Recall that the IS-LM model present two markets that
interact
- Money: Provide an equilibrium for the quantity of money and the interest
rate. This equilibrium is affect by output or income (goods market)
- Goods: In this market the production of goods is determined. Output is

affected by interest rates, which are determined in the money market
Derivation of the IS curve: The Goods Market

Def. IS curve: a graph of all combinations of r and Y that result in goods market eq.
The equation for the IS curve is Y  C (Y - T ) + I (r ) + G
Derivation of the IS curve:

Derivation of the IS curve: The Goods Market

Def. IS curve: a graph of all combinations of r and Y that result in goods market eq.
The equation for the IS curve is Y  C (Y - T ) + I (r ) + G
Derivation of the IS curve:

The Goods Market: The IS Curve & Fiscal Policy

Derivation of the LM Curve: The Money Market

Def. LM curve: a graph of all combinations of r and Y that result in money market eq.
The equation for the LM curve is
Derivation of the LM curve:
Derivation of the LM Curve: The Money Market

Def. LM curve: a graph of all combinations of r and Y that result in money market eq.
The equation for the LM curve is
Derivation of the LM curve:
If Y increases:
Demand for
money is
higher, L shifts
to the right.
The
equilibrium L (r , Y2 )
interest rate
increases
Note: in the derivation of the IS “r” was exogenous (fixed or given), and in order to derive the IS we move
“r”. In the derivation of the LM “y” is exogenous, and we move this variable
The Money Market: The LM Curve & Monetary Policy

 Same exercise: FED raise “r” (contractionary MP). In
order to raise “r”, the FED contracts the money supply
For the same level of output

The IS-LM Model: Equilibrium
We can use the IS-LM model to analyze the effects of fiscal policy
(G and/or T) and monetary policy ( M)
“Y” is determined, is endogenous “r” is determined, is endogenous

From the point of view of the From the point of view of the
goods market (partial money market (partial
equilibrium), “r” is fixed or equilibrium), “Y” is fixed or
exogenous exogenous
Changes in “G” will change “Y” Changes in “MS” will change “r”

exogenous exogenous
If there are changes in the goods market, “Y” will

change. Changes in “Y” will affect the market for
money, because money demand depends on “Y”

If there are changes in the market for money, “r”
will change. Changes in “r” will affect the goods
market, because investment depends on “r”

exogenous exogenous
If there are changes in the goods market, “Y” will

change. Changes in “Y” will affect the market for
money, because money demand depends on “Y”
The IS-LM Model

 Following Begg et. al (2014), a simplified version of the
IS-LM model (a more complete version is on the
University of London’s study guide) is given by
Y  A - br IS _ schedule A, b  0
Y  D + er LM _ schedule e  0, 0  D  A
IS  LM : A - br  D + er
r   A - D  b + e Y   Ae + bD   b + e 
The IS-LM Model
Changes in Fiscal Policy &

Monetary Policy
The IS-LM Model: Fiscal Policy, an Increase in G
Key point: there is an interaction between the two markets. The reduction
in private investment related to an expansionary fiscal policy is called
“CROWDING OUT” effect
IS-LM & Aggregate Demand
IS-LM & Aggregate Demand

Aggregate Demand
 The IS-LM model is a model for the short-run. It assumes
that prices are fixed in the short run
 Now, the question is what is the relation between the
model and aggregate demand?
 Aggregate demand is a negative relation that indicates
that the higher the level of prices, the lower the quantity of
goods demanded in the economy
 Fortunately, the IS-LM model considers these two
variables: prices and output
IS : Y  C  Y  + I  r  + G
LM : M P  L  r , Y 
Derivation of Aggregate Demand
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
hP g i(M/P )
IS
g LM shifts left Y2 Y1 Y
P
g hr
P2
g iI
P1
g iY
AD
Y2 Y1 Y
Aggregate Demand: Expansionary Fiscal Policy
r LM
Expansionary fiscal policy
(hG and/or iT ) increases r2
agg. demand: r1 IS2
iT g hC IS1
Y1 Y2 Y
g IS shifts right P
g hY at each
P1
value of P
AD2
AD1
Y1 Y2 Y
Aggregate Demand: Expansionary Monetary Policy
r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
hM g LM shifts right
IS
g ir Y1 Y2 Y
P
g hI
g hY at each P1
value of P AD2
AD1
Y1 Y2 Y
IS-LM, Aggregate Demand & Aggregate Supply
IS-LM, Aggregate Demand &

Aggregate Supply
Business Cycle Measurement: GDP and Unemploym.

Recession Recession
Output
Potential
Output output
(GDP)
Time
Unemployment
Natural rate of
unemployment
Actual unemployment
Time
Note: recession in the graph is defined as: output below potential

NBER recession: period of falling output
US data: GDP/potential vs Unemployment-Natural U
Note: GDP and

potential is in
billions of 2009
dollars
Aggregate Supply
 Aggregate supply represents the production side of the
economy
 Aggregate supply describes the relation between output,
that firms are willing to produce, and prices
 We will not provide a formal model to derive the
aggregate supply curve
 In the short run, we can argue that the supply curve
(SRAS) is upward sloping (firms are willing to produce more
if prices are higher), while in the long run the aggregate
supply is vertical (production is determined by supply side
factors like technology or productivity and there is no
relation between production and prices)
Aggregate Supply & Demand

 Equilibrium in the short run

 Equilibrium in the long run
 We have a self-correcting mechanism:
 If Y  Y,nno pressures on the labor market (output
is equal to its potential, which is consistent with the
natural rate of unemployment or NAIRU - no
accelerating inflation rate of unemployment)
 If Y  Y n , production is above its potential. Firms
will want to hire more workers. Labor markets are
tight, wages increase, production costs increase, the
SRAS shifts to the left
 If Y  Y n, the opposite
 Note that we require flexibility in the labor market, or
that wages are flexible

 Adjustment to long run equilibrium: from 1 to 3
Shocks & Aggregate Supply & Demand

 Changes in equilibrium caused by AD shock
 Short run: from 1 to 1’ / Long run: from 1’ to 2

 An AD shock can be a change in autonomous
investment or consumption. The same movements can
be generated using an expansionary government policy
 Government policies affect output in the short-run
Shocks & Aggregate Supply & Demand

 Changes in equilibrium caused by AS shock
 Short run: from
1 to 2
 Long run: from
2 to 1
 An AS shock can be a weather shock, or new temporary

government’s regulations that affect firms performance
 Adjustment requires a reduction in prices, as in the
figure. Keynesians argue that the adjustment process is
very slow (wages are sticky), and the government can
intervene (fiscal/monetary) to stabilize the economy
Productivity Shocks
 We mentioned that the supply side is linked to the
production side of the economy, in particular, to firms
 Firms are typically modeled in the following way
  AF  K , L  - wL - rK
 The firms’ profits () are the difference between (1)
income or production (which is a combination of
productivity A, capital K and labor L) and (2) production
costs (the wage cost, which is the product of wages w
and labor, and the cost of capital, which is the product of
the cost per unit of capital r and capital)
 A positive productivity shock can be interpreted as an
increase in potential output, or an increase in the LRAS

ISLM ClosedEconomy

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UOL Summer Camp 2017 - Macro

Goods market Market for money

- Goods: In this market the production of goods is determined. Output is

The Goods Market

The Goods Market

The Goods Market

(1) Consumption function: C  C (Y - T )

(2) Gov. policy variables: G  G , T T

(1-3) Planned expenditure: PE  C (Y - T ) + I (r ) + G

Equilibrium condition: actual expenditure = planned expenditure

The Consumption Function

The Investment Function

The Investment Function

US - Investment and The Interest Rate Spread

The Goods Market: Equilibrium

The Goods Market: Equilibrium

The intersection of the two curves represent the equilibrium. This

Fiscal Policy & The Goods Market

Impact of Government Expenditures: Multiplier

 MPC �DY + DG because ΔC = MPC ΔY

Collect terms with ΔY Solve for ΔY :

Initially, the increase in G causes an equal increase in Y

 What are the effects of an increase in the tax rate?

Money and Banking

Back to the IS-LM model: the

The Money Market

The Money Market

How to interpret the

The Money Market: Equilibrium

Monetary Policy & Money Market

Note: the demand

The Money Market

The IS-LM Model

Goods market Market for money

- Goods: In this market the production of goods is determined. Output is

Derivation of the IS curve: The Goods Market

Derivation of the IS curve:

Derivation of the IS curve: The Goods Market

Derivation of the IS curve:

The Goods Market: The IS Curve & Fiscal Policy

Derivation of the LM Curve: The Money Market

Derivation of the LM Curve: The Money Market

The Money Market: The LM Curve & Monetary Policy

For the same level of output

The IS-LM Model: Equilibrium

The IS-LM Model: Equilibrium

Goods market Market for money

“Y” is determined, is endogenous “r” is determined, is endogenous

The IS-LM Model: Equilibrium

Goods market Market for money

“Y” is determined, is endogenous “r” is determined, is endogenous

If there are changes in the goods market, “Y” will

The IS-LM Model: Equilibrium

Goods market Market for money

“Y” is determined, is endogenous “r” is determined, is endogenous

If there are changes in the goods market, “Y” will

The IS-LM Model

The IS-LM Model

Changes in Fiscal Policy &

The IS-LM Model: Fiscal Policy, an Increase in G

IS-LM & Aggregate Demand

IS-LM & Aggregate Demand

Derivation of Aggregate Demand