The IS - LM Model
• Interest Rates and Rates of Return
– Assumption: Only 1 interest rate
– Functions of Interest Rates
The IS - LM Model
• Interest rates help allocate saving
– Return for investors
– Cost for borrowers
» Compare borrowing costs, investment returns
• Central to the role of monetary policy
– Types of Interest Rates
• Short-term versus long-term
September 14 & 16, 1999
1
The IS - LM Model
September 14 & 16, 1999
Figure 4-1
2
The Payoff to Investment for an Airline and the Economy
• The Relation of A(p) to the Interest Rate
– Rate of Return and Interest Rates
» Figure 4-1
• Business fixed investment
• Residential investment
• Consumer durable goods
– Business and Consumer Optimism
» Figure 4-2
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Figure 4-2 Effect on Autonomous Planned Spending of an Increase in Business and
Consumer Confidence
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The IS - LM Model
• The Relation of A(p) to the Interest Rate
– The Demand of A(p)
• Combining G, -cT, and NX
– which do not depend on r
• and I(p) and a
– which do depend on r
» Figure 4-3
• “Autonomous” A(p), i.e., when r = 0
– Shifts in the A(p) Demand Schedule
• Changes in G, T, NX, business or consumer
confidence
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1
Figure 4-3 Relation of the Various Components of Autonomous Planned Spending to
the Interest Rate
The IS - LM Model
• The IS Curve
– Introduction
• Y depends on A(p)
• A(p) depends on r
• Therefore Y depends on r
– This relationship is know as the IS curve
– Exogenous variables
» G, T, and NX
» Business and consumer confidence
» c and s
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September 14 & 16, 1999
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Figure 4-4 Relation of the IS Curve to the Demand for Autonomous Spending and the
Amount of Induced Saving
The IS - LM Model
• The IS Curve (continued)
– How to Derive the IS Curve
• Start with A(p) demand curve
– Pick an initial interest rate and find the associated A(p)
• Find Y(e) via induced saving
– Y(e) = A(p) / s or A(p) * multiplier
– Establishes a Y(e), r point
• Repeat
» Figure 4-4
• IS curve plots the values of Y(e) and r
– IS curve = A(p) demand curve * multiplier
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September 14 & 16, 1999
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Figure 4-5 Effect on the IS Curve of a Rightward Shift in the Demand for Autonomous
Planned Spending
The IS - LM Model
• The IS Curve (continued)
– What the IS Curve Shows
• Combinations of Y, r at which the economy’s
market for goods and services is in equilibrium.
– Where Y(e) = E(p)
• Disequilibrium adjustment
– What Changes the IS Curve?
• Changes in A(p) shift the IS curve
» Figure 4-5
• Changes in k and/or the interest sensitivity of A(p)
rotate the IS curve
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September 14 & 16, 1999
12
2
The IS - LM Model
The IS - LM Model
• Why People Use Money
• Income, r, and the Demand for Money (L)
– The Introduction of Money
– Income and the Demand for Money
• Definition
• Functions
• M(d)/P = dY
– The Interest Rate and the Demand for Money
– A Medium of Exchange
– A Store of Value
– A Unit of Account
• M(d)/P = dY - f * r
» Figure 4-6
– Change in the M(d)/P Curve
• Changes in r move along L
• Changes in Y shift L
» Figure 4-7
September 14 & 16, 1999
Figure 4-6
13
14
Figure 4-7 Effect on the Money Demand Schedule of a Decline in Real Income from
$4000 to $3000 Billion
The Demand for Money, the Interest Rate, and Real Income
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September 14 & 16, 1999
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The IS - LM Model
September 14 & 16, 1999
Figure 4-8
16
Derivation of the LM Curve
• The LM Curve
– Introduction
• M(s) is exogenous
• M(d)/P = f( Y, r )
• Equilibrium in the money markets requires
– M(s)/P = M(d)/P = f ( Y, r ) where f(1) > 0, f(2) < 0
» Figure 4-8 (left panel)
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September 14 & 16, 1999
18
3
The IS - LM Model
The IS - LM Model
• The LM Curve (continued)
• The LM Curve (continued)
– How to Derive the LM Curve
– What the LM Curve Shows
• Select a level for Y
• All combinations of Y and r where the money
market is in equilibrium
• Disequilibrium adjustment
– Find the M(d) curve associated with this level of Y
• Find r at the intersection of the M(s)/P and M(d)/P
• Plot Y, r in a separate graph
• Repeat with a new level for Y
• Connect all of the Y, r pairs into the LM curve
September 14 & 16, 1999
–
–
–
–
19
Change in P
Change in r
Change in Y
Change in Y and r
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Figure 4-9 The Effect on the LM Curve of an Increase in the Real Money Supply from
$1000 Billion to $1500 Billion
The IS - LM Model
• The LM Curve (continued)
– What Makes the LM Curve Shift?
• Change in M(s)
• Changes in M(d)/P
– M(d)/P becomes more/less interest sensitive
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The IS - LM Model
September 14 & 16, 1999
Figure 4-10
22
The IS and LM Schedules Cross at Last
• The IS Curve Meets the LM Curve
– General equilibrium requires both
• Equilibrium in the commodity market
• Equilibrium in the money market
» Figure 4-10
– Disequilibrium dynamics
– Endogenous variables
• Y, r
– Exogenous variables
• Business & consumer confidence, M(s), G, T & NX
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September 14 & 16, 1999
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4
Figure 4-11
LM Curve
The IS - LM Model
The Effect of a $500 Billion Increase in the Money Supply with a Normal
• Monetary Policy in Action
– Expansionary Monetary Policy
» Figure 4-11
• Transmission effects
– Liquidity effect
– Income effect
• Results
– Higher Y
– Higher r
– Contractionary Monetary Policy
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September 14 & 16, 1999
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Figure 4-12 The Effect on Real Income and the Interest Rate of a $250 Billion Increase
in Government Spending
The IS - LM Model
• Fiscal Policy in Action
– Expansionary Fiscal Policy
» Figure 4-12
• Effect on the multiplier
– and “crowding out”
• The crowding out effect
– Changes the composition of spending
• Can crowding out be avoided?
– Expansionary monetary policy
– Other possibilities
– Contractionary Fiscal Policy
September 14 & 16, 1999
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September 14 & 16, 1999
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5
Money and Financial Markets
Money and Financial Markets
• Financial Institutions, Markets, and
Instruments
• Financial Institutions, Markets, and
Instruments (continued)
– Financial markets and financial intermediaries
perform the function of channeling funds from
savers to borrowers
– Reasons for Saving and Borrowing
– Financial Institutions and Financial Markets
• Financial markets channel funds directly
– Size is an important consideration
• Financial intermediaries channel funds indirectly
– Spread risk and collect information efficiently
• Businesses -- net borrowers
• Households -- net savers
• Government -- mixed
• Foreign Sector -- mixed
September 14 & 16, 1999
• Figure 13 - 1
3
Figure 13-1
The Role of Financial Intermediaries and Financial Markets
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4
Money and Financial Markets
• Financial Institutions, Markets, and
Instruments (continued)
– Categories of Financial Institutions and
Instruments
– Table 13 - 1a
• Depository Institutions
• Contractual Savings Institutions
• Investment Intermediaries
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September 14 & 16, 1999
Money and Financial Markets
Money and Financial Markets
• Financial Institutions, Markets, and
Instruments (continued)
• Definitions of Money
6
– Introduction
• There is a spectrum of financial assets running the
gamut of medium-of-exchange to store-of-value
• Financial deregulation has blurred the distinction
between different kinds of financial assets
– Financial Market Instruments
– Table 13 - 1b
• Money Market Instruments
– Original maturities of one year or less
• Capital Market Instruments
– Original maturities of more than one year
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September 14 & 16, 1999
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1
Money and Financial Markets
Money and Financial Markets
• Definitions of Money (continued)
• Definitions of Money (continued)
– The M1 Definition of Money
– The M2 Definition of Money
– Table 13 - 2
– Table 13 - 2
• Currency
• Transactions accounts
• Travelers checks
• M1
• Savings deposits
• Time deposits
• Money market mutual funds
– Excluded from M2 are mutual funds and all
money and capital market instruments
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September 14 & 16, 1999
10
Money and Financial Markets
Money and Financial Markets
• Definitions of Money (continued)
• High-Powered Money and Determinants of
the Money Supply
– Money Supply Definitions and the Instability of
Money Demand
• The demand for M2 may shift unpredictably when
these omitted assets become more attractive relative
to the assets that are included in M2
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– Money Creation on a Desert Island
• An example
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Money and Financial Markets
Money and Financial Markets
• High-Powered Money and Determinants of
the Money Supply (continued)
• High-Powered Money and Determinants of
the Money Supply (continued)
– Required Conditions for Money Creation
– The Money-Creation Multiplier
• Equivalence of coins and deposits
• Redeposit of proceeds from loans
• Holding of cash reserves
• Willing borrowers
• Introduction
– High-powered money is the sum of currency held outside
of depository institutions and the reserves held in them
– The demand for high-powered money to be held as
reserves equals the supply of high-powered reserves
– If banks stop lending their excess reserves, the process of
money creation would stop
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13
e*D=H
D=H/e
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2
Money and Financial Markets
Money and Financial Markets
• High-Powered Money and Determinants of
the Money Supply (continued)
• High-Powered Money and Determinants of
the Money Supply (continued)
– The Money-Creation Multiplier (continued)
– The Money-Creation Multiplier (continued)
• Comparison with Income-Determination Multiplier
• Comparison with Real-World Conditions
– The intuition behind the money-creation multiplier is the
same as the income-determination multiplier
– e reflects the leakages from the money creation process
– Need to keep everything in the banking system
• Cash Holdings
– Multiplier changes as cash leaks out of the system
(e*D)+(c*D)=H
(e+c)*D=H
D=H/(e+c)
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September 14 & 16, 1999
Money and Financial Markets
Money and Financial Markets
• High-Powered Money and Determinants of
the Money Supply (continued)
• High-Powered Money and Determinants of
the Money Supply (continued)
– The Money-Creation Multiplier (continued)
16
– Gold Discoveries and Bank Panics
• Cash Holdings (continued)
• Can change H, c, or e
M=D+c*D=(1+c)*D
M=(1+c)*D={(1+c)*H}/(e+c)
– The ratio of the money supply to high-powered money
( M / H ) is called the money multiplier
M/H=(1+c)/(e+c)
– There is a separate money multiplier for each definition of
the money supply
September 14 & 16, 1999
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September 14 & 16, 1999
Money and Financial Markets
Money and Financial Markets
• The Fed’s Three Tools for Changing the
Money Supply
• The Fed’s Three Tools for Changing the
Money Supply (continued)
– In order to control the money supply the Fed
must predict the public’s desired cash-holding
ratio ( c ), over which the Fed has no control.
– Then the Fed can adjust H and e to make its
desired M consistent with the public’s chosen c
18
– First Tool: Open-Market Operations
• Purchases and sales of government securities made
by the Federal Reserve
• H is Created out of Thin Air
• Effect on Interest Rates
– Sometimes the Fed engages in open-market operations
even when it has no desire to raise or lower the money
supply
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September 14 & 16, 1999
20
3
Money and Financial Markets
Money and Financial Markets
• The Fed’s Three Tools for Changing the
Money Supply (continued)
• The Fed’s Three Tools for Changing the
Money Supply (continued)
– Second Tool: Discount Rate
– Third Tool: Reserve Requirements
• The interest rate the Federal Reserve charges
depository institutions when they borrow reserves
• Most an emergency tool
• The minimum fraction of deposits that must be held
as reserves
– Required reserves
– Held in reserve accounts at the Fed or as vault cash
• The Fed can change the money supply by changing
bank reserve requirements, e
• Banks would hold some reserves even without
reserve requirements but they would be much less
September 14 & 16, 1999
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September 14 & 16, 1999
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Money and Financial Markets
Money and Financial Markets
• The Fed’s Three Tools for Changing the
Money Supply (continued)
• CASE STUDY:
How Financial Deregulation and Innovation
Steepened the IS and LM Curves
– Why the Fed Can’t Control the Money Supply
Precisely (Money-Multiplier Shocks)
– Deregulation of financial markets can increase
the volatility of interest rates
• Multiple Definitions of Money
• The Public Chooses the Amount of Currency
– Foreigners
• Deposit Shifts between Reserve Categories
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September 14 & 16, 1999
Money and Financial Markets
Money and Financial Markets
• CASE STUDY (continued)
• CASE STUDY (continued)
– Effects of Regulation Q
29
– Financial Deregulation and the IS Curve
• Disintermediation, the effect on interest rates,
mortgage financing, and housing activity
• Financial deregulation and innovations
–
–
–
–
Repeal of Req. Q
Introduction of interest-sensitive deposit accounts
Development of the mortgage-backed securities
Introduction of adjustable-rate mortgages
• Because disintermediation no longer stymies
spending, larger increases in interest rates are now
required to reduce spending by the same amount
» Figure 13 - 3a
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September 14 & 16, 1999
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4
Figure 13-3
The Effect of Financial Deregulation in the Commodity and Money Markets
Money and Financial Markets
• CASE STUDY (continued)
– Why the LM Curve Became Steeper
• Financial deregulation and innovations
– Introduction of interest bearing substitutes
– Development of mutual funds
» Figure 13 - 3b
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September 14 & 16, 1999
33
Figure 13-4
The Effect of a Lower Money Supply on Interest Rates and Output
Money and Financial Markets
• CASE STUDY (continued)
– Effects on Interest Rates
• The main effect of deregulation is likely to be
increased volatility of interest rates
» Figure 13 - 4
• Deregulation can have adverse side effects that may
partially offset the benefits of greater efficiency and
fairness when prices play the main role in balancing
supply and demand in financial markets
September 14 & 16, 1999
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September 14 & 16, 1999
35
5