Chapter 17A
Online Appendix
The IS-LM Model
and the DD-AA
Model
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Preview
• IS-LM model
• Effects of permanent and temporary
– Increases in the money supply
– Fiscal expansions
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IS-LM Model
• The DD-AA model assumed that investment
expenditure is determined by exogenous business
decisions.
• In reality, the amount of investment expenditure
depends on the interest rate.
– Investment projects use saved or borrowed funds, and
the relevant interest rate represents the (real) cost of
spending or borrowing those funds.
– A higher interest rate means less investment
expenditure.
• The IS-LM model predicts that investment
expenditure is inversely related to the relevant
interest rate.
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IS-LM Model (cont.)
• The IS-LM model also allows for
consumption expenditure and expenditure
on imports to depend on the interest rate.
– A higher interest rate makes saving more
attractive and consumption expenditure (on
domestic and foreign products) less attractive.
– However, the effect of the interest rate is much
larger on investment expenditure than it is on
consumption expenditure and imports.
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IS-LM Model (cont.)
• The IS-LM model expresses aggregate demand
as:
D = C(Y – T, R-e ) + I(R-e)+ G + CA(EP*/P, Y – T, R-e)
Consumption
as a function
of disposable
income and the
real interest
rate R-πe
Investment
as a function
of the real
interest rate
R-πe
Government
purchases
are
exogenous
Current account as
a function of the real
exchange rate,
disposable income
and the real interest
rate R-πe
• Or more simply: D = D(EP*/P, Y – T, R-e, G)
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IS-LM Model (cont.)
• Instead of relating exchange rates and output, the
IS-LM relates interest rates and output.
• In equilibrium, aggregate output = aggregate
demand
Y = D(EP*/P, Y – T, R-e, G)
• In equilibrium, interest parity holds
R = R* + (Ee –E)/E
E(1+R) = ER* + Ee
E(1+R–R*) = Ee
E = Ee/(1+R–R*)
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IS-LM Model (cont.)
• Y = D(EeP*/P(1+R–R*), Y – T, R-e, G)
– This equation describes the IS curve: combinations of
interest rates and output such that aggregate demand
equals aggregate output, given values of exogenous
variables Ee, P*, P, R*, T, e, and G.
– Lower interest rates increase investment demand (and
consumption and import demand), leading to higher
aggregate demand and higher aggregate output in
equilibrium.
– The IS curve slopes down.
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IS-LM Model (cont.)
• In equilibrium, the quantity of real monetary
assets supplied matches the quantity of real
monetary assets demanded: Ms/P = L(R,Y)
– This equation describes the LM curve: combinations of
interest rates and output such that the money market is
in equilibrium, given values of exogenous values P and
Ms.
– Higher income is predicted to cause higher demand of
real monetary assets and higher interest rates in the
money market.
– The LM curve slopes up.
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Fig. 17A-1: Short-Run Equilibrium in the
IS-LM Model
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Permanent and Temporary Increases in
the Money Supply
• The IS-LM model can be used to analyze
the effects of monetary and fiscal policies.
– A temporary increase in the money supply
shifts LM to the right, lowering the interest rate
and expanding output.
– A permanent increase in the money supply,
however, shifts LM to the right but also shifts
IS to the right, since in an open economy that
schedule depends on Ee, which now rises.
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Permanent and Temporary Increases in
the Money Supply (cont.)
• The right-hand side of Figure 2 shows
these shifts.
– At the new short-run equilibrium following a
permanent increase in the money supply (point
2), output and the interest rate are higher than
at the short-run equilibrium (point 3) following
an equal temporary increase.
– The nominal interest rate can even be higher at
point 2 than at point 1.
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Permanent and Temporary Increases in
the Money Supply (cont.)
• The left-hand side of Figure 17A-2 shows how the
monetary changes affect the exchange rate.
• The interest rate R2 following a permanent
increase in the money supply implies foreign
exchange market equilibrium at point 2’, since the
accompanying rise in Ee shifts the curve that
measures the expected domestic currency return
on foreign deposits.
• That curve does not shift if the money supply
increase is temporary, so the equilibrium interest
rate R3 that results in this case leads to foreign
exchange equilibrium at point 3’.
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Fig. 17A-2: Effects of Permanent and
Temporary Increases in the Money
Supply in the IS-LM Model
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Permanent and Temporary Fiscal
Expansions
• A temporary increase in government
spending shifts IS to the right but has no
effect on LM.
• The new short-run equilibrium at point 2 in
Figure 17A-3 shows a rise in output and a
rise in the nominal interest rate, while the
foreign exchange market equilibrium at
point 2’ indicates a temporary currency
appreciation.
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Permanent and Temporary Fiscal
Expansions (cont.)
• A permanent increase in government
spending causes a fall in the long-run
equilibrium exchange rate and thus a fall
in Ee.
• The IS curve does not shift out, unlike for
a temporary policy.
• It does not shift at all: a permanent fiscal
expansion has no effect on output or the
home interest rate.
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Permanent and Temporary Fiscal
Expansions (cont.)
• The reason why permanent fiscal policy
moves are weaker than transitory ones
can be seen in the figure’s left-hand side
(point 3’).
• The accompanying change in exchange
rate expectations generates a sharper
currency appreciation and thus, through
the response of net exports, a complete
“crowding out” effect on aggregate
demand.
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Fig. 17A-3: Effects of Permanent and
Temporary Fiscal Expansions in the IS-LM
Model
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Summary
1.
The IS-LM model compares interest rates with output.
2.
The IS curve shows combinations of interest rates and
output where aggregate demand = aggregate output.
3.
The LM curve shows combinations of interest
rates and output where the money market is
in equilibrium.
4.
The IS-LM model can be used with the model of the
foreign exchange markets to compare output, interest
rates, and exchange rates.
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