Outline
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IS and LM
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Chapter 5: Short-run economic fluctuations Econ206 - Francesc Ortega
Conclusions
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Outline 1. A bit of history 2. Long-run trend versus short-run fluctuations 3. The IS and LM curves 4. Short-run equilibrium 5. The Natural rate of unemployment 6. Long-run equilibrium 7. Dynamics 8. Fiscal and monetary policy 9. Economic fluctuations Reading: Chapters 9, 10 and 11 (Mankiw 6e or 7e)
Fluctuations
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The Keynesian Theory
• The Great Depression and the resulting huge
unemployment caused many economists to question the usefulness of the neoclassical theory. • In 1936, English economist John Maynard Keynes wrote
The General Theory of Employment, Interest, and Money. In it, he proposed a new way to analyze the economy. • With the Great Recession in 2008-2009 Keynesian theory
was at the forefront of the policy discussion. It prescribes a role for monetary and fiscal policy to accelerate the recovery.
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The Keynesian Theory • In neoclassical economics output is supply-determined:
Y = AF (K , L). • Keynes proposed that low aggregate demand is
responsible for the low income and high unemployment that characterize economic downturns. • In the short run the level of income and output (Y) is
determined by the desire to spend by households, firms, the government (and net exports). • Thus the fundamental problem during recessions is that
spending is too low. • Only in the long run income and output are supply-side
determined.
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Long-run trends • In neoclassical theory supply always equals demand in
all markets. • The neoclassical model is our theory behind the
long-run trends in macroeconomic variables. • Output (real GDP) always at its potential level and “full
employment". • Full employment: the unemployment rate is at its long-run
level (the natural rate of unemploymentu around 5%). Yt
= F (Kt , Lt )
Lt
= (1 − u)LFt
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Short-run fluctuations • Obviously, output and employment not always at their full
potential. • E.g. US employment and real GDP were much lower in
2009.Q2 than in 2008.Q2 despite no reductions in the amount of capital and labor available for production. • The economy is constantly hit by (positive or negative)
shocks, which push it above or below the long-run trend. • The economy needs some time to absorb these shocks
and return to its long-run trend. • What prevents the economy from returning immediately to
its long-run trend?
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Price rigidities • Prices (including nominal wages) are sticky. It takes
time for firms to change their prices for a variety of reasons. • Consider a 5% drop in the money supply. In long run, no
effects on real variables. Simply a 5% reduction in all prices (including nominal wages). • But firms do not change their prices or cut workers’ wages
immediately. • As we shall see, price rigidities imply that the reduction in
the money supply will have real effects in the short run. Employment and real GDP will fall! • Once all prices adjust, employment and real GDP will go
back to their long-run values, as predicted by the neoclassical theory.
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The 1994 Alan Blinder study • Firms surveyed about their price adjustment decisions
1. The typical firm adjusts prices only once or twice a year. 2. About 10% of firms adjust more often. About the same amount adjust less often. 3. Main reasons given for delaying adjusting prices: • Coordination failure (60%). They are waiting for
competitors to do it first. • Menu costs (30%). It is costly to relabel and print new
brochures. • Nominal contracts (35%). Price has been fixed with
customers for a period of time. • Implicit contracts (50%). Tacit agreement (with customers
or other firms) to stabilize prices.
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New framework: the IS and LM model
• Let us introduce a new framework to think about the
economy. The IS (investment=saving) and LM (liquidity=money) model. • Designed to think about short-run fluctuations. Embodies
the essence of Keynesian economics. • Underneath the new diagram lie the markets we already
know. • But in the short-run factor (labor) markets are sluggish
because of price rigidities.
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The IS curve • Given (G, T , I), the IS curve is the collection of pairs (Y , r )
such that supply equals demand in the loans & credit market (and in the goods market). • We now introduce exports X and imports. Let net exports be NX = X − M. Assume exogenous NX . • The demand for loans in the economy is given by I + NX . • Both Investors and the Rest of the world demand loans to purchase current US output. Supply equal demand in the loans and credit market: S(Y , r ) = I(I, r ) + NX • Recall S(Y , r ) = S P (Y , r ) + T − G. Hence, supply equal
demand in the goods market as well: C(Y − T , r ) + I(I, r ) + G + NX
= Y
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IS slope
• Graphical derivation of the IS curve in Figure 1 • Movements along the IS. An increase in Y shifts the
savings curve to the right. As a result, r falls. Hence, the IS slopes down.
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IS position The IS curve shifts to the right if: 1. Government purchases (G) increase. 2. Taxes (T ) fall. In both cases we have a shift to the left of the savings curve. 3. Investors’ optimism about the future (animal spirits, I) increases. This is a shift of the investment function (demand for loans) to the right. I(I, r ) = I − br , for any b>0 4. Net exports (NX ) increase.
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The LM curve
s
• Given (M , P, π e ), the LM curve is the collection of pairs
(Y , r ) such that supply equals demand in the market for real money balances. s
M = L(Y , r + π e ) P
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LM slope
• Graphical derivation of the LM curve in Figure 3 • Movements along the LM. An increase in Y shifts the
demand for real money balances to the right. As a result, r rises. Hence, the LM slopes up.
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LM position
The LM curve shifts to the right if: 1. The money supply (M s ) increases. 2. The price level (P) falls. In both cases we have an increase in the supply for RMB. 3. Increase in future expected inflation (π e ). In this case the demand for RMB falls.
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Short-run equilibrium Definition
• The key feature: the price level if fixed in the short-run. • Given (M s , G, T , I, NX , π e ), a short-run equilibrium is a
vector (Y ∗ , r ∗ , P ∗ ) such that:
1. The loans & credit and the goods markets clear i.e. the IS condition holds. 2. The market for real money balances (liquidity) clears i.e. the LM condition holds. 3. The price level is fixed: P ∗ = P. • Note that factor markets need not clear in a short-run
equilibrium. So the unemployment rate may be above or below the NRU.
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Short-run equilibrium • Note that we have two equations for two unknowns (Y,r)
Y
= C(Y − T , r ) + I(I, r ) + G
s
M P
= L(Y , r + π e )
• The solution is denoted by (Y ∗ , r ∗ ) • Graphically, this is the intersection of the IS and LM
curves. Note that the position of the LM(P) is a function of the given price level P. • Note that changes to factor endowments will not affect the
short-run level of output!
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The NRU • Define the natural rate of unemployment as the long-run
average unemployment rate. We will denote it by u. • Over the last fifty years the natural rate of unemployment in
the US has been around 5%. Why is the NRU above zero? • Search and matching frictions. Dale Mortensen, Chris
Pissarides, Peter Diamond got the Noble prize for this. • It takes time for a worker to find an acceptable job.
Workers pickiness depends on how generous unemployment benefits are. • Likewise it takes time for a firm to find an acceptable
worker. How picky firms are depends on how costly it is to fire a worker if he turns out to be a “lemon". Also depends on workers’ skills.
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Labor market institutions and the NRU
• Why the natural rate of unemployment is higher in Europe
(around 10%) than in the US? • Many European countries had overly generous
unemployment benefits. Over the last decade they have been redesigning them to fix the incentive problems. • The US has lower firing costs. So firms are quicker to
hire workers when the economy gets out of a downturn than European firms.
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The problem with Long-term unemployment
• Several analysts have warned about the dangers of not
being aggressive against unemployment. • A serious argument is based on skills depreciating while
out of work. • If a worker can’t find work for several years his skills
become obsolete and the worker becomes less employable. • Long-term unemployment can turn into a higher NRU!
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Short-run fluctuations • Define Y = F (K , L) as the full-employment level of
production. This is the equilibrium output in the neoclassical model. • Recall that “full employment" means L = (1 − u)LF , where
u is the NRU and LF is the labor force. • Compare to the SRE level of production Y ∗ = F (K , L∗ ). • Negative shocks push output and employment below their
full-employment levels. That is, Y ∗ < Y and L∗ < L. • Positive shocks have the opposite effect: Y ∗ > Y and
L∗ > L. • When L∗ < L, the unemployment rate is above the NRU.
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Long-run equilibrium Definition
• The key feature: all markets clear. • Given (M s , G, T , I, π e ), a long-run equilibrium is a vector
(Y ∗ , r ∗ , P ∗ ) such that:
1. The loans & credit and the goods markets clear i.e. the IS condition holds. 2. The market for real money balances (liquidity) clears i.e. the LM condition holds. 3. Factor markets clear. That is, we have full employment: Y ∗ = Y = F (K , L). So the unemployment rate equals the NRU. • This is exactly the neoclassical model, but with new
diagrams.
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Long-run equilibrium • The level of production and use of factors of production
given by Y = F (K , L). • The price level and the real interest rate are the solution to
the following system: Y
= C(Y − T , r ) + I(I, r ) + G
s
M P
= L(Y , r + π e )
• The solution is denoted by (P ∗ , r ∗ ) • Graphically, the LRE is the intersection of three curves:
the IS, the LM, and Y . • Everything we know about the neoclassical model applies
to the long-run equilibrium of the model we have here.
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Finding the LRE the 3 steps again
1. Market clearing in the factor markets determines the level of output: Y = F (K , L) 2. Given Y , market clearing in the loans and credit market determines the real interest rate. This is the intersection between the IS curve and Y . 3. Given (Y , r ∗ ), market clearing in the RMB market determines the price level: P∗ =
Ms L(Y , r ∗ + π e )
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Dynamics
• Suppose the economy is at a short-run equilibrium below
full employment. • At the current price level P0 , the IS and LM(P0 ) intersect at
a level of real income Y0 < Y . • Point A in Figure 5. • Is the economy going to remain at this point? No. This is
not a long-run equilibrium.
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Self-adjustment • After some time the price level in the economy will begin
to adjust. • Where is the economy going to head to? Let us find the
long-run equilibrium from our initial situation. Follow the sacred 3 steps. • The economy will travel from A to B in Figure 5. • In words, through a process of deflation the economy
returns to full employment. • Deflation increases the supply for RMB, which lowers
the interest rate. • The declining interest rates spur consumption and
investment, bringing the economy back to full employment.
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What’s going on? • Consider a situation where the economy has a level of
output below its long-run level. That is, unemployment is above the NRU. • What brings the economy back to full employment? • Unemployment is relatively high. This puts downward
pressure on wages. As wages fall, firms’ costs also fall, allowing them to cut the prices of their goods. • As more firms cut their prices, the price level gradually
falls. This increases the supply of real money balances. • As a result, real interest rates fall, spurring consumption
and investment.
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Fiscal policy
• Suppose economy starts off at full employment. Consider
now an increase in government purchases (used for government consumption). • The IS shifts to the right. • Figure 6 depicts the SRE (given P0 ) and the LRE.
Initial equil. SRE LRE
Y Y Y1 > Y Y
r r0 r1 > r0 r2 > r1
P P0 P0 P1 > P0
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• In the short run (while the price remains rigid), output and
the real interest rate both rise. Investment falls. Ambiguous change in Consumption. But drop in C+I smaller than increase in G. • As the price adjusts upward, the LM shifts to the left.
This pushes up the real interest rate and reduces output. Both investment and consumption are falling now. • Comparing the initial and final LRE, the drop in
private-sector spending is exactly equal to the increase in government purchases. Complete crowding out. • The long-run effects of expansionary fiscal policy:
inflation and complete crowding out.
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Monetary policy
• Suppose economy starts off at full employment. Consider
now an increase in the money supply. • The LM shifts to the right. • Figure 7 depicts the SRE (given P0 ) and the LRE.
Initial equil. SRE LRE
Y Y Y1 > Y Y
r r0 r1 < r0 r2 = r0
P P0 P0 P1 > P0
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• In the short run (while the price remains rigid), output
rises and the real interest rate falls. Spurs investment and consumption. • As the price adjusts upward, the LM shifts to the left.
This pushes up the real interest rate and reduces output. Both investment and consumption are falling now. • Comparing the initial and final LRE, identical consumption,
investment, RGDP, and real money balances. The neutrality of money. • The long-run effects of expansionary monetary policy:
inflation.
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Demand shocks
• A well-known fact of business cycles is that investment is
highly volatile (compare to consumption or GDP). • In part this is due to the constant arrival of news about the
future that affect investors’ optimism. When becoming more pessimistic, they will reduce current investment. • In Keynes’ words, an important driver of investment are
animal spirits. I(r ) = I − br , for any b>0 • A reduction in consumers’ confidence has similar effects.
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A loss of confidence Laisser-faire
• Suppose the economy starts off at a LRE. Now investors
become pessimistic, shifting the IS to the left. • In the short run, output and the interest rate fall. • The laisser-faire LRE: the price level will fall, shifting the
LM to the right until we go back to full employment. Increase in real money balances. • The adjustment process (deflation) may be slow. For a
long time economy below full employment.
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Stabilization policies Fiscal stimulus
• In theory, the government can provide for a faster return to
full employment. • Consider the SRE, with price level P0 . Figure 8. • The government can use expansionary fiscal policy to shift
the IS to the initial point (increasing purchases or cutting taxes). The price level remains at P0 . • Potentially faster than waiting for deflation to do the job.
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Stabilization policies Monetary expansion
• The Fed can also deliver a faster return to full employment. • Consider the SRE, with price level P0 . Figure 8. • The Fed can increase the money supply. This will shift the
LM to the right while the price level remains at P0 . • Increase in real money balances. • Again it is fast since we do not need to wait for deflation to
do the job.
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Demand shocks Summary Figure 8
Initial LRE SRE LRE LF LRE FP LRE MP
Y
r
P
Y Y1 < Y Y Y Y
r0 r1 < r0 r2 < r1 r0 r2 < r1
P0 P0 P1 < P0 P0 P0
Note: LF stands for laissez-faire, FP stands for fiscal policy and MP stands for monetary policy.
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Supply shocks
• Anything that affects Y = AF (K , L). • Natural disasters (reduce K or L), shocks to Total Factor
Productivity (e.g. reflecting changes in the price of energy), and so on. • Suppose the economy is at a LRE with full employment Y 0 . • Negative supply shock occurs. • No immediate effects. • Increase in the price level shifts LM to left until output
equals Y 1 < Y 0 . • Long-run effects: inflation and falling output.
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Supply shocks Stabilization policy
• Suppose Fed wants to move economy back to initial output
Y 0. • Increase in money supply. New LM(P1 , M1 ). • Temporarily, it works. • Eventually, another inflation wave shifts LM(P2 , M1 ) back
to Y 1 . • Similarly if government uses fiscal stimulus to maintain
initial output Y 0 .
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Supply shocks Summary Figure 9
Initial LRE SRE LRE LF LRE MP
Y Y0 Y0 Y1 < Y0 Y1 < Y0
r r0 r0 r1 > r0 r1 > r0
P P0 P0 P1 > P0 P2 > P1
Note: LF stands for laissez-faire, FP stands for fiscal policy and MP stands for monetary policy.
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In a nutshell
• The economy is constantly being hit by positive or negative
shocks. Some affect the aggregate demand, others the full-employment output. • In the short run, rigidities in prices. Income is
demand-determined. • After some time the price level adjusts and market forces
bring back supply equal to demand in all markets. The economy goes back to full employment, as described by the neoclassical model.
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Policy advice
• Importantly, fiscal and monetary policy can in theory be
used to stabilize the economy and shorten recessions. • In practice, some challenges: 1. The appropriate response depends on the nature of the shock (supply versus demand shocks). Often not known at the time. 2. In addition, delayed effects of fiscal and monetary policies. Hard to figure out the right amount of stimulus. 3. One should also keep in mind that the consequences of current policies for long-run economic growth. E.g. avoid sustained crowding out of investment.
