The ISLM Model

TheISLMModel
AddingFinancialMarkets
to the Real Side
totheRealSide

AndrewRose,GlobalMacroeconomics9

Assumptions
Continuetoignoreaggregatesupply
C ti
t i
t
l
Prices/inflationfixed(businesscycleassumption)
Prices/inflation fixed (business cycle assumption)

Continuetoignorerestofworld(X=M=0)
Closedeconomy/autarkyorlargeeconomy

AndrewRose,GlobalMacroeconomics9

Add Financial Sector

AddFinancialSector
Atleasttwoassetsnecessary
At l t t
t
Money:liquid,safe,low/zeroreturn
Money: liquid, safe, low/zero return
Bonds:illiquid,risky,interestreturn

AndrewRose,GlobalMacroeconomics9

Changes to Real Markets

ChangestoRealMarkets
Investment
I
t
t nowdependsnegativelyon
d
d
ti l
interestratebecauseofPVreasons(I=I
( obi))
Adeclineininterestrates(i)causesinvestment
torise(I)
Hencemultiple
Hence multiple expansioninincome
expansion in income

AndrewRose,GlobalMacroeconomics9

Other Sectors
OtherSectors
Continuetousesame(Keynesian)
C ti
t
(K
i )
Consumptionfunction
p
C=C0 +cYD =(C0 +cTr)+c(1t)Y

ContinuetotreatG(directgovernment
spending)asexogenous

AndrewRose,GlobalMacroeconomics9

Adding It All Up
AddingItAllUp
Y=C+I+G,but
Y=C+I+G but
C=C0 +cYD =(C0 +cTr)+c(1t)Y
I=Iobi
bi

Y=(C0 +cTr)+c(1t)Y+Iobi+G0,so
Y=[1/(1c(1t)]*[(C0 +cTr)+Iobi+G0]

AndrewRose,GlobalMacroeconomics9

Graphically: IS
Graphically:IS
i
Algebraically
A

IS
Y

TechnicalNote:thisisnolongerareducedformorsolution
since interest rates are endogenous and on right hand side
sinceinterestratesareendogenousandonrighthandside.
AndrewRose,GlobalMacroeconomics9

IS: Goods Market Equilibrium

IS:GoodsMarketEquilibrium
Name:Investment=Savings
N
I
t
t S i
b t onlyina
but
l i
closedeconomy!
Equilibriumrelationshipbetweeninterestrate
andlevelofoutputtherealeconomy/market
for goods and services clear
forgoodsandservices
clear andarein
and are in
equilibrium
AndrewRose,GlobalMacroeconomics9

IS Curve
ISCurve
Slope ofISgivenbyimpactofchangeininterest
of IS given by impact of change in interest
ratesoninvestmentandhenceoutput(through
multiplier) likelysteep
Location ofISchangedbyautonomous
of IS changed by autonomous
componentsofaggregatedemand(e.g.,
autonomousinvestment,I0 orfiscalpolicy,G
f
l l
0)
Multipliercanalsochange(taxes,confidence/MPC)
AndrewRose,GlobalMacroeconomics9

Financial Market Equilibrium

FinancialMarketEquilibrium
LiquidityPreference
Liquidity Preference theory:equilibriumportfoliosofmoneyand
theory: equilibrium portfolios of money and
bonds
Probablyreasonabletoassumecontinuousequilibriumforfinancial
markets(pricesmovequickly)
Moneyisriskless,liquidbutpaysnointerest
Bondsarerisky,illiquidandpayinterest(i)

Ifmoneymarketclears,sodoesbondmarketandviceversa
Walras'Law
Henceignorebondmarketequilibriumifmoneymarketinequilibrium

AndrewRose,GlobalMacroeconomics9

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Money Market Equilibrium

MoneyMarketEquilibrium
DemandforRealMoney(Liquidity)
Demand for Real Money (Liquidity)
Positivefunctionofrealincome(transactions
demand)
Negative(small)functionofopportunitycost(interest
Negative (small) function of opportunity cost (interest
rate)
RealMoneySupplyisgivenbyratioofmoneysupply
(determinedbycentralbank)tofixedprices(M
(determined
by central bank) to fixed prices (Ms/P)
AndrewRose,GlobalMacroeconomics9

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Money Market Equilibrium

MoneyMarketEquilibrium
i

L,M

AndrewRose,GlobalMacroeconomics9

LM

12

LM Algebra
LMAlgebra
(Ms/P)
/P)=L(i,Y)
L(i,Y)
Name:DemandforLiquidity(L)=MoneySupply(M)
i
LM

Y
AndrewRose,GlobalMacroeconomics9

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More on LM
MoreonLM
Slope
Sl
ofLMreflectsinterestandincome
f LM fl t i t
t di
elasticitiesofmoneydemand(likelysteep)
Location ofLM:ExpansionaryMonetaryPolicy
raisesrealbalancesandhencelowersinterest
rates at a given level of real income
ratesatagivenlevelofrealincome
LMcurveshiftsdownandtoright
AndrewRose,GlobalMacroeconomics9

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Together
LM

IS

AndrewRose,GlobalMacroeconomics9

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ISLM
IS
LMEquilibrium
Equilibrium
Bothrealandfinancialmarketsinequilibriumonlyat
Both real and financial markets in equilibrium only at
intersectionofISandLMcurves
Henceboth interestratesandoutputareendogenous
Thingsthatdependoninterestrates(e.g.,investment)also
g
p
( g,
)
endogenous
Thingsthatdependonincome(e.g.,consumption)also
Things that depend on income (e g consumption) also
endogenous

AndrewRose,GlobalMacroeconomics9

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Good Question
GoodQuestion
How
Howmuchdoesoutputfallifinterestrates
much does output fall if interest rates
risealittle(e.g.,100basispoints)?

AndrewRose,GlobalMacroeconomics9

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Fiscal Policy Shock: G

FiscalPolicyShock:G
i

LM
B

IS'

IS

Y
AndrewRose,GlobalMacroeconomics9

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Discretionary Fiscal Policy

DiscretionaryFiscalPolicy
ExpansionaryFiscalPolicy
p
y
y ((e.g.,increaseinG)
g,
)
Y=[1/(1c(1t)]*[(C0 +cTr)+Iobi+G0]
Grises,shiftsIScurveoutandtorightraisingboth
interest rates and income
interestratesandincome
Extentdependsonformofgovernmentfinancing
(bonds/taxes/seigniorage usuallytreatbondsas
defa lt)
default)
PrintingMoneyimpliesLMshiftsaswell

Directgovernmentspendingcrowdsoutinvestment
(
(sinceinterestratesrise)
)
Presentcrowdsoutfuture;also,publiccrowdsoutprivate

Canalsohandletransfers(Tr)ortaxes(t)
( )
()
AndrewRose,GlobalMacroeconomics9

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Expansionary Monetary Shock: M

ExpansionaryMonetaryShock:M
Moneyrises,shiftsLMcurvedown/right,
M
i
hift LM
d
/ i ht
loweringinterestrates(i)whileraising
g
( )
g
income(Y)

AndrewRose,GlobalMacroeconomics9

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Monetary Shock Graphically

MonetaryShockGraphically
i

LM'

LM

B
IS

Y
AndrewRose,GlobalMacroeconomics9

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More on Monetary Policy

MoreonMonetaryPolicy
Money(M1)isdefinedascurrencyheldby
M
(M1) i d fi d
h ld b
publicanddemanddeposits
Butcentralbankdoesntcontroldepositsand
hencemoney(directly)
Instead,itdirectlycontrolsamorenarrow
Instead it directly controls a more narrow
monetaryaggregate
AndrewRose,GlobalMacroeconomics9

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More on Money Supply

MoreonMoneySupply
Ms =
= HPM
HPM
ismoneymultiplier
afunctionoftworatios(Currency/Deposits),
a function of two ratios (Currency/Deposits)
(CommercialBankReserves/DD)
Usuallyexogenous,movesslowly
Financialcrisismayleadtoreservehoarding(20089)

HPMishighpoweredmoneyormonetary
basecontrolledbyCentralBank

AndrewRose,GlobalMacroeconomics9

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HighPowered
High
PoweredMoney
Money
Liabilitiesofcentralbank:
ab t es o ce t a ba :
Currencyincirculationheldbypublic
Commercialbankreserves(CBR)

Assetside:
InternationalReserves(IR=FX+gold+SDRs)
CentralBankCredit(CBC=governmentdebtheldby
centralbank notall treasuries,justthoseheldby
central bank)
centralbank)
Usuallynotprivatebonds/equityexceptincrisis

Thatis,HPM
,
IR+CBC=Currency+CBR
y
AndrewRose,GlobalMacroeconomics9

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HowDoesCentralBankActually
ChangeMonetaryPolicy?
h
l ?
Anexpansionaryopenmarketoperationconsistsof
p
y p
p
centralbanksaleofCurrency/CBRtothepublicin
exchangeforincreaseinCBC(governmentdebt)
Purchasesofgovernmentdebtraisetheirprice,lower
P h
f
t d bt i th i i l
interestrates
Provideliquiditytomarkets
q
y

Traditionallyatshortmaturityendofdebtmarket
InUS,thisisdonethroughFederalFundsmarket
CanalsodounconventionalQuantitativeEasingatlonger
maturities directcentralbankpurchasesofotherassets

AndrewRose,GlobalMacroeconomics9

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Exceptional Cases
ExceptionalCases
1 LMmaybeflat
1.
LM may be flat atlownominalinterestrates
at low nominal interest rates
JapaneseLiquidityTrap

AndrewRose,GlobalMacroeconomics9

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Exceptional Cases
ExceptionalCases
2.

LMmaybevertical
LM
may be vertical ifinterestratesdon
if interest rates dontt
matter
QuantityTheory
Q
y
y

AndrewRose,GlobalMacroeconomics9

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Two Concluding Notes

TwoConcludingNotes

Can derive Aggregate Demand Curve by

CanderiveAggregateDemandCurve
by
changingprices,shiftingLMcurveout,raising
income

This all shortrun

Thisallshort
runanalysis:effectsof
analysis: effects of
productivity,capital,labor,anddebtaccumulate
b
butareignoredintheshortrun.
h h

Remember:pricesarestickyonlyinshortrun
AndrewRose,GlobalMacroeconomics9

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Key Takeaways
KeyTakeaways
Interaction
InteractionofRealandFinancialMarkets
of Real and Financial Markets
determinebothinterestratesandoutput
MonetaryPolicyShocks,openmarket
Monetary Policy Shocks open market
operations
LiquidityTrap
Li idi T

AndrewRose,GlobalMacroeconomics9

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