the economy: the is-lm-fe model -...

Linking the Financial System andthe Economy: The IS-LM-FE Model

CHAPTER

24Beginning in late 1991, the Fed cut short-term interest rates to stimulate the economy’s recovery from the 1990–1991 recession. In particular, the Fed hopedto encourage businesses to invest in new plant and equipment by making it cheaperto finance spending on capital assets. As output increased and the economy recov-ered, the Fed increased interest rates in 1994 and 1995 to keep output on a steadygrowth path and to dampen inflationary pressures. In late 1998, the Fed cut short-term interest rates, fearful of the consequences of the Asian financial crisis for theU.S. economic expansion. In 2001 and 2002, the central bank lowered short-termrates to reduce the severity of the recession.

How does the Fed know that interest rates will have an effect on output? Whatis the link between the actions of participants in the financial system—the centralbank, firms participating in financial markets to raise funds, and savers seekingfinancial assets—and the performance of the economy?

We begin to answer these questions in this chapter by building a model—the IS-LM-FE model—that links interest rate determination in asset markets to output deter-mination in the market for goods and services. Like many models, the IS-LM-FE modelmakes many simplifications about the economy. Nonetheless, its predictions about theeffect of interest rates on output—and output on interest rates—gives monetary poli-cymakers insights about how the economy will respond to policy changes.

We start the chapter with a description of the assumptions that we use to build themodel and the simplifications that the model makes about the financial system and theeconomy. In addition to building the model, we observe how the model allows us topredict changes over time in interest rates, output, and other variables that measureeconomic performance.

A Model for Goods and Asset Markets: AssumptionsThe IS-LM-FE model is a model of behavior in the market for goods and services and inthe market for financial assets. These markets in developed economies such as the UnitedStates are complex. Thousands of goods and services are traded, and an array of financialassets changes hands each day. Suppliers in the goods market decide how much to pro-duce, and buyers decide how much to purchase. Suppliers of securities in financial marketsdecide how much to borrow, and buyers of those securities decide how much to lend andhow to allocate their wealth. In any specific market—for apples or autos or T-bills—theprice adjusts to equate the quantities demanded and supplied by market participants.

We begin with a simplification: We focus on the equilibrium of goods and finan-cial markets at a point in time. Taking into account the interactions among markets,economists refer to a general equilibrium as an outcome in which all the markets in theeconomy are in equilibrium at the same time.

555

Another simplification that we make in our model is to group all the individualmarkets for goods and services into three broad categories: (1) goods, (2) money, and(3) nonmoney assets. The goods market includes trade in all goods and services that theeconomy produces at a particular point in time. We group all trades of assets used asthe medium of exchange in the money market. These assets are currency, checkabledeposits, and other close substitutes for cash. The third market, the nonmoney assetmarket, includes trades of assets other than money that are stores of value. Purchasesand sales of stocks, bonds, houses, and other nonmoney financial assets fall into thisgroup. Separating markets into these three categories allows us to describe simply andgraph the effects of changes in the economy or of government policy on prices in mar-kets for goods and services and for financial assets.

We build the IS-LM-FE model using graphs and equations, and we use two vari-ables to summarize equilibrium in the markets for goods, money, and nonmoney assets.We represent current output of goods and services by Y. This variable typically repre-sents gross domestic product (GDP), and it is a measure of economic activity.✝ The sec-ond key variable in our model is the expected real interest rate, r, which measures thereturn to savers and the cost of funds to borrowers.

We build the IS-LM-FE model in three steps that coordinate with our grouping ofmarket and our interest in the behavior of participants in the goods market and in thefinancial markets:

1. We investigate the demand for current output and construct the IS curve.

2. We then examine firms’ willingness to supply current output and construct theFE line.

3. Finally, we determine the willingness of individuals to hold money and non-money assets and construct the LM curve.

When we combine these curves, we have a model that illustrates the economy’s equi-librium and allows us to observe the factors that change it. Working with the IS-LM-FE model, we can predict the effect of changes in monetary policy on output and onother economic variables.

The IS Curve

We begin our investigation of the market for goods and services by describing the behav-ior of individuals and firms. In examining the decisions that individuals make in deter-mining how much to consume or to save and the decisions that firms make indetermining how much to invest in capital equipment, we can construct a relationshipbetween interest rates and output called the IS curve.

Saving, Investment, and Aggregate Demand

We start with an equation that represents the goods market for a closed economy whenit is in equilibrium. We will relax the assumption of a closed economy later on and extendour analysis to an economy that engages in foreign trade and investment. When the goodsmarket is in equilibrium, the quantity of goods demanded equals the quantity of goodssupplied. We represent the quantity of goods supplied by current output Y. In a closedeconomy, the quantity of goods demanded, or aggregate demand, is equal to the sum of:

556 PART 6 The Financial System and the Macroeconomy

✝ Y, you will recall, has other meanings as well. It can represent aggregate income. We also used Y in Chap-ter 23 to represent the volume of transactions. In this chapter, our analysis is eased by viewing Y as output.

Web Site Suggestions:http://www.gpoaccess.gov/indicators/browse.htmlPresents aggregatedata on saving andinvestment in theCouncil of EconomicAdvisers’ EconomicIndicators.

web_links556.html

National consumption, C: The quantity of goods and services that house-holds want to consume (C is a measure of house-hold spending on goods and services);

National investment, I: The quantity of capital goods demanded by busi-nesses for investment (I is a measure of businessspending on capital goods); and

Government purchases, G: The quantity of goods and services purchased bythe government (G is a measure of governmentspending on goods and services).

The goods market is in equilibrium when current output supplied equals aggregatedemand:

(24.1)

We return to the supply of current output later. Subtracting C and G from both sidesof Eq. (24.1), we get

Investment represents the increase in capital investment by businesses. The left-handside, Y � C � G, represents output not consumed in the current period by householdsor the government—that is, national saving, S. Therefore Y � C � G � S. When thegoods market is in equilibrium, national saving and investment are equal, or

(24.2)

Our next task is to identify the behavior that causes individuals and governmentsto save and businesses to invest in capital assets. This analysis will allow us to predictlevels of saving and investment in the economy that accompany changes in output. Thisinformation will help us to construct our model of behavior in the goods markets, butit is also useful for policymakers who may want to encourage saving or investment.Saving and investment contribute to the future well-being of the economy. If policy-makers know the incentives that individuals and businesses have to save or invest, theycan design programs to increase the amounts saved or invested.

Determinants of National Saving

The determinants of national saving are current output, household consumption,spending, and government purchases. Therefore we need to consider both householdand government spending and saving decisions to determine the level of national sav-ing. Let’s begin with households.

Households care not only about current consumption, but also about future con-sumption spending. For example, you may save to pay for your education, to raise afamily, to buy a house, or to fund your retirement. The three key factors determininghousehold saving are current income, expected future income, and the expected realrate of interest.

Current income. What would you do if your current income went up—say, youwon $5000 in the lottery—but your future prospects didn’t change? You would prob-ably spend part of the income on consumption goods that you have been wanting, suchas a new CD player. Because you care about future consumption, too, you would

S � I.

Y � C � G � I.

Y � C � I � G.

CHAPTER 24 Linking the Financial System and the Economy: The IS-LM-FE Model 557

probably save part of the extra income. Hence both your consumption and savinglikely will increase when your current income increases. If your current income falls,the process works in reverse: Both current consumption and saving fall. This argumentcan be extended to the economy as a whole, suggesting that when total output changes,current consumption also changes, but to a lesser degree than the change in total out-put. Hence the level of national saving, Y – C – G, increases when current output risesand decreases when current output falls.

Expected future income. Suppose your company sponsors your training in gradu-ate school, making you eligible for a higher-paying position when the training is complete.Because you anticipate a higher income, you will probably increase your spending today.Similarly, if you expect that your company will pay you less beginning next year, you mayreduce your consumption today to build a cushion for the future. For the economy as awhole, an expected future increase in income raises consumption, so if current outputdoesn’t change, national saving, Y – C – G, falls. An expected future decrease in incomelowers consumption, so if current output doesn’t change, national saving rises.

Expected real interest rate. The expected real interest rate represents the returnthat savers expect to earn from lending their funds to borrowers in the financial system.An increase in the real interest rate increases your reward for saving for future consump-tion while also allowing you to save less to pay for future consumption. A decline in thereal interest rate decreases your reward for saving but requires that you save more to meeta given goal for future consumption. Available empirical evidence suggests that householdsaving increases with the interest rate, although the effect probably isn’t large.

Government purchases. Government purchases, G, for goods and services suchas military equipment, highways, education, and public employees’ salaries also influ-ence national saving. If we hold current output constant, an increase in governmentpurchases reduces national saving as long as household consumption falls less than onefor one in response. Evidence suggests that consumers do not reduce their spending dol-lar for dollar in response to more government purchases. That is, if nothing elsechanges, an increase in government purchases lowers national saving.

Determinants of National Investment

Businesses invest in capital assets to increase future profits. The two principal determi-nants of the size of national investment are the expected future profitability of capitalinvested and the expected real interest rate.

Expected future profitability of capital. An increase in expected future prof-itability of capital (from, say, a new technology or discovery) enhances businesses’ will-ingness to invest (as we described in Chapter 6). Corporate taxes also influenceexpected future profitability. An increase in taxes on business income or a decrease intax incentives for new investment will reduce businesses’ willingness to invest at anylevel of expected future pretax profitability. Similarly, a decrease in business incometaxes or an increase in tax incentives for new investment stimulates businesses’ will-ingness to invest at any level of expected future pretax profitability.

Expected real interest rate. When businesses evaluate investment alternatives,they must weigh other possible uses for their funds, including purchasing financial


assets. The expected real interest rate represents the cost of funds for investment. Hencean increase in the expected real interest rate lowers the demand for investment, as busi-nesses could hold funds more profitably in other assets. Conversely, a drop in theexpected real interest rate raises investment demand.

Constructing the IS Curve

Using the information about the effect of interest rates on investment and saving, wecan construct a curve that shows how aggregate demand for current output respondsto changes in interest rates. The resulting curve, the IS curve, summarizes the equilib-rium in the market for goods and services, and it is the first part of our model linkingthe financial system with the goods market.

To construct the IS curve, we start with a relationship between investment and sav-ing and the interest rate. In the diagram shown in Fig. 24.1(a), the horizontal axis rep-resents national saving and investment, and the vertical axis represents the real interestrate. (For simplicity, we assume that the expected and actual real interest rates areequal.) We hold the other determinants of saving and investment constant. The savingcurve slopes up; an increase in the real interest rate raises the level of saving, all elsebeing equal. The investment curve slopes down; an increase in the real interest ratereduces the level of investment, all else being equal.

Figure 24.1(a) shows saving and investment curves for two values of current out-put Y: $10,000 billion and $11,000 billion. When current output increases, saving alsoincreases. Therefore each current output level is associated with a different savingcurve. An increase in current output from $10,000 billion to $11,000 billion shifts thesaving curve to the right from S0 to S1, thereby changing the equilibrium in the goodsmarket from E0 to E1 and reducing the real interest rate from 4% to 3%.

The two equilibrium points in Fig. 24.1(a) are plotted in Fig. 24.1(b) as two pos-sible current output–real interest rate combinations that equilibrate saving and invest-ment. In Fig. 24.1(b), the IS curve depicts the general relationship between aggregatedemand for current output and the real interest rate. At each point on the IS curve,desired saving equals desired investment; that is, the IS curve presents combinations ofcurrent output and the real interest rate for which the quantities of goods demandedand supplied are equal. The IS curve slopes downward and to the right because athigher levels of current output, current saving rises and the real interest rate falls torestore equilibrium in the goods market.

Points that are not on the IS curve represent unequal levels of saving and invest-ment; the goods market is not in equilibrium for the corresponding real interest rates.Consider the example shown in Fig. 24.2(a). At a real interest rate of 5% and an out-put of $10,000 billion, saving exceeds investment, creating an excess supply of goods,indicated at point 1. To restore equilibrium in the goods market, the real interest ratemust fall to 4%, at point 3. At a real interest rate of 3% and output of $10,000 bil-lion, investment exceeds saving, creating an excess demand for goods, indicated at


You and other investors have just formed Biopil, a pharmaceutical corporation. If TheWall Street Journal reports that the federal government has initiated a tax break fornew investment, how does that news affect your investment decision? If theexpected future pretax profitability of your investment doesn’t change, the tax breakreduces your cost of funds. You should expand Biopil’s capital investment. ♦

C H E C K P O I N T

point 2. To restore equilibrium in the goods market, the real interest rate must rise to4%, at point 3.

The curve shown in Fig. 24.2(b) reflects this pattern. At point 3, the goods mar-ket is in equilibrium; therefore point 3 lies on the IS curve. Points such as 1 that lieabove the IS curve represent an excess supply of goods. Point 1 represents the samelevel of current output supplied as at point 3 but at a higher real interest rate. Recallthat an increase in the real interest rate reduces desired consumption, increasingdesired saving and decreasing desired investment. The level of goods demanded at areal interest rate of 5% is less than the current output of goods; that is, there is anexcess supply of goods at point 1.

Points such as 2 that lie below the IS curve represent an excess demand for goods.Point 2 represents the same level of current output as at point 3 but at a lower real rateof interest. Then consumption increases, decreasing saving and increasing investment.The quantity of goods demanded exceeds the current output of goods.

The IS Curve for an Open Economy

So far, we have assumed that demand and supply in the goods market are limited todomestic saving and investment. When savings can be channeled internationally in anopen economy, the goods market is in equilibrium when desired international lending(or borrowing) by a country equals desired international borrowing (or lending) byother countries.


S1 (Y = $11,000 billion)

S0 (Y = $10,000 billion)

4

Rea

l in

tere

stra

te, r

(%)

Saving, Investment, S, I Current output,Y (in billions)

2. Real interest rate falls.

(b) The IS Curve(a) The Saving-Investment Diagram

I

3

4

Rea

l in

tere

stra

te, r

(%)

IS

31. Current output rises.

$10,000 $11,000

E1

E0

E1

E0

Along the IS curve,an increase in currentoutput is associatedwith a fall in thereal interest rate.

The IS Curve

As shown in (a):1. An increase in current output from $10,000 to $11,000 billion increases current saving, shifting the S curve to the right from S0 to S1. 2. The increase in saving reduces the real interest rate r from 4% to 3%.

As shown in (b):The IS curve slopes downward, maintaining equality of saving and investment; higher levels of current output are associated with lower valuesof the real interest rate.

FIGURE 24.1

To understand how international capital mobility affects the IS curve in a largeopen economy such as that of the United States, Japan, or Germany, note that domes-tic saving (sources of funds from within the economy) need not equal domestic invest-ment (demand for funds within the economy). Because capital is mobile internationallyin an open economy, an increase in domestic saving can finance either domestic or for-eign investment.

Recall that an increase in domestic saving in a large open economy causes thedomestic real interest rate to fall (Chapter 6). However, greater domestic savingfinances investment at home and abroad, so the real interest rate doesn’t have to fallby as much as it would in a closed economy to absorb the greater quantity of domes-tic saving. Likewise, an increase in investment in the domestic economy can befinanced by savings from abroad as well as from home. Hence the real interest ratewon’t have to rise by as much as it would in a closed economy to restore equilibriumin the goods market. In a large open economy, in contrast to a closed economy, anychange in the demand for current output requires a smaller change in the domestic realinterest rate. As a result, the IS curve for a large open economy is flatter than that fora large closed economy. (We analyze this difference in the appendix to this chapter.)

The flatter IS curve for the large open economy illustrates the important effects offinancial market integration on the economy. Figure 24.1 showed that when currentoutput increases, desired saving increases, and that the supply of goods exceedsdemand at the initial real rate of interest. To restore equilibrium in the goods market,


S (Y = $10,000 billion)

4

Rea

l in

tere

stra

te, r

(%)

Saving, Investment, S, I Current output,Y (in billions)

Excess supplyof goods.

(b) The IS Curve(a) The Saving-Investment Diagram

I

4

Rea

l in

tere

stra

te, r

(%)

IS

3

Excess demandfor goods.

$10,000

3

55

3 3

2

1

Excess demandfor goods.

Excess supplyof goods.

1 1

2 2

Excess Demand and Supply in the Goods Market

As shown in (a):When desired saving exceeds desired investment (as at 1), there is an excess supply of goods. When desired saving is less than desiredinvestment (as at 2), there is an excess demand for goods. Desired saving equals desired investment at point 3.

As shown in (b):When there is an excess supply of goods (as at 1), the real interest rate is above its equilibrium level. When there is an excess demand forgoods (as at 2), the real interest rate is below its equilibrium level. Only points on the IS curve (as at 3) represent equilibrium combinations ofthe real interest rate and the quantity of output demanded.

FIGURE 24.2

the domestic real interest rate must fall to raise the quantity of goods demanded to thequantity of goods supplied. The same events occur in an open economy, but the inte-gration of the goods market and asset market modifies them. As for the closed econ-omy, the domestic real interest rate falls as desired domestic saving increases. However,the decline in the interest rate (which also is felt abroad in integrated capital markets)increases both the foreign and domestic demand for domestic goods. As a result, invest-ment increases in the foreign country and foreign saving decreases. Foreigners increasetheir international borrowing, so some of the increased domestic saving flows abroad.

The flow of goods matches exactly this movement of savings in an open economy.The domestic economy lends funds to foreigners, and its current account balance—thedifference between exports and imports, or net exports—increases as foreignersincrease their demand for domestically produced goods. The foreign economy borrowsfunds from the domestic economy, and its own current account balance decreases asforeigners demand more goods from the domestic economy. In a large open economy,the real interest rate doesn’t have to fall by as much to restore equilibrium in the goodsmarkets in response to an increase in current domestic output. Similarly, the real inter-est rate doesn’t have to increase by as much to restore equilibrium in response to adecrease in current domestic output.

Our analysis of implications for the slope of the IS curve of international integra-tion of goods and financial markets is relevant for the large open economies such as theUnited States, Germany, and Japan. Goods and financial markets in a small open econ-omy are integrated with those of the rest of the world. However, flows of goods andcapital to and from a small open economy are too small to affect the world interestrate. As a result, the IS curve for a small open economy is simply horizontal at theworld real rate of interest rW. A small open economy therefore can lend or borrow ininternational capital markets at that real rate of interest. Any value of output in thesmall open economy is consistent with the equilibrium real interest rate. In our graph-ical analysis of the economy’s equilibrium, we use the IS curve for a large openeconomy.


Are SavingsInternationally Mobile?

Our discussion of the IS curve for alarge open economy implies that if sav-ing were completely mobile amongcountries, domestic saving wouldn’thave to equal domestic investment.Savings would flow to the economiesthat offered the highest expectedreturn, and expected returns wouldequalize around the world (adjustingfor differences in the risk, liquidity, and information characteristics of the financial instruments). As a result, if saving increased in a country,rather than reducing the domestic realinterest rate below worldwide levels

(thereby increasing investment athome), some of the additional fundswould flow abroad.

Using data from the 1960s and 1970s,Martin Feldstein and Charles Horiokaexamined relationships betweendomestic saving and investment rela-tive to aggregate output in the UnitedStates, Japan, and many Europeancountries.✝ They estimated that a$1.00 change in domestic saving led toan approximately equal change indomestic investment, casting doubt oninternational capital mobility. However,Feldstein and Philippe Bacchetta laterfound that during the 1980s, changesin domestic saving and invest-ment were not as highly correlated.✝✝

Hence the most recent evidence sug-gests that the economies of theUnited States, Japan, and many Euro-pean nations are large openeconomies and that international bor-rowing and lending are significant infinancial markets.✝ Martin Feldstein and Charles Horioka, “DomesticSaving and International Capital Flows,” EconomicJournal, 90:314–329, 1980.✝✝ Martin Feldstein and Philippe Bacchetta,“National Saving and International Investment,” inB. Douglas Bernheim and John B. Shoven, eds.,National Saving and Economic Performance,Chicago: University of Chicago Press, 1991.

C O N S I D E R T H I S . . .

Shifts of the IS Curve

Increases or decreases in the demand for goods change the equilibrium real interest ratefor each level of current output and cause the IS curve to shift. These increases ordecreases in the real interest rate may be the result of an increase or decrease in one ofthe determinants of desired saving and investment: current and expected future income,government purchases, or the expected future profitability of capital. An increase inone of these factors shifts the IS curve up and to the right by increasing the real inter-est rate that is required to reach equilibrium in the goods market for any given level ofcurrent output. For example, a military buildup, an increase in the overseas popularityof U.S. cars, a decline in households’ willingness to save, or development of a majornew technology that produces an environmentally safe substitute for plastics causessuch a shift. A reduction in one of the determinants shifts the IS curve down and to theleft by decreasing the real interest rate that is required to reach equilibrium in the goodsmarket for any given level of current output. Table 24.1 summarizes the factors thataccount for shifts in the IS curve.

Determining Output: The Full Employment LineThe IS curve illustrates combinations of the level of current output and the real interestrate for which the goods market is in equilibrium. Each point on the IS curve representsequilibrium in the goods market, but we cannot use the IS curve alone to find the level ofcurrent output that actually prevails in the market for goods and services. We needanother piece of information: the level of output that firms are willing to supply in thegoods market. The supply of current output, or the level of output that firms produce atany particular time, is determined by (1) the existing capital stock and (2) the use of vari-able production factors, such as labor. The capital stock reflects the accumulated invest-ment of previous years. We therefore assume that it is fixed, with new investment beingincorporated as capital stock for use in the future. For simplicity, we also assume that thesupply of variable factors is fixed. (Later, we will examine output in the long run whenfirms can adjust all factors in production.) Hence full employment output in the economyin the current period is the production level that is achieved by the use of all availableproduction factors, regardless of the real rate of interest. Therefore it is constant at Y* inFig. 24.3, and the resulting vertical line is called the full employment (FE ) line.

The intersection of the IS curve and the FE line represents goods market equilib-rium. For example, suppose that (as shown in Fig. 24.3) the equilibrium in the goodsmarket is described by the combination of current output of $10,000 billion and a realinterest rate of 4%. When output equals $10,000 billion, a real interest rate of 4%ensures that desired saving equals desired investment because the point (Y � $10,000billion, r � 4%) is on the IS curve.


Suppose that the real interest rate in Massachusetts is very low—say, 0.5%—butthe real interest rate in California is very high—say, 10%. What would you do ifyou were a Massachusetts saver? You probably would invest part of your savingsin California to take advantage of the higher expected return. As financial markets havebecome more global, savings can flow abroad in search of higher returns. ♦

C H E C K P O I N T

Current output is influenced by the efficiency of existing production factors. Anincrease in the current productivity of either capital or labor shifts the FE line to theright. For example, if everyone decided to work harder each hour this year, current pro-ductivity would rise, shifting the FE line to the right. By contrast, an unexpected oil priceincrease reduces the productivity of energy-using machines, shifting the FE line to theleft. Although changes in expected future productivity affect investment and the IScurve, they don’t affect current output. Only the productivity of factors that are alreadyin place affect current output. Table 24.2 summarizes the factors that account for shiftsin the FE line.


Accounting for Shifts of the IS Curve

An Increase in . . . Shifts the IS Curve . . . Because . . .

government purchases an increase in government purchases increases the demand for current output,decreasing saving and increasing thereal interest rate required to restore equilibrium in the goods market.

foreign demand for domestically an increase in foreign demand increases the produced goods demand for current output, increasing the

real interest rate required to restore equilibrium in the goods market.

households’ willingness to save an increase in saving decreases thedemand for current output, reducing thereal interest rate required to restore equi-librium in the goods market.

expected future profitability of with higher expected future profitability of capital capital, firms want to invest more, raising

the demand for current output and the real interest rate required to clear the goods market.

TABLE 24.1

r

IS0

Y

IS1

r

IS0

Y

IS1

r

IS0

Y

IS1

r

IS0

Y

IS1

Suppose that you manage a tool factory in northern Michigan. What would hap-pen to your company’s ability to use its plant and equipment to generate outputif a series of snowstorms idled the factory for several weeks? What effect wouldthe storms have on the FE line? If workers were unable to get to work, current out-put would fall, shifting your factory’s FE line to the left. Weather fluctuations, strikes,and trade disruptions act as productivity shocks, shifting the economy’s FE line. ♦

C H E C K P O I N T


The First Gulf War and“Confidence”The determinants of saving and busi-ness investment are based on expec-tations of the future, which can beinterpreted in part as a reflection ofconsumer confidence or optimismabout the future. Iraq’s invasion ofKuwait in August 1990 and the ensu-ing Gulf War in early 1991 adverselyaffected U.S. consumer and businessconfidence. Consumers worried aboutthe effects of possible increases in oilprices on the purchasing power oftheir incomes. In fact, a University ofMichigan survey measured consumerconfidence dropping by 28% in thelast half of 1990 and rebounding afterthe war’s conclusion. Business confi-dence also dropped, and firms cutback on inventory investment and, toa lesser extent, on capital investment.At the same time, the U.S. govern-ment increased its expenditures tofinance the war. How did thesechanges in spending affect aggregatedemand?

Researchers at the Federal ReserveBank of San Francisco found thatreductions in consumption and invest-ment due to falling consumer confi-dence shifted the IS curve down to theleft from IS0 to IS1. This effect domi-nated the higher U.S. governmentpurchases, which shifted the IS curveup to the right from IS0 to IS2, asshown in the accompanying diagram.Analysts believe that the net result ofthe two movements was a shift downto the left, because the military prin-

cipally used its stock of existingweapons rather than spending moneyon new weapons.

With the experience of the first GulfWar in mind, monetary and fiscal pol-icymakers evaluated options to cush-ion the blow of anticipation of a U.S.war with Iraq in 2003.

Source: “The Gulf War and the U.S. Economy,”Federal Reserve Bank of San Francisco WeeklyLetter, September 13, 1991.

O T H E R T I M E S , O T H E R P L A C E S . . .

IS1

Rea

l in

tere

st r

ate,

r

Current output,Y

Reduced consumerand business confidence

IS0

IS2

Increased governmentpurchases to fight war

Rea

l in

tere

stra

te, r

(%

)

Current output,Y (in billions)

r* = 4

Y * = $10,000

Goods market equilibrium

FE

IS

Determining Current Outputin the Goods MarketEquilibrium output in the goodsmarket is Y*, given by full utiliza-tion of all existing production fac-tors. The equilibrium real interestrate, r*, brings saving and invest-ment into equilibrium at that levelof output.

FIGURE 24.3

The LM CurveWe now turn to the third step in building a model that shows the relationship betweenthe financial system and the economy. In this section, we construct the LM curve, agraphical relationship between the interest rate and output that exists when asset mar-kets are in equilibrium.

We simplify our view of asset markets by dividing them into money and nonmoneymarkets. The money market is in equilibrium only when the nonmoney asset marketalso is in equilibrium. We first establish the link between the equilibrium in the moneymarket and equilibrium in the nonmoney asset market. Then we examine the condi-tions in which the money market is in equilibrium.

Asset Market Equilibrium

Money assets and nonmoney assets (such as stocks and bonds) offer savers alternativeways to allocate their wealth. For example, Jane Rich must decide how to allocate herwealth, w, between money and nonmoney assets. Her demand for money balances, md,added to her demand for nonmoney assets, nd, equals her total wealth, w, or

Each household and business faces this portfolio allocation decision. The marketsfor money and nonmoney assets are in equilibrium when the total quantitiesdemanded equal the total quantities supplied. Therefore, for the economy as a whole,the total demand for money balances, Md, and nonmoney assets, Nd, equals totalwealth, W, or

(24.3)

On the supply side, total wealth W equals the sum of the total quantity of moneysupplied, Ms, and the total quantity of nonmoney assets supplied, Ns, or

(24.4)Ms � Ns � W.

Md � Nd � W.

md � nd � w.


Accounting for Shifts of the FE Line

A(n) . . . Shifts the FE Line . . . Because . . .

increase in current productivity an increase in productivity implies that of capital or labor more output can be produced from the

existing amount of factors.

decrease in current productivity a decrease in productivity implies that less of capital or labor output can be produced from a given

amount of factors in place.

TABLE 24.2

r FE0

Y

FE1

r FE1

Y

FE0

Because the market mechanism ensures that in equilibrium, the quantity of an assetsupplied equals the quantity demanded, we can equate Eq. (24.3) and Eq. (24.4). Doingso gives us a relation between the equilibrium in the two asset markets:

(Md � Ms) � (Nd � Ns) � 0, or(24.5)

When the total quantity of money demanded exceeds the quantity supplied, that is,Md � Ms, the expression on the left-hand side of Eq. (24.5) is positive, representing anexcess demand for money. When Ns � Nd, the total quantity of nonmoney assets sup-plied exceeds the quantity demanded, creating an excess supply of nonmoney assets. ThusEq. (24.5) states that the excess demand for one of the two assets (money or nonmoney)equals the excess supply of the other. In equilibrium, asset prices adjust so that there is noexcess demand or supply in the money market; in other words, the left-hand side of Eq.(24.5) equals zero. Hence the right-hand side of Eq. (24.5) must also equal zero. There-fore the money market is in equilibrium only if the nonmoney market is in equilibrium.Knowing that the equilibrium in one of the two asset markets is related to the equilib-rium in the other, we can make an important simplification: Any combination of currentoutput and the real interest rate for which the money market is in equilibrium will implythat the nonmoney asset market is in equilibrium, and vice versa. We use this simplifica-tion to confine our attention to determinants of equilibrium in the money market.

Constructing the LM Curve

On the supply side, the quantity of real money balances supplied equals the aggregatemoney supply Ms divided by the general price level P: (M/P)s, or MS. The demand forreal money balances is (M/P)d, or MD. But money demand depends on real income (oroutput) Y, the interest rate on nonmoney assets i, the return on money iM, and otherfactors, so we can replace (M/P)d with the function L(Y, I, iM). Equilibrium is reachedwhen the quantity of real money supplied equals the quantity of real money demanded:

where L is the liquidity preference relation linking the demand for real money balancesto its determinants.

Let’s examine those determinants more closely. The variable i represents the nominalmarket interest rate on nonmoney assets and is the sum of the underlying real interestrate, r (assumed to be the expected real rate of interest), and expected inflation, �e:

M

P

M

PL Y i i

s dM

=

= ( , , , ),K

Md � Ms � Ns � Nd .


If Jane Rich is satisfied with the proportion of her wealth that is held in money, isshe also satisfied with her nonmoney asset holdings of savings in bonds andstocks? Yes. Jane’s demand for real money balances depends on the expectedreturns that are available on nonmoney assets. Her satisfaction with her wealth allo-cation implies that she has compared her returns from holding money with expectedreturns on other assets (adjusted for differences in risk, liquidity, and informationcosts). ♦

C H E C K P O I N T

Web Site Suggestions:http://www.federalreserve.gov/releasesOffers informationfrom the FederalReserve on measuresof money.

web_links567.html

Substituting this expression for the nominal interest rate i into the preceding expres-sion, we get

(24.6)

Equation (24.6) contains too many variables for our analysis of r and Y. If we holdconstant the other factors in Eq. (24.6)—the nominal money supply M, price level P,expected rate of inflation �e, and nominal return on money iM—we can describe com-binations of current output Y and real interest rate r for which the money market (andhence the nonmoney asset market) generally is in equilibrium.

Suppose that households and businesses are satisfied with their real money balancesM/P when output in the economy is $10,000 billion and the real rate of interest is 4%,indicated by E0 in Fig. 24.4(a); that is, the money market is in equilibrium at that point.If real output increases to $11,000 billion, Eq. (24.6) indicates that the quantity of realmoney demanded, (M/P)d, increases; the money demand curve shifts from MD0 to MD1.With all the other factors held constant, the real interest rate r must increase from 4%to 5% to reduce the quantity of real money demanded, as shown by E1 in Fig. 24.4(a).

Figure 24.4(b) illustrates the combinations of current output and the real interestrate for which the money market is in equilibrium, a set of points called the LM curve.

M

PL Y e= +( , , , ). r iMπ L

i = r + eπ .


MD0(Y = $10,000 billion)

5

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stra

te, r

(%)

Real money balances, M/P Current output,Y (in billions)

2. Real interest rate rises.

(b) The LM Curve(a) The Money Market

4

5

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l in

tere

stra

te, r

(%)

LM

4

1. Output increases.

$10,000 $11,000

MS

MD1(Y = $11,000 billion)

E0

E1

E0

E1

The LM CurveAs shown in (a):1. When current output increases, real money demand increases.2. If real money balances supplied are held constant, an increase in current output raises the real interest rate.

As shown in (b):The LM curve slopes upward. To maintain equilibrium in the money market, higher levels of current output result in higher values of the realinterest rate.

FIGURE 24.4

It is a graph of the relationship in Eq. (24.6), in which the quantity of real moneydemanded (the liquidity preference function L) equals the quantity of money supplied.Because a higher real interest rate is associated with a higher level of output in a moneymarket equilibrium, the LM curve slopes upward to the right. The size of the increasein the real interest rate that is required to restore equilibrium in the money marketdepends on how responsive money demand is to the interest rate. Therefore the slope ofthe LM curve depends on the sensitivity of the demand for real money balances to thenominal interest rate i.

When the interest sensitivity of the demand for real money balances is low, interestrates must change a lot for the money market to remain in equilibrium if output changes.Since large interest rate changes are associated with a given output change, the LM sched-ule will be steeply sloped. If the demand for real balances were completely insensitive tothe opportunity cost of holding money, the LM curve would be vertical. Conversely, if thedemand for real money balances were sensitive to the interest rate, then whenever moneydemand changed in response to an increase in output, a much smaller increase in the realinterest rate would be required to restore equilibrium in the money market. In this case,the LM curve would be relatively flat. If the demand for real balances were infinitely sen-sitive to the interest rate, the LM curve would be horizontal.

To summarize, the slope of the LM curve depends on the interest sensitivity of thedemand for money. If the demand for money is sensitive to the interest rate, the LMcurve is relatively flat; if the demand for money is insensitive to the interest rate, theLM curve is relatively steep.

At any point along the LM curve, the quantity of money demanded equals the quan-tity supplied. However, as was the case for the IS curve, only points on the LM curve rep-resent an equilibrium in the asset markets. To understand why, consider Fig. 24.5(a). Whencurrent output is $10,000 billion and the real interest rate is 5%, there is an excess supplyof money, indicated by point 1. Households and businesses use some of this excess moneyto buy nonmoney assets, causing their prices to rise and the interest rate to fall until thereal interest rate equals 4%, at point 3. Conversely, when output equals $10,000 billionand the real interest rate is 3%, there is an excess demand for money, indicated by point2. Households and firms sell nonmoney assets for money, causing their price to fall andthe interest rate to rise until the real interest rate equals 4%, at point 3.

Figure 24.5(b) illustrates this process with the LM curve. Point 1 and others thatare above the LM curve represent an excess supply of money and an excess demand fornonmoney assets. Point 2 and others that are below the LM curve represent an excessdemand for money and an excess supply of nonmoney assets. Again, money demandand supply are in equilibrium at point 3.


Suppose that the Fed wanted to induce you to hold no more than $1000 of yourassets in currency and non-interest-bearing checkable deposits. If you wanted tohold more than $1000 because your income and volume of transactions are ris-ing, how could the Fed convince you not to hold more currency in your wallet orchecking account? If the Fed could raise the real rate of return on other financialassets, you would want to increase your holdings of financial assets. How much thereal rate would have to rise depends on how sensitive to interest rate changes yourportfolio decisions are. Along your LM curve, then, an increase in Y (income) is asso-ciated with an increase in r. ♦

C H E C K P O I N T

Shifts of the LM Curve

When we analyzed the IS curve, we saw that changes in variables other than currentoutput or the real interest rate could shift the curve. The same is true for the LM curve.The variables that are responsible for shifts of the LM curve are those in Eq. (24.6): thenominal money supply M, the price level P, the nominal return on money iM, and theexpected rate of inflation �e.

Changes in real money balances supplied. The level of real money balances—the nominal money supply divided by the price level—is taken as a given in the deriva-tion of the LM curve. What happens to the money market equilibrium when the quantitysupplied of real balances increases as occurs, for example, when the Fed pursues anexpansionary monetary policy? To restore equilibrium in asset markets, the quantity ofmoney demanded must be increased in one of two ways. For a constant output level, adrop in the real interest rate makes the option of holding money more attractive and thusincreases the quantity of money demanded. In other words, if expected inflation is heldconstant, the nominal interest rate falls to reduce the opportunity cost of holding moneyinstead of nonmoney assets. Or if the real interest rate is held constant, an increase in theequilibrium level of output increases the quantity of real balances demanded. In eithercase, the LM curve shifts down and to the right.

When the quantity supplied of real money balances declines, as in the case of a con-tractionary monetary policy, equilibrium is restored by reducing the quantity of money


4

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tere

stra

te, r

(%)

Real money balances, M/P Current output,Y (in billions)

Excess supplyof money

(b) The LM Curve(a) The Money Market

MD(Y = $10,000 billion)

4

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stra

te, r

(%)

3

Excess demandfor money

$10,000

3

55

3 3

2

1

Excess demandfor money

Excess supplyof money

1

2

MS

LM

Points Off the LM CurveAs shown in (a):When real money balances supplied exceed the quantity demanded (as at 1), there is an excess supply of money. When the quantity of moneydemanded exceeds the quantity supplied (as at 2), there is an excess demand for money. The money market is in equilibrium at point 3, where thequantities demanded and supplied of real balances are equal.

As shown in (b):When there is an excess supply of money (as at 1), the real interest rate is above its equilibrium level. When there is an excess demand formoney (as at 2), the real interest rate is below its equilibrium level. Only points on the LM curve (as at 3) represent equilibrium combinationsof the real interest rate and output consistent with asset market equilibrium.

FIGURE 24.5

demanded. For a constant current output level, an increase in the real rate of interestrestores equilibrium in the money market by lowering the quantity of real balancesdemanded. For a constant real interest rate, a decline in current output restores moneymarket equilibrium. A decrease in the nominal money supply, M, for a constant pricelevel, shifts the LM curve up and to the left.

These possibilities illustrate shifts of the LM curve that are caused by changes inthe nominal money supply (for a constant price level). Similarly, we can examine theeffects on the LM curve of a change in the price level by holding the nominal moneysupply constant. For example, a decline in the price level because of a drop in energyprices increases real money balances, causing the LM curve to shift down and to theright. An increase in the price level because of a rise in energy prices reduces real moneybalances so that the LM curve shifts up and to the left.

Changes in the nominal return on money. Increases or decreases in the nom-inal return from holding money change the demand for money and cause the LM curveto shift. Recall that households and businesses compare returns on money and non-money assets when deciding how much wealth to hold as money balances. Althoughnot all components of money (currency, for example) pay interest, some (such as inter-est-bearing checkable deposits) do. What is the effect on the LM curve of an increasein the nominal return on money—say, as the result of deregulation of the interest paidon checkable deposits?

If we assume that the other determinants of money demand do not change, anincrease in iM (the nominal return on money) makes money balances more attractive toinvestors relative to nonmoney assets. As a result, the quantity of real money balancesdemanded increases. A higher real interest rate, then, is required to restore equilibriumin the money market. As the real interest rate on nonmoney assets increases, the nom-inal interest rate on those assets rises relative to the nominal return on money, makingthem more attractive to investors than money, thereby reducing the quantity of moneydemanded. Asset market equilibrium is restored by increasing the real interest rate forany level of output. A decrease in the nominal return on real money balances makesnonmoney assets more attractive to investors than money. As a result, the quantity ofmoney demanded declines. To restore equilibrium in the money market, the nominalinterest rate must fall. Asset market equilibrium is restored by increasing the quantityof money demanded.

Therefore, if nothing else changes, an increase in the nominal return on moneyshifts the LM curve up and to the left. A decrease in the nominal return on money shiftsthe LM curve down and to the right.

Changes in expected inflation. Recall that the nominal rate of interest equalsthe sum of the expected real rate of interest r and the expected rate of inflation �e.Increases or decreases in the expected rate of inflation affect asset market equilibriumby changing the nominal rate of interest associated with any real rate of interest.

What if expected inflation rises because of the public’s expectation that the Fed ispursuing a policy that will spur inflation? If the real interest rate were to remainunchanged, the nominal interest rate would rise. For a constant nominal return onmoney, nonmoney assets would be relatively more attractive to savers, reducing thedemand for real money balances. To restore equilibrium in the money market, the realinterest rate must fall at any level of output to preserve asset market equilibrium.


An increase in expected inflation causes the LM curve to shift down by the amountby which the expected rate of inflation increases. Similarly, a drop in expected inflationcauses the LM curve to shift up by the amount of decline in the expected rate of infla-tion. Table 24.3 summarizes the factors that affect the LM curve.


Suppose that widespread use of bank debit cards and credit cards reduces thedemand for money at any particular level of income and interest rates. How doesthe LM curve respond if the money supply doesn’t change? Because the demandfor money has fallen, the real interest rate at any particular income level would haveto be lower to encourage the public to hold the quantity of money supplied. The LMcurve shifts down and to the right. ♦

C H E C K P O I N T

Factors Shifting the LM Curve

An Increase in . . . Shifts the LM Curve . . . Because . . .

the supply of nominal money the real interest rate falls, increasingbalances, Ms demand for money at any output level.

aggregate price level, P the real interest rate rises, reducing demandfor money at any output level.

nominal return on money, iM the real interest rate rises, reducing demandfor money at any output level.

expected rate of inflation, �e the real interest rate falls, increasing demand for money at any output level.

TABLE 24.3

r LM0

Y

LM1

r LM1

Y

LM0

r LM1

Y

LM0

r LM0

Y

LM1

The Financial System and the Economy: The IS-LM-FE ModelEach curve in the IS-LM-FE model represents a portion of the behavior that we are try-ing to explain: effects of changes in interest rates on output, effects of output on inter-est rates, and the supply of current output. Changes in interest rates affect outputthrough the IS curve, and changes in output affect interest rates through the LM curve.The FE line represents the amount of current output that can be produced by fullemployment of the economy’s resources. At the intersection of the IS curve and the LMcurve, the economy’s real interest rate equates saving and investment, and householdsand businesses are satisfied with their allocation of assets between money and non-money assets. At the intersection of the IS curve and the FE line, current output is con-sistent with full employment of the economy’s resources.

The financial system and the goods market are both in equilibrium when the IScurve, FE line, and LM curve all intersect at the same point, as Fig. 24.6 shows. Thisequilibrium point establishes the level of current output and the real interest rate. Thusequilibrium occurs at the real interest rate at which the current output supplied is equalto the current output demanded. We now analyze how this equilibrium changes inresponse to factors that shift the IS curve, FE line, and LM curve.

Using the Model to Explain the Economy’s Equilibrium

Shifts in the IS curve, FE line, or LM curve cause changes in the equilibrium of thefinancial system and the economy. We describe examples of each type of shift; we thenexamine how policymakers use the model to analyze how the financial system and theeconomy return to equilibrium.

Shifts in the IS curve. Changes in government purchases of goods and servicesshift the IS curve. Suppose that the president and Congress decide that the United States


Rea

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tere

stra

te, r

Current output, Y

LM

Long-run equilibrium

FE

IS

r*

Y*

The Economy and FinancialSystem in Long-RunEquilibriumLong-run equilibrium in the econ-omy occurs when a combinationof the real rate of interest, r*, andthe level of current output, Y*,causes the IS curve, LM curve,and FE line to intersect.

FIGURE 24.6

should undertake a large-scale military buildup, as occurred in the early 1980s andagain in the early 2000s. Starting from equilibrium at E0 in Fig. 24.7(a), an increase ingovernment purchases shifts the IS curve up and to the right, from IS0 to IS1. Note thatthe IS1 curve intersects the FE line at E1, representing the same level of output as E0but at a higher real interest rate. However, if we hold expected inflation and the nom-inal return on money constant, the asset markets are no longer in equilibrium; the inter-section of the IS curve and FE line is not on the LM curve, and there is an excess supplyof money. Moreover, the intersection of the IS and LM curves at E2 is not on the FEline, since the implied current output level is greater than the current output level indi-cated by the FE line. Hence, if we hold the determinants of the three curves constant,there is no combination of current output and real interest rate for which all marketsin the economy and the financial system are in equilibrium.

Shifts in the FE line. Suppose that the economy is at equilibrium initially at E0in Fig. 24.7(b) and that a decline in energy prices leads to a temporary increase in pro-ductivity, as occurred in the middle and the late 1980s. The increase in productivityshifts the FE line to the right from FE0 to FE1, while the positions of the IS and LMcurves remain unchanged. As a result, the IS curve and FE1 now intersect at E1, atwhich the asset markets are no longer in equilibrium. At E1, the real rate of interest istoo low to maintain asset market equilibrium at current levels of output, prices,expected inflation, and nominal return on money. The excess demand for real moneybalances throws the asset markets out of equilibrium. At the intersection of the IS andLM curves at E0, the output level is less than that at FE1.


Excessdemandfor money

IS

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st r

ate,

rExcess supplyof money

LM

Current output,Y

(a) Increase inGovernment Purchases

Rea

l in

tere

st r

ate,

r

IS0

IS1

FE

E2

E0

E1

LM1

Current output,Y

(c) Increase in the NominalMoney Supply

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st r

ate,

r LM0

IS

FE

E2

E0

E1

Desired saving ≠desired investment

FE0 FE1

E0

E1

Current output,Y

(b) Temporary Increase inCurrent Productivity

LM

Changing the EquilibriumAs shown in (a):At point E0 , the economy and the financial system are in equilibrium. The increase in government purchases shifts the IS curve from IS0 toIS1. The IS curve and FE line intersect at E1, but the asset markets aren’t in equilibrium. There is an excess supply of money.

As shown in (b):At point E0 , the economy and the financial system are in equilibrium. The boost in current productivity shifts the FE line from FE0 to FE1. Thenew goods market equilibrium lies at point E1, but the asset markets aren’t in equilibrium. There is an excess demand for money.

As shown in (c):At point E0 , the economy and the financial system are in equilibrium. When the Fed increases the nominal money supply, the LM curve shiftsfrom LM0 to LM1. It intersects the IS curve at E2 , but that point isn’t on the FE line. The LM curve and FE line intersect at E1 , but desired sav-ing and investment are not equal.

FIGURE 24.7

Shifts in the LM curve. What happens to the equilibrium of the financial systemand the economy if the Fed significantly increases the money supply, as occurred in thelate 1970s? Suppose that the goods market and asset markets are in equilibrium at E0in Fig. 24.7(c). An increase in the nominal money supply shifts the LM curve down andto the right from LM0 to LM1.

As a result, E0—where the IS curve and FE line intersect—no longer denotes anasset market equilibrium. Because E0 lies above the new LM curve, it represents anexcess supply of money. At E1, the new LM curve intersects the FE line, but the goodsmarket is no longer in equilibrium. Because E1 lies below the IS curve, there is an excessdemand for goods at that point. Note that at E2—where the IS and LM curves inter-sect—desired saving and investment are not equal, and the implied value of currentoutput is greater than actual current output (represented by the FE line). Hence, if wehold the determinants of the three curves constant, there is no combination of currentoutput and real interest rate for which all markets in the economy and the financial sys-tem are in equilibrium.

Restoring Equilibrium: Price-Level Adjustment

How can the economy and financial system achieve equilibrium when one of the threecurves shifts? Some variable will have to change in response to the changes that we ana-lyzed. Let’s assume that the price level P is flexible and can adjust freely in response tosuch changes. Is this assumption realistic? The answer depends on the definition of theperiod over which prices adjust. If the period is a week, the assumption of flexibleprices may not be realistic. If the period is three years, the assumption may be moreaccurate. In Chapter 25, we examine reasons why prices may not be flexible in theshort run and show how sticky prices affect short-run equilibrium. For now, however,let’s assume that prices are flexible in the long run and return to the shifts in the IScurve, FE line, and LM curve that we analyzed earlier.

Shifts in the IS curve. Recall that the shift in the IS curve resulting from a mil-itary buildup left the asset markets out of equilibrium, with a higher real interest ratethan at initial equilibrium. With the increased opportunity cost of money, householdsand businesses try to use their higher than desired real money balances to buy goods,putting upward pressure on prices. As Fig. 24.8(a) shows, the higher price level reducesthe supply of real money balances, causing the LM curve to shift from LM0 to LM1,where it intersects the IS curve and the FE line at E1.

Hence, if nothing else changes, an increase in government purchases has no effecton output in the long run when prices are flexible. However, both the real rate of inter-est and the price level increase, so the quantity of real money balances demanded equalsthe quantity supplied. For any expected rate of inflation, the higher real rate of inter-est implies a higher nominal rate of interest and a decline in the quantity of real moneybalances demanded.

The higher real rate of interest in the economy increases private saving anddecreases current consumption and investment. The reduction in private consumptionand investment that accompanies an increase in government purchases in a closedeconomy is known as crowding out.✝


✝ In a large open economy, such as the U.S. economy, an increase in the real rate of interest increases desiredinternational lending by foreign investors, resulting in capital flows from abroad into the domestic economy.Consequently, the current account balance of the domestic economy deteriorates. In other words, an increasein government purchases results in a decrease in net exports.

Shifts in the FE line. In Fig. 24.8(b), starting from equilibrium at E0, an increasein the full employment level of current output generates an excess demand for realmoney balances. At levels of the real interest rate and current output that lead to equi-librium in the goods market, households prefer to hold larger money balances. Theexcess supply of goods pushes prices down. Lower prices, in turn, increase the demandfor goods and increase households’ real money balances. The LM curve shifts fromLM0 to LM1 to intersect the IS curve and FE line at E1, and the asset markets returnto equilibrium, but at a lower real interest rate and a higher level of current output.

Hence, if nothing else changes, an increase in productivity in the current periodraises output while decreasing the price level and the real interest rate. For a givenexpected inflation, the lower real interest rate increases the quantity of real money bal-ances demanded. The lower price level raises the real value of money balances.✝

Shifts in the LM curve. Finally, recall the situation in which the Fed increasedthe nominal money supply, shifting the LM curve down and to the right. In that case,at E0 in Fig. 24.8(c), households and businesses have more real money balances thanthey desire. At E1, where LM1 and the FE line intersect, there is excess demand forgoods and services. What would happen if households and businesses tried to spendtheir excess real money balances to purchase additional goods and services in the goodsmarket? If the aggregate output of goods is fixed in the short run (represented by the


LM0

IS

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ate,

r

1. Government purchases rise.

LM0

Current output,Y

(a) Increase inGovernment Purchases

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st r

ate,

r

IS0

IS1

FE

E0

E1

LM1

Current output,Y

(c) Increase in the NominalMoney Supply

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ate,

r LM0

IS

FE

E0

E1

FE0

FE1

E0

E1

Current output,Y

(b) Temporary Increasein Productivity

LM12. Price level rises.

1. Money supply rises.

2. Price level falls.

LM1

2. Price level rises.

1. Productivity rises.

Price-Level Adjustment to Restore the Economy’s EquilibriumAs shown in (a):1. From an initial equilibrium at E0 , higher government purchases shift the IS curve from IS0 to IS1.2. The price level rises, shifting the LM curve from LM0 to LM1 to restore equilibrium at E1.

As shown in (b):1. From an initial equilibrium at E0 , increased productivity shifts the full employment line from FE0 to FE1.2. A fall in the price level shifts the LM curve from LM0 to LM1 and restores equilibrium at E1.

As shown in (c):1. From an initial equilibrium at E0 , an increase in the nominal money supply shifts the LM curve from LM0 to LM1.2. The price level increases, shifting the LM curve back from LM1 to LM0 and restoring equilibrium at E0.

FIGURE 24.8

✝ In a large open economy, such as the U.S. economy, a drop in the real interest rate reduces desired inter-national lending from abroad to the domestic economy, and the current account balance increases.

FE line), higher spending by households and businesses will not raise output but willraise the price level.

As the price level rises, real money balances fall because they equal nominal moneybalances divided by the price level. The reduction in real money balances causes theLM curve to shift up and to the left (from LM1 back to LM0). To restore equilibriumin all markets, the price level must rise by the amount by which the nominal moneysupply initially increased. The economy and the financial system return to equilibriumat E0.

Money, Output, and Prices in the Long Run

Our conclusions about the effects of changes in the money supply on equilibriumstrongly suggest that any percentage increase in the nominal money supply leads to anequal percentage increase in the price level, leaving real money balances unchanged.This constancy of money’s effect on the economy in the long run is known as the neu-trality of money. Monetary neutrality implies that a one-time change in the nominalmoney supply affects only nominal variables, such as nominal output or the price level.Real output and the real interest rate remain unaffected by a one-time increase ordecrease in the nominal money supply.

The concept of monetary neutrality depends on the assumption that prices are flex-ible. Recall that the way in which neutrality is achieved in response to an increase inthe money supply is for the price level to rise. Over short periods of time, the assump-tion of price flexibility isn’t realistic. Many economists believe that changes in themoney supply do affect the real economy in the short run (as we will demonstrate inChapter 26). However, economists generally accept the long-run neutrality of money.

Earlier in the chapter, we described the big changes in fiscal policy, monetary pol-icy, and productivity growth that took place in the 1980s and 1990s. We can use theIS-LM-FE model to analyze these events. We can represent the large increases in mili-tary spending in the early 1980s and early 2000s by an expansionary, outward shift ofthe IS curve, creating short-run pressures for higher output and interest rates. In the mid-to late 1990s, a decline in military spending was associated with an emerging federalbudget surplus that put downward pressure on interest rates. Two major monetarypolicies dominated the period. The major monetary contraction beginning in late 1979can be represented by a contractionary upward shift of the LM curve, putting upwardpressure on interest rates and downward pressure on output in the short run. In the late1980s and 1990s, the increase in the credibility of the Federal Reserve’s anti-inflationstance reduced the public’s expectation of inflation. The decline in expected inflationcan be represented by a downward shift of the LM curve, putting downward pressureon interest rates and upward pressure on output in the short run. Finally, growth inproductivity in the economy can be represented by an outward shift of the FE line,increasing output. The rise in energy prices in the early 1980s reduced productivity inthe short run, shifting the FE line to the left, reducing output.


KEY TERMS AND CONCEPTS

Current output

Full employment (FE) line

Full employment output

General equilibrium

Goods market

IS curve

LM curve

Money market

Neutrality of money

Nonmoney asset market

gloss577.html


The argument is simpleand convincing: Driven byan inexorable urge to cutcosts and boost profits,business buys the latestlabor-saving technology andfires workers. Repeated bycompanies across the econ-omy, these increases in pro-ductivity yield a “joblessrecovery” like the one theU.S. is suffering. As technol-ogy gets better, business getsby with still fewer workers.What jobs U.S. employerscan’t automate, they moveto China and India. The“jobless recovery” persists.Rising productivity boostsprofits. American workerssuffer. . . .

The argument is sim-ple, convincing—and wrong.Surging growth in produc-tivity, the amount of stuffwe make for each hour ofwork, is not the cause ofour current economicmalaise. Wishing forslower productivity growthso we can have more jobsis foolish. . . .

So it’s easy to draw aline from higher productiv-ity to higher unemploy-ment. But history suggeststhe economy doesn’t workthat way. Productivitygrew better than 3% a yearbetween 1962 and 1968,and so did employment. It

grew rapidly during thelate 1990s and unemploy-ment fell to the lowest lev-els in a generation. Andwe’ve had periods of slug-gish productivity growth—the late 1970s, for one—inwhich business also hiredreadily. The current combi-nation of rising productiv-ity up falling employmentdown is unusual.

Rising productivitymeans the economy cangrow faster, but it also

means the economymust grow faster, to

reduce unemployment.Productivity growth doesdestroy some jobs, nodoubt about that. Threequarters of all Americansworked on farms in 1800.Only 40% did in 1900.And, today, because Amer-ican farms are increasinglyefficient and mechanized,less than 3% of workersfeed the rest of us. Theevaporation of farm jobsbrought wrenching changeto farm families and ruraltowns, but it allowed moreAmericans to work in fac-tories and hospitals, teachin schools, and play in rockbands.

Only by improving pro-ductivity can an economyraise wages and free

workers to staff new

industries. Productivitygrowth expands an econ-omy’s capacity to supplygoods and services; itallows us to make morewith less effort. It’s why wehave more things than ourgrandparents did.

That sounds good. Sowhy are so many peopleunemployed? Because theeconomy isn’t yet creatingenough new jobs to replacethose lost as businessesdeploy technology or reor-ganize. Why aren’t busi-nesses hiring more?Because consumers, busi-nesses and foreigners aren’tbuying more. Companieswould make and hire moreif they thought they couldsell more.

The unpleasantly highunemployment rate reflectsa wide gap between theU.S. economy’s capacity tosupply goods and servicesand current demand forthem. This isn’t a perma-nent problem. It’s a tempo-rary, albeit painful, one.Closing the gap is the jobof macroeconomic policy.The stated aim of the folkswho cut taxes, increasespending and reduce inter-est rates is to increasedemand so businesses willresume hiring.

THE WALL STREET JOURNAL AUGUST 21, 2003

Productivity: The Magic Elixir

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M O V I N G F R O M T H E O R Y T O P R A C T I C E . . .M O V I N G F R O M T H E O R Y T O P R A C T I C E . . .


Most economists believe that the late1990s and early 2000s witnessed thebeginning of a long-term accelerationin U.S. productivity growth. As theeconomy produces more with fewerinputs, incomes rise. Against thishappy chorus came a concern that asthe economy recovered from a reces-sion in 2002 and 2003, fast productiv-ity growth meant that few, if any, jobswould be created in the near future.While such concerns fueled politicaldiscussions, economists generally sup-port the idea that an acceleration inproductivity growth benefits the nationand does not doom job growthprospects in the medium run.

In fact, increases in productivityraise our standard of living. An

increase in productivity increases theeconomy’s full employment level ofoutput. As shown in the figure, theproductivity boom shifts the FE line tothe right, from FE0 to FE1, increasingthe economy’s full employment level ofoutput from Y0 to Y1. If nothing else

happened, eventually the economy’sequilibrium would be restored with alower price level and real interest rateand a higher current output [as in themovement described in Fig. 24.8(b)]—definitely good news. This productiv-ity-led economic expansion wouldhave the opposite effects on the econ-omy as did the adverse oil supplyshocks of the 1970s.

What if the increase in productiv-ity growth is small or short-lived?

The salutary effects of the rightwardshift of the FE line described abovewould be attenuated. To the extentthat monetary policy had been setbased on the assumption of more sig-nificant productivity growth, inflation-ary pressure could materialize.

In the 1990s and early 2000s, the Fedbelieved that the rise in productivitygrowth was structured and accommo-dated it. For most of the period, then,output growth was higher without anincrease in inflation.

For example, improvements inthe way people use existing tech-

nology can increase the productivity ofinformation technology capital andother capital. These productivityimprovements reinforce the favorableshift in the economy’s full employmentoutput depicted in the figure.

For further thought . . .

Assuming the validity of the efficientmarkets hypothesis, how should stockprices react to an increase in theexpected rate of productivity growth?

Source: David Wessel, “Rising Productivity: Never a Bad Thing, Evenfor U.S. Workers,” The Wall Street Journal, August 21, 2003. Repub-lished by permission of Dow Jones, Inc., via Copyright ClearanceCenter. Copyright © 2003 Dow Jones and Company, Inc. All RightsReserved Worldwide.a

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A N A L Y Z I N G T H E N E W S . . .A N A L Y Z I N G T H E N E W S . . .

IS

Rea

l in

tere

st r

ate,

r FE0 FE1

Y1Y0 Current output,Y

LM

1. Productivity rises.

2. Output rises.


SUMMARY

1. Combinations of current output and the real rate ofinterest for which the goods market is in equilibriummake up the IS curve. The IS curve slopes downward:Higher current output requires a lower real interestrate to equate desired saving and investment andachieve equilibrium.

2. The IS curve shifts in response to changes in variablesthat change the equilibrium real interest rate associatedwith a specific level of current output. These variablesinclude government purchases, foreign demand fordomestic goods, households’ willingness to save, andthe expected future profitability of capital.

3. The full employment (FE) line represents current out-put supplied by full employment of existing factors ofproduction. It is assumed to be independent of thereal rate of interest. The intersection of the IS curveand FE line shows the interest rate and output in thegoods market.

4. Asset market equilibrium refers to equilibrium in themarkets for money and nonmoney assets. When oneof the two asset markets is in equilibrium, the otheralso is in equilibrium. Plotting combinations of thereal interest rate and current output for which themoney market is in equilibrium yields the LM curve.

5. The LM curve slopes upward because money demanddepends positively on current output and negativelyon the real interest rate. The more sensitive thedemand for money is to the interest rate, the flatterthe LM curve is.

6. Factors that change the supply of or demand for realmoney balances shift the LM curve. They include thenominal money supply, price level, nominal interestrate on money, and expected rate of inflation.

7. When the financial system and the economy are inequilibrium, the IS curve, LM curve, and FE lineintersect at the same real interest rate and level of cur-rent output. The financial system and the economyare in general equilibrium when the goods and assetmarkets are in equilibrium simultaneously. When thecurves do not intersect simultaneously, the price leveladjusts, causing the LM curve to shift to maintainequilibrium.

8. In long-run equilibrium, one-time changes in thenominal money supply affect only the price level, notreal output or the real interest rate. Hence, as long asthe price level in the economy is flexible, money isneutral.

REVIEW QUESTIONS

1. How does an increase in the nominal money supplyaffect the IS and LM curves and FE line?

2. Suppose that the quantity of money balances suppliedequals the quantity of money balances demanded.Can the demand for nonmoney assets exceed the sup-ply of nonmoney assets? Why or why not?

3. Of the IS curve, LM curve, or FE line, which isshifted directly by a change in fiscal policy in a closedeconomy? In which direction does it shift if govern-ment expenditures increase?

4. The LM curve shows points of equilibrium in themoney market for what two variables?

5. What is general equilibrium? In the IS-LM-FE model,what happens to the IS and LM curves and FE line atgeneral equilibrium?

6. What are the three components of aggregate demandin a closed economy? What is the relationship ofnational saving and investment in a closed economyat equilibrium?

7. What are the two principal determinants of investment?

8. Why does the IS curve slope downward?

9. Suppose that data showed no relationship between thelevels of saving and investment in various countries.What would that suggest about whether the countrieshave closed or open economies? Suppose that, instead,the data showed saving and investment to be highlycorrelated. What would that imply?

10. Why does the LM curve slope upward?

11. Why is the FE line vertical? What determines thelocation of the FE line?

12. What does “money is neutral” mean? If money isneutral, what effect does a 10% increase in the nom-inal money supply have on current output? On thereal interest rate? On real money demand? On theprice level?

13. Why do many economists believe that changes in themoney supply affect the economy in the short run butnot in the long run?

QUIZ

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14. Suppose the demand for investment spending doesnot depend on the expected real interest rate. Drawthe resulting IS curve. In these circumstances, whatwill be the effect on equilibrium output of an increasein the nominal money supply?

15. Suppose that firms become nervous about the futurebecause of increased uncertainty; as a result, theyreduce their investment spending. Of the IS curve, LMcurve, or FE line, which would be shifted by this reduc-tion? In what direction would it shift?

16. What effect does each of the following events have onnational saving, and what happens to the IS curve asa result?

a. The government cuts defense spending by 10%.

b. The Alaskan oil fields actually are much smallerthan was earlier believed, cutting expected futureincome by 3%.

c. Barriers to international trade are lowered, allow-ing gains from specialization and increasingexpected future income by 5%.

d. The government expands its health care coverage,increasing government purchases by 15%.

17. Suppose that during a particular year the full employ-ment level of output increases by 5%, when policy-makers in Washington had expected it to increase by2%. What is likely to happen to the actual inflation rel-ative to the expected inflation rate?

18. Suppose that a large open economy is initially at equi-librium with domestic saving equal to domesticinvestment so that the current account balance iszero. Now suppose that current domestic outputdecreases. What happens to the real interest rate,domestic saving, domestic investment, and the cur-rent account balance?

19. Suppose that a country that has a small open econ-omy passes a law taxing investment heavily. Whateffect would the tax have on desired investment?What happens to the real interest rate? What happensto the country’s current account balance?

20. What effect does each of the following events have onreal money demand and real money supply? Whathappens to the LM curve as a result?

a. Expected inflation rises because of an oil priceincrease.

b. Increased bank regulation forces banks to reduce thenominal interest rate they pay on checking accounts.

c. A drop in the exchange rate causes an increase inthe price level.

d. The Fed makes open market purchases.

21. Consider a small open economy that is in generalequilibrium. What effect on the real interest rate andoutput level does each of the following events haveafter equilibrium is restored?

a. An increase in expected future productivity ofinvestment.

b. A decrease in government purchases.

c. An increase in expected inflation.

d. A decrease in foreign demand for domesticallyproduced goods.

e. An increase in the nominal interest rate on moneyassets.

f. An increase in households’ willingness to save.

g. A decrease in nominal money balances.

h. A decrease in the price level.

22. Suppose that a closed economy is in general equilib-rium when new antipollution laws go into effect,reducing current productivity. What happens to thereal interest rate, current output, the price level, sav-ing, investment, and real money demand?

23. What happens to the price level to restore equilibrium ineach of the following cases for a closed economy?

a. The IS curve shifts up and to the right.

b. The IS curve shifts down and to the left.

c. The FE line shifts to the right.

d. The FE line shifts to the left.

e. The LM curve shifts down to the right.

24. Use an IS-LM-FE diagram to show the effect of theAsian financial crisis of 1997–1998 on the U.S. econ-omy. On the same diagram show the Fed’s policyresponse to the crisis (as discussed at the beginning ofthis chapter).

25. What happens if Europeans reduce their demand forU.S.-made automobiles? Which curve or line shifts inresponse? Does the price level rise or fall to restoreequilibrium? What happens to the real interest rateand the level of current output? What happens to sav-ing, investment, real money demand, nominal moneysupply, and the current account, if we assume that theUnited States is a large open economy?

ANALYTICAL PROBLEMSQUIZ

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DATA QUESTIONS

33. Olivier Blanchard of M.I.T. and Lawrence Summersof Harvard University calculated the annual realinterest rate on medium-term U.S. Treasury bonds foreach year from 1980 through the first quarter of1984 to be 1.0%, 2.2%, 6.9%, 4.3%, and 6.5%.Find a recent issue of the Economic Report of thePresident on the World Wide Web or in your libraryand calculate the percentage change in aggregate out-put in each year (from Table B-2). Using the

IS-LM-FE diagram, offer an explanation for theobserved pattern in real interest rates and outputgrowth during this period.

34. Locate the most recent Flow of Funds report issued bythe Federal Reserve at http://www.federalreserve.gov/releases/Z1/ and find gross domestic product for thepast seven years. Calculate the percentage change inGDP from one year to the next. Then check the annualaverage inflation rate (http://inflationdata.com/

26. In the IS-LM-FE model, what happens whenexpected inflation declines? Which curve or line shiftsinitially? What happens to restore equilibrium? Whatare the ultimate effects on the real interest rate andcurrent output?

27. In a small open economy, what happens to the pricelevel if the world real interest rate falls?

28. What happens to the IS curve of a large open econ-omy in which capital controls are enforced to preventinternational borrowing or lending?

29. Suppose that new computer technology greatlyenhances the ability of doctors to diagnose and treatdiseases, sharply reducing the amount of time thatworkers spend on sick leave. What effect does thishave initially on the IS-LM-FE model? How does theprice level change to restore equilibrium? What is theultimate effect on the real interest rate and the level ofcurrent output?

30. Suppose that widespread use of bank debit cards andcredit cards reduces the demand for money at anyparticular level of income and interest rates. Whatwould be the effect on long-run equilibrium in the IS-LM-FE model? (In long-run equilibrium, prices areflexible.)

31. In the early 1980s, the U.S. government cut incometaxes without reducing spending, significantlyincreasing the government’s budget deficit (the differ-ence between government purchases and taxes, net oftransfers). Suppose that private saving didn’t increaseto offset the decrease in government saving.

a. What are the effects on the price level and realinterest rate, assuming that nothing else changesand that the United States has a closed economy?

b. Now suppose that the United States and its principaltrading partners (such as Germany) are large openeconomies. What is the effect of the U.S. tax cut onthe real interest rate and price level in Germany?

c. What could Germany or the United States do tooffset the effects of U.S. budget deficits on theprice levels in the two countries?

The following question pertains to the discussion in theappendix to this chapter.

32. A closed economy has the following characteristics:

Consumption: C � 0.75(Y � T) � 120r � 450.

Investment: I � 600 � 180r.

Government purchases: G � 300.

Taxes, net of transfers: T � 225.

Demand for real money balances:

L � 0.15Y � 120i � 87.75.

Nominal money supply: Ms � 600.

Expected rate of inflation πe � 0.05.

The goods market equilibrium is represented by the IScurve.

a. What is the equation of the IS curve?

b. Plot the IS curve.

Asset market equilibrium is described by the LMcurve.

c. Suppose that the price level is 3. What is the equa-tion of the LM curve?

d. For the assumption in (c), draw the LM curve.

Current output supplied is represented by the FE line.

e. Suppose that full employment current output Y* �

4665. What are the equilibrium values of the pricelevel and the real interest rate in the economy?

Suppose that the nominal money supply increasesfrom 600 to 660.

f. What happens to the price level, the real interestrate, and output in the new long-run equilibrium?

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Derivation of the IS CurveBy making simple assumptions about the relationship between national saving andinvestment, we can derive the IS curve algebraically. We do so here for a closed econ-omy, a large open economy, and a small open economy.

Closed EconomyAs discussed in the chapter, we determine equilibrium in the goods market by equat-ing national saving, S, and investment, I, or

S � I. (24A.1)

In a closed economy, the financial system matches domestic saving and investment, sonational saving consists of domestic private saving, SP, and government saving, SG.

Private saving equals income, Y, minus taxes (net of transfer payments), T, lesscurrent consumption, C.✝ Government saving equals taxes (net of transfer payments),T, minus government purchases, G. Substituting these variables into Eq. (24A.1) wehave

(24A.2)

Note that equating saving and investment in Eq. (24A.2) yields an expression foraggregate demand for current output in the closed economy:

(24A.3)

Equation (24A.3) shows that total output is the sum of current consumption, invest-ment, and government spending on goods and services.

Equation (24A.3) is an accounting identity, not a model of economic decisions.Current consumption C depends positively on current disposable income (total currentincome Y minus taxes, net of transfers, T ) and negatively on the real interest rate r(which measures the opportunity cost of trading current for future consumption).Hence

(24A.4)

where C0 represents other potential determinants of consumption (for example,wealth, consumer confidence, or households’ preference for current consumption

C = c1( ) ,Y T c r C− − +2 0

Y � C � I � G.

( ) ( ) .Y T C

S

T G

S

I

S

P G

�1 24 34 1234

1 244 344

� � � �

✝ We do not consider business saving separately here. In the economy, households own businesses and busi-ness savings.

A P P E N D I X

inflation/inflation_rate/HistoricalInflation.aspx) andthe nominal returns on medium-term Treasury bonds(http://www.federalreserve.gov/Releases/h15/), anduse this information to construct real interest ratedata for the same years. What pattern do youobserve, and how do the data correspond to shifts in

the IS-LM-FE model? Explain the effects on thismodel that would result from (i) a large increase inthe inflation rate, (ii) a decision by the Fed to mone-tize large portions of the federal budget deficits, (iii)an increase in taxes, and (iv) an increase in militaryspending.

relative to expected future consumption). The coefficient on income after taxes, net oftransfers, c1, represents the marginal propensity to consume: When the real interest rateand other determinants of consumption are held constant, an increase in (Y � T ) by$1.00 raises C by c1, which has a value between 0 and 1.

Investment I depends positively on the profitability of investment opportunities I0and negatively on the real interest rate r, or

(24A.5)

An increase in the profitability of investment opportunities increases I0. John MaynardKeynes, whose work in the 1930s led to development of the IS-LM model, thought thatshifts in the investment schedule were driven by businesses’ confidence about thefuture, which he called animal spirits.

For simplicity, let’s take government spending on goods and services and taxes, netof transfers, as a given at levels G and T, respectively. We can now equate domestic sav-ing and investment in the economy:

(24A.6)

Collecting terms, we express Eq. (24A.6) as a relationship between aggregate demandfor current output and the real interest rate:

(24A.7)

Current output increases in response to an increase in C0, I0, and G. Increases in T andr decrease current output. The first term in Eq. (24A.7) consists of variables whose val-ues are exogenous—that is, given outside the model. We know that r and Y are endoge-nous variables, the equilibrium values of which we are trying to determine.

By how much does output increase in response to an increase in these variables?From Eq. (24A.7) and for a constant r, a $1.00 increase in C0, I0, or G raises thedemand for current output by $1/(1 � c1). If the marginal propensity to consume c1were 0.8, a $1.00 increase in C0, I0, or G would raise Y by $1.00/(1 � 0.8), or $5.00.✝

Large Open EconomyWe derive the IS curve for a large open economy by extending our closed economymodel to include net saving supplied by foreigners SF. The equality of saving and invest-ment then becomes

(24A.8)SP � SG � SF � I.

YC I G c T

cc a

cr= + + −

−− +

−

0 0 1

1

2

11 1.

SP

1 2444444 3444444S IG

123 1 24 34

S1 244444444 344444444

[Y � T � (c1(Y � T) � (c2r � C0)] � (T � G) � � ar � I0.

I � �ar � I0.


✝ Note that the coefficient of G in Eq. (24A.7) is 1/(1 – c1), whereas the coefficient of T is –c1/(1 – c1). Hence raising both G and T by $1.00 (a “balanced budget” change) raises aggregate demandby

An equal increase in government purchases and taxes, net of transfers, raises aggregate demand by theamount of the increase in G and T in this approach.

1

1 � c1

�c1

1 � c1

� 1.

When SF � 0, foreign saving flows into the domestic economy. This capital inflowfinances greater domestic consumption and investment. As a result, the current accountbalance NX, the difference between exports and imports, falls. Hence, as we showedin Chapter 22,

The national income accounting identity for an open economy is

(24A.9)

To convert Eq. (24A.9) into an equation for the IS curve, we first let

The NX0 term allows for shifts in demand for domestic versus foreign goods. Anincrease in the domestic real interest rate r increases the flow of foreign savings into thedomestic economy, thereby decreasing the current account balance. Substituting for theelements of the right-hand side of Eq. (24A.9) gives us the equation for the IS curve:

Rearranging terms, we get

or

(24A.10)

The IS curve is flatter (that is, �r/�Y is smaller in absolute value) than the closed econ-omy IS curve derived in the text.

Small Open EconomyIn a small open economy, the rate of interest for the IS curve is the world real rate ofinterest, or r � rw. Unlike a large open economy, a small open economy cannot affectthe world real rate of interest by increasing or decreasing its desired national saving orinvestment.

rc

c a dY

c a dC I G c T NX= − −

+ +

++ +

+ + − +1 11

2 20 0 1 0( ).

YC I G NX c T c a d r

c= + + + − − + +

−( ) ( )

,0 0 0 1 2

11

C1 244444 44 3444444

NX123 1 24 34

I G1 24 34Y � [C0 � c1(Y � T ) � c2r] � (I0 � ar) � G � (NX0 � dr).

NX � NX0 � dr.

Y � C � I � G � NX.

SF � �NX.


the economy: the is-lm-fe model -...

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