! #$%&'()&* +,-.

/ /012*

Allen Tang

The 0niveisity of Noith Caiolina at Chapel Bill


I. Intiouuction

In this papei I will exploie the specifications of a uisciete uynamical IS-LN mouel
anu uiscuss how this mouel can be useu pieuict the effects of exogenous shocks,
specifically the implementation of monetaiy policy, to an economy. The stanuaiu
static IS-LN mouel aiises in the Keynesian fiamewoik of macioeconomics. Peihaps
the simplest veision of the mouel is given by the following two equations:

I. y =! +"y !c
0
r

II. m= c
1
y !c
2
(r +!
e
)

Wheie ! is given by the log of ieal output, # is the ieal inteiest iate
1
, !
!
is the
expecteu iate of inflation
2
, $% ln(&'() is the log of ieal money balances
S
, anu all
othei vaiiables aie positive paiameteis. The fiist equation is commonly iefeiieu to
as the *+ ,-./012/ anu is ueiiveu fiom an equilibiium conuition in the goous anu
seivices maiket. It suggests that the uemanu foi output is equal to a function
incieasing in income, !, anu uecieasing in the ieal inteiest iate, #. Equation (II), the
3& ,-./012/, is an equilibiium conuition in the money maiket that suggests the
uemanu foi ieal money balances is equal to ieal money supply.
When both of the equations aie plotteu on a cooiuinate system with output
on the x-axis anu ieal inteiest iate on the y-axis the foim the *+43& ,56-/. The
inteisection of the two cuives gives us the equilibiium inteiest iate, #78 anu
equilibiium output, !7 (see Figuie 1). We can then solve foi !7 as a function of $
anu !
!
anu also solve foi #7 similaily.

III. y* = y(m, !
e
) = k a +
c
0
c
2
m+c
0
!
e
!
"
#
$
%
&
, wheie k !
1
1"! +c
0
c
1
c
2

Iv. r* =
1
c
2
c
1
y*!m!c
2
!
e
( )


1
equal to the nominal inteiest iate uiviueu by the piice level (
2
ueiiveu unuei the assumption of auaptive expectations
S
ieal money balances equal to &'(, nominal money supply uiviueu by the piice
level
Tang
! #$%&'()&* +,-./ /012*
2

3(4562 78 9056)2: ;<<=:>>7?@=?@*049=0<?)0'>-A29BCDE;F(0>G5GH(IJ%FK+>!!!!!!!!!L/>0MI/GM-
N1;O>97NOO>+,-./P2J5(*(@6(5'?Q=4

II. The Bynamical mouel

To tiansfoim the above mouel to fiom a static mouel to a uynamical mouel it is
necessaiy to make a few basic assumptions about piice expectations, the change in
piice ovei time, anu the giowth of the money supply. Fiist we make the assumption
that the aggiegate supply cuive is well uefineu by the (.92295, -1#:/. The (.92295,
-1#:/ can be ieaiiangeu to expiess inflation at time ;, !
t
4
! as a function of inflation
expectations anu cuiient output less the natuial iate of output !.

v. !
t
= !
t
e
+!(y
t
! y)

Seconu we assume that the nominal money supply & giows at a constant iate !,
given by a Fiieuman type monetaiy policy iule
S
, i.e.:

vI. M
t+1
= M
t
e

; wheie ! is constant ! ln
M
t+1
M
t
"
#
$
%
&
'
=

4

P
t+1
= P
t
! e
!
t
"!
t
= ln
P
t+1
P
t
#
$
%
&
'
(

S
See Smith, Touu foi uefinition anu ueiivation
Tang
! #$%&'()&* +,-./ /012*
S

Lastly we make the assumption that expectations aie auaptive iathei than iational,
i.e., foiecasts foi futuie levels of inflation aie calculateu fiom a combination of
pievious levels of inflation:

vII. !
e
t+1
= !
t
e
+" !
t
!!
t
e
( )
wheie 0 !! !1anu is given.

The above equations can then be useu to ueiive a system of uisciete uynamic
equations. Fiist we will ueiive the uynamic equation foi inflation. Combining
equation (v) anu (vII) yielus:

vIII. !
e
t+1
= !
t
e
+!" y
t
! y
( )

0sing this equation (vIII) anu the equation foi the equilibiium output (III)
|iepiouuceu below anu with auueu time subsciiptsj we can constiuct the equation
foi expecteu inflation (IX).
y
t
= y
t
* = y(m
t
, !
t
e
) = k a +
c
0
c
2
m
t
+c
0
!
t
e
!
"
#
$
%
&

IX. !
e
t+1
= !
t
e
+"# k a +
c
0
c
2
m
t
+c
0
!
t
e
!
"
#
$
%
&
' y
(
)
*
+
,
-, oi expanueu
X. !
e
t+1
="#k
c
0
c
2
m
t
+ 1+" !# ! k ! c
0
( )
!
t
e
+"#(k ! a " y)
Foi simplicity we will uefine seveial new vaiiables,
! =" ! k !
c
0
c
2
; h =!(k !" " y)
Substituting these into equation (X) will yielu oui final uynamic equation foi piice
expectations.
XI. !
e
t+1
=" !#! m
t
+ 1+" !#! c
2
( )
!
t
e
+" ! h
Next we will ueiive the uynamic equation foi the money supply, $<

XII.
m
t+1
!m
t
= ln
M
t+1
P
t+1
!ln
M
t
P
t
= ln
M
t+1
M
t
!ln
P
t+1
P
t



Tang
! #$%&'()&* +,-./ /012*
4
By use of Fiieuman's monetaiy policy iule anu the uefinition of inflation
4
equation
(XII) will yielu:
m
t+1
!m
t
= !!
t
" m
t+1
= m
t
+ !!
t


Substituting with equation (v) anu by use of the equilibiium equation foi output
aujusteu with time notations (both iecalleu below) we obtain equation (XIII)

!
t
= !
t
e
+!(y
t
! y) ; y
t
= y
t
* = y(m
t
, !
t
e
) = k a +
c
0
c
2
m
t
+c
0
!
t
e
!
"
#
$
%
&


XIII. m
t+1
= m
t
!!
e
t
!" k a +
c
0
c
2
m
t
+c
0
!
t
e
"
#
$
%
&
'
! y
(
)
*
+
,
-+

Simplifieu we finu:
m
t+1
= 1!! " k "
c
0
c
2
#
$
%
&
'
(
m
t
! 1+" "! " k " c
0
( )
!
t
e
!"(k " a ! y) +

The final uynamic equation is obtaineu by substituting oui new vaiiables, !, h.

XIv. m
t+1
= (1!!)m
t
! (1+!" c
2
)"
t
e
+u!h

Anu thus finally oui uynamic IS-LN system is as follows:

Xv.
!
e
t+1
=" !#! m
t
+ 1+" !#! c
2
( )
!
t
e
+" ! h
m
t+1
= (1"#)m
t
"(1+#! c
2
)!
t
e
+u"h
#
$
%
&
%



III. Analysis

Finuing the stationaiy tiajectoiies of the system will allow us to iewiite the system
as a system of uiffeience equations anu thus allow uiscussion on the stability of the
mouel, which is quite impoitant when consiueiing economics. The stationaiy
tiajectoiies occui when:

m
t+1
= m
t
= m = constant, !t " N
!
e
t+1
= !
t
e
= !
e
= constant, !t " N

0sing these conuitions anu the system (Xv) we finu that
m= !
1+!c
2
!
"
e
+
1
!
!h
( )
foi m
t+1
= m
t
= m anu
Tang
! #$%&'()&* +,-./ /012*
S
m= !c
2
!
e
!
1
!
h foi !
e
t+1
= !
t
e
= !
e

The two equations above anu the uynamic system have solutions in:

XvI.

!
e
=
m= !c
2
!
1
"
h
"
#
$
%
$


Now we can iewiite system (Xv) using the solutions of (XvI) as a system of
uiffeience equations given by:

XvII.
m
t+1
! m= 1!!
( )
m
t
! m
( )
! 1+a" c
2
( )
!
e
t
!!
e
( )
!
t+1
e
!!
e
=! "" m
t
! m
( )
+ 1+! """ c
2
( )
!
e
t
!!
e
( )
#
$
%
&
%


Assigning vaiiables =; anu !; to m
t
! m
( )
anu !
e
t
!!
e
( )
iespectively will finally allow
us to wiite the system in a moie familiai foim. That is:

XvIII. A =
1!! ! 1+a" c
2
( )
! "" 1+! """ c
2
( )
#
$
%
%
&
'
(
(
,
!
x
t
=
x
t
y
t
#
$
%
%
&
'
(
(
wheie
!
x(t +1) = A
!
x(t)

Which gives iise to the geneial solution
!
x(t) = A
!
x
0
.
To moie easily analyze the system we will uiagonalize the matiix > using the
foimula S
!1
AS = B wheie ? is the uiagonal matiix with entiies associateu with the
eigenvalues of the tiansfoimation anu + is a matiix whose columns foim an
eigenbasis foi >, that is:

B =
!
1
0
0 !
2
!
"
#
#
$
%
&
&

S =
!
v
1
!
v
2
!
"
#
$
,
!
v
1
,
!
v
2
eigenvectois

Consiuei that S
!1
AS = B " A = SBS
!1
anu thus

A
t
= (SBS
!1
)
t
= (SBS
!1
)(SBS
!1
)...(SBS
!1
) = SB
t
S
!1
, now it follows that

XIX.
!
x(t) = A
t
!
x
0
= SB
t
S
!1
!
x
0
oi equivalently,
!
x(t) = S
!
t
1
0
0 !
2
t
!
"
#
#
$
%
&
&
S
'1
!
x
0


Tang
! #$%&'()&* +,-./ /012*
6
To ueteimine the values of !
1
, !
2
we use the chaiacteiistic equation of a 2x2 matiix >
given by:

In oui mouel the iesults aie:

!
2
!(2 !" +# """ c
2
)! +1!" +# "" +# """ c
2
= 0

Notice that this equation iesembles a polynomial of uegiee 2, i.e. a quauiatic
equation with solutions, oi ioots:

!
1
, !
2
=
tr(A) tr(A)
2
! 4det A
2
,

!
1
, !
2
will have ieal solutions when the uisciiminant is non-negative. Expanuing
anu simplifying the uisciiminant will yielu:

! =! ! " 4"
( )
+! #"# c
2
! # c
2
"2
( )
$
%
&
'


By the mouel specifications we know that all paiameteis aie positive anu thus the
uisciiminant will be negative in the case of ! >
1
4
" , if this conuition occuis then the
ioots of the chaiacteiistic equation, !
1
, !
2
, will be complex conjugates. This is useful
because we know that the zeio state of the system will be asymptotically stable if:

lim
t!"
!
x(t) = lim
t!"
(A
t
!
x
0
) =
!
0

which will occui if (anu only if) !
1
= !
2
<1; !
1
, !
2
complex eigenvalues. In oui
system we finu:

!
1
= !
2
= 1!" +# "" +# """ c
2
, it follows

1!! +" "! +" "!" c
2
<1#" "! 1+c
2
( )
<! #" <
1
1+c
2
.

Recall fiom (vII) anu (vII) that the paiametei! acts as a "leaining" paiametei when
pieuicting futuie inflation unuei the assumption of auaptive expectations. 0ui
uynamic IS-LN system will be stable when the paiametei satisfies:

1
4
! <" <
1
1+c
2


det(A!!I
2
) = !
2
!(trA) +det A = 0
Tang
! #$%&'()&* +,-./ /012*
7


Substituting oui oiiginal paiameteis foi ! the inequality becomes

1
4
! ! k !
c
0
c
2
<" <
1
1+c
2


anu by the specifications of the eqn. foi equilibiium output (III) can be wiitten as

1
4
! !
c
0
c
2
1"" +c
0
c
1
c
2
<# <
1
1+c
2
.

Iv. Conclusion

A phase poitiait of this system woulu contain an inwaiuly spiialing tiajectoiy that
appioaches @ as ; incieases towaius infinity. When consiueiing the economic
implications of an IS-LN mouel this is exactly the iesult we expect. In a Keynesian
macio-economic mouel, which ielies heavily on the *+43& ,56-/, an exogenous
inciease to the ieal money supply, &8 will, in the shoit iun, cause a tempoiaiy
inciease in output, !, anu a simultaneous ueciease in the piice level, (8 which ovei
time is measuieu by inflation, ! . Bowevei, unuei stable conuitions anu in the long
iun, the shock becomes absoibeu in the money maiket anu the effects of the
exogenous shock aie minimizeu, i.e. y ! y anu ! !! will appioach @. Whethei oi
not the system is stable uepenus heavily on the paiametei ! , oi in othei woius oui
ability to accuiately pieuict futuie piice levels. This suppoits the claim, assuming
stability, that Keynesian economists piefei goveinmental inteivention in the
economy in the foim of fiscal policy iathei than monetaiy policy as the lattei will
have little to no effect on long iun output anu inflation.







Tang
! #$%&'()&* +,-./ /012*
8
L2A262%)29


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