01 04 Islm 2013

The IS-LM model
Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti
IS-LM MODEL
Since now…
Business Economics and Organization – prof. Francesco Venuti
1. We looked at the GOODS MARKET

2. We looked at FINANCIAL MARKETS
… we now look at goods and financial markets together

IN THE SHORT RUN!
We look at the IS-LM model as developed by Hicks and

Hansen, summarizing Keynes’s GENERAL
THEORY of 1936.
Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 2
1
The Goods Market and the IS Relation
We already know that:
• the GOODS MARKET is in equilibrium when production (Y)

is equal to the demand for goods (Z or D). This condition is

called the IS relation.
• The DEMAND for goods is the sum of consumption (C),

investment (I) and government spending (G) (plus,
eventually, net export, if we consider an open economy).
• We assumed that consumption was a (linear) function of

disposable income
In the simple model developed in the first part,

the interest rate did not affect the demand for
goods.
The equilibrium condition was then given by:
Y = C(Y − T ) + I + G
2
The main simplification of this first model was

that the interest rate did not affect the demand
for goods.
Now, it’s time to abandon this simplification

and introduce the interest rate in the goods
market.

Investment, Sales, and the Interest Rate
Investment depends primarily on two factors:

The level of sales (+)
Consider a firm facing an increase in sales.

-> Probably it needs to increase production
-> to do so, it may need to buy additional machines or build an
additional plant… it needs to INVEST.
3

The interest rate (-) (i or r)
Consider a firm deciding whether to buy a new machine. Suppose

that to buy the new machine, the firm must borrow.
The highest the interest rate, the less attractive it is to borrow and
buy the machine.


I = I (Y , i )
The interest rate (-)
( + ,− )
I = a ⋅Y − b ⋅ i
or
I = I0 − b ⋅ i
4
Determining Output
Taking into account the investment relation, the

equilibrium condition in the goods market becomes:
Y = C(Y − T ) + I (Y , i ) + G
For a given value of the interest rate i, demand is an
increasing function of output, for two reasons:
An increase in output leads to an increase in
income and also to an increase in disposable
income.
An increase in output also leads to an increase in
investment.

Determining Output
Note two characteristics of Z:

Because it’s assumed that the consumption and

investment relations are linear, Z is, in general, a
curve rather than a line.
Z is drawn flatter than a 45-degree line because it’s

assumed that an increase in output leads to a less
than one-for-one increase in demand.
5
Determining Output
Figure 5
Equilibrium in the
Goods Market
The demand for goods is an
increasing function of output.
Equilibrium requires that the
demand for goods be equal to
output.

Determining Output
Note two characteristics of Z:

Because it’s assumed that the

consumption and investment
relations in Equation (5.2) are
linear, Z is, in general, a curve
rather than a line.
Z is drawn flatter than a 45-

degree line because it’s
assumed that an increase in
output leads to a less than one-
for-one increase in demand.
6
Deriving the IS Curve
We have drawn the demand relation (Z) for a

given value of the interest rate.
We now want to draw the relation between

the interest rate and production (IS
CURVE).
What happens if the interest rate changes?

What happens if the interest rate changes?
In words:
“The increase in the interest rate decreases
investment.
The decrease in investment leads to a
decrease in the aggregate demand and in
output, which further decreases consumption
and investment through the multiplier effect.”
i I Z Y Yd C Z Y …..
7
Figure
The Derivation of the IS
Curve
(a) An increase in the interest
rate decreases the
demand for goods at any
level of output, leading to a
decrease in the equilibrium
level of output.
(b) Equilibrium in the goods

market implies that an
increase in the interest
rate leads to a decrease in
output. The IS curve is
therefore downward
sloping.

The IS Curve
the independent variable is the interest rate and the dependent variable is the level of income
(even though the interest rate is plotted vertically)
is drawn as downward-sloping with the interest rate (ii) on the vertical axis and GDP (gross
domestic product: Y) on the horizontal axis
the initials IS stand for "IInvestment and Saving equilibrium"
the IS curve is a locus of points of equilibrium in the "real" (non-financial)

economy
8
The IS Curve

Shifts of the IS Curve
We have drawn the IS curve, taking as given the values of taxes,

T, and government spending, G. Changes in either T or G will
shift the IS curve.
To summarize:
Equilibrium in the goods market implies that an increase in
the interest rate leads to a decrease in output. This relation
is represented by the downward-sloping IS curve.
Changes in factors that decrease the demand for goods,
given the interest rate, shift the IS curve to the left. Changes
in factors that increase the demand for goods, given the
interest rate, shift the IS curve to the right.
9
Figure
An increase in taxes
shifts the IS curve to
the left.
Financial Markets and the LM Relation
Let’s now turn to financial markets

The interest rate is determined by the equality of the supply of

and the demand for money:
M = $YL(i )
M = nominal money stock

$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate
10
Real Money, Real Income, and the Interest Rate
The equation M = $YL(i ) gives a relation between money,

nominal income, and the interest rate.
The LM relation: in equilibrium, the real money supply is equal

to the real money demand, which depends on real income, Y,
and the interest rate, i:
= YL(i )
M
P
recall that Nominal GDP = Real GDP multiplied by the GDP
deflator:
$Y = YP
Equivalently: $Y
=Y
P

Deriving the LM Curve
Figure a) An increase in income leads, at a given b) Equilibrium in the financial
interest rate, to an increase in the demand for markets implies that an
The Derivation of the
money. Given the money supply, this increase increase in income leads to an
LM Curve
in the demand for money leads to an increase increase in the interest rate.
in the equilibrium interest rate. The LM curve is therefore
upward sloping.
11
The Figure plots the equilibrium interest rate, i, on

the vertical axis against income on the horizontal

axis.
This relation between output and the interest rate

is represented by the upward sloping curve. This
curve is called the LM curve.

12
Shifts of the LM Curve
Figure
Shifts of the LM curve
An increase in
money causes
the LM curve to
shift down.

Shifts of the LM Curve
■ Equilibrium in financial markets implies that, for a given real

money supply, an increase in the level of income, which
increases the demand for money, leads to an increase in

the interest rate. This relation is represented by the
upward- sloping LM curve.
■ An increase in the money supply shifts the LM curve

down; a decrease in the money supply shifts the LM
curve up.
13
Putting the IS and the LM Relations
Together
IS relation: Y = C(Y − T ) + I (Y , i ) + G
M
LM relation: = YL(i )
P
Figure
The IS–LM Model
Equilibrium in the goods market
implies that an increase in the
interest rate leads to a
decrease in output. This is
represented by the IS curve.
Equilibrium in financial markets
implies that an increase in
output leads to an increase in A
the interest rate. This is
represented by the LM curve.
Only at point A, which is on
both curves, are both goods
and financial markets in
equilibrium.
The short-run equilibrium
IS relation: Y = C(Y − T ) + I (Y , i ) + G
M
LM relation: = YL(i )
P i
LM
The short-run
equilibrium is the
combination of r and Y
that simultaneously
satisfies the
IS
equilibrium conditions
in the goods & money
Equilibrium Y
markets
interest
Equilibrium
rate
level of
income
14
Summary
• The IS-LM model translates the General Theory of Keynes

into neoclassical terms
• It was proposed by John Hicks in 1937 and enhanced by
Alvin Hansen.
• The model examines the combined equilibrium of two
markets :
The goods market, which is at equilibrium when investments
equal savings, hence IS.
The money market, which is at equilibrium when the demand for
liquidity equals money supply, hence LM.
Examining the joint equilibrium in these two markets allows us to
determine two variables : output Y and the interest rate i.
Summary
IS curve
comes from “Keynesian cross” when planned investment depends
negatively on interest rate
shows all combinations of r and Y

that equate planned expenditure (demand) with
actual expenditure on goods & services
Theory of Liquidity Preference

basic model of interest rate determination
takes money supply & price level as exogenous
an increase in the money supply lowers the interest rate
LM curve
comes from liquidity preference theory when
money demand depends positively on income
shows all combinations of r and Y that equate demand for real
money balances with supply
15
Summary
IS-LM model
Intersection of IS and LM curves shows the unique point (Y, r )
that satisfies equilibrium in both the goods and money markets.
Is a short-run (fix price) model

There exists excess production capacity in the economy
This is why IS-LM remains central to modern macroeconomics, and

has been extended to explain more markets/ variables:
The AS-AD model adds inflation into the problem
The Mundell-Fleming model deals with international trade

Together
The IS-LM Model
Is a short-run (fix price) model
There exists excess production capacity in the economy
This is a complete change in perspective compared to classical

economics:
The level of demand determines the level of output and employment.
There can be (and usually THERE IS) an equilibrium level of
involuntary unemployment.
Why can there be insufficient demand ?

Criticism of Say’s law: Uncertainty can lead to precautionary saving
rather than consumption.
Monetary criticism: the preference for liquidity can lead to under-
investment as savings are kept in the form of liquidity.
16
Together
• IS-LM can be used to assess the impact of

exogenous shocks on the endogenous variables of

the model (interest rates and output)
• One can also use the IS-LM to evaluate the

effectiveness of the policy mix, i.e. the combination
of:
Fiscal policy: changes to government spending and
taxes
Monetary policy: changes to money supply

Together
Types of Policy: IS-LM Model
• Fiscal Policy: change G, T, t, or other

components of autonomous goods and services

expenditure
Shift the IS curve.
• Monetary Policy: change the nominal money

supply (MS)
Shift the LM curve.
17
Together
Expansionary and Contractionary Policy
• Expansionary
shifts the appropriate curve rightward.
• Contractionary
shifts the appropriate curve leftward

Together
Fiscal Policy, Activity, and the Interest Rate
Fiscal contraction, or fiscal consolidation, refers to

fiscal policy that reduces the budget deficit.
An increase in the deficit is called a fiscal expansion.
Taxes affect the IS curve, not the LM curve.
18
Together
The effect of an increase in GOVERNMENT SPENDING
1. An increase in spending ∆G 2. … By an amount: 1

∆G
Interest rate i
pushes IS to the right … 1− c

LM
But as Y increases (multiplier

effect), so does money demand.
i2 The interest rate must increase to
compensate, which discourages
investment
i1
IS’
IS The difference between Yk and
YIS-LM is the crowding out effect
Y1 YIS-LM YK Income, Output Y

Together
Remember that the equilibrium condition of the economy can be expressed as:
G – T = S(Y ) – I(i )
Now that we have integrated interest rates, if G-T increases (fiscal policy), the
economy attempts to correct the disequilibrium by:
Increasing S (multiplier effect on output)
Reducing I (crowding
crowding out on private investment)
19
Together
Money is not neutral (in the short run)!!

This is one of the central contributions of Keynes

This conclusion will change somewhat if we consider inflation and the long-
run

Together
1. The multiplier is 2 and

government spending increases by
LM
$500, so the IS increases by $1000.
9%
2. If the demand for
money is totally
insensitive to the
$1000 interest rate, the
interest rate
4% increases from 4%
IS1 to 9%.
IS0 3. The increase in the

interest rate causes a
$6000 $7000 decrease in investment
that completely offsets
Aggregate Output the increase in
government spending.
20
Together
When complete crowding out occurs, fiscal policy is ineffective, changing

only interest rates, not output.
Crowding out is greater if:
Money demand is very sensitive to income changes
Money demand is not very sensitive to interest rate changes

Together
Fiscal Policy, Activity, and
the Interest Rate
Figure
The effect of an increase

in TAXES
Equilibrium in the goods market
implies that an increase in the
interest rate leads to a
decrease in output. This is
represented by the IS curve.
Equilibrium in financial markets
implies that an increase in
output leads to an increase in
the interest rate. This is
represented by the LM curve.
Only at point A, which is on
both curves, are both goods
and financial markets in
equilibrium.
21
Together
Monetary Policy, Activity, and the Interest Rate
Monetary contraction, or monetary tightening, refers to a

decrease in the money supply.
An increase in the money supply is called monetary expansion.
Monetary policy does not affect the IS curve, only the LM curve.
For example, an increase in the money supply shifts the LM
curve down.

Together
Monetary Policy, Activity, and the Interest Rate
Figure
A monetary expansion leads to higher
The Effects of a output and a lower interest rate. 1. An increase in
Monetary Expansion money supply
shifts LM to the
Interest rate i
right ….
LM
2. …Which
reduces the rate
of interest...
LM’
3. …And
increases output
by stimulating
investment.
i1
i2
IS
Y1 Y2 Income, Output Y
22
Using a Policy Mix
Table The Effects of Fiscal and Monetary Policy

Movement Movement in
Shift of IS Shift of LM in Output Interest Rate

Increase in taxes Left None Down Down
Decrease in taxes Right None Up Up
Increase in spending Right None Up Up
Decrease in spending Left None Down Down
Increase in money None Down Up Down
Decrease in money None Up Down Up
Deficit Reduction: Good or Bad for Investment?

Investment = Private saving + Public saving

I = S + (T – G)
A fiscal contraction may decrease investment. Or, looking

at the reverse policy, a fiscal expansion—a decrease in
taxes or an increase in spending—may actually increase
investment.
23
Using a Policy Mix
The combination of monetary and fiscal

polices is known as the monetary-fiscal
policy mix, or simply, the policy mix.
Sometimes, the right mix is to use fiscal and

monetary policy in the same direction.
Sometimes, the right mix is to use the two

policies in opposite directions—for example,
combining a fiscal contraction with a
monetary expansion.
Using a Policy Mix
The two policies are not independent, as they both

affect the endogenous variables:
The interest rate i

Income Y
Hence the idea of a policy mix…
24
The Central Bank’s response to ∆G > 0
• Suppose Congress (the Government) decides

to increases G.
• Possible Central Bank (FEB, ECB…)

responses:
1. hold M constant
2. hold r constant
3. hold Y constant
In each case, the effects of the ∆ G are different
Response 1: hold M constant

If Congress raises G,
the IS curve shifts i
right LM1
If Fed holds M
constant, then LM
curve doesn’t shift. i2
i1
Results:
IS2
∆Y = Y 2 − Y1 IS1
Y
Y1 Y2
25
Response 2: hold i constant

If Congress raises G,
the IS curve shifts i LM1
right
LM2
To keep r constant,
Fed increases M to i2
shift LM curve right. i1
Results: IS2
∆Y = Y 3 − Y1 IS1
∆i = 0 Y1 Y2 Y3
Y
Response 3: hold Y constant

If Congress raises G, LM2

the IS curve shifts i LM1
right
To keep Y i3
constant, Fed i2
reduces M to shift i1
LM curve left. IS2
Results: IS1
∆Y = 0 Y
Y1 Y2
26
Using a Policy Mix
The two policies are not independent, as they both

affect the endogenous variables:
The interest rate i

Income Y
Hence the idea of a policy mix…
Examples of policy mix issues

The good: the Clinton deficit reduction in 1993,
The bad: the German reunification in 1992,
The current debate on the “liquidity trap”,
U.S. recession of 2001
The Clinton-Greenspan Policy Mix
1992 Clinton elected

Concern over federal budget
This suggest a fiscal contraction

By 1998 the deficit was eliminated
The problem, however, was that the US was just emerging
from a recession, and a fiscal contraction is recessionary
Table Selected Macro Variables for the United States, 1991-1998

1991 1992 1993 1994 1995 1996 1997 1998
Budget surplus (% of GDP) −3.3 − 4.5 − 3.8 − 2.7 − 2.4 − 1.4 − 0.3 0.8
(minus sign = deficit)
GDP growth (%) −0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7
Interest rate (%) 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8
27
The Clinton-Greenspan Policy Mix
The Clinton deficit reduction in 1993

1. Clinton decides to reduce the US
deficit (by increasing taxes) , which
Interest rate i
shifts IS to the left

LM
2. At the same time, Alan Greenspan
increases money supply in order to
stimulate output
LM’
i1 3. The end result is that output is held
constant, with a strong fall in interest
rates
i2
IS
i3
IS’
German reunification
1990: one country

Huge increase in G, on the east
Bundesbank worried about inflation intervened to slow demand
Selected Macro Variables for West Germany, 1988-1991

1991 1992 1993 1994
GDP growth (%) 3.7 3.8 4.5 3.1
Investment growth (%) 5.9 8.5 10.5 6.7
Budget surplus (% of GDP) −2.1 0.2 −1.8 −2.9
(minus sign = deficit)
Interest rate (%) 4.3 7.1 8.5 9.2
28
German reunification
The German reunification in 1992 1. The German reunification resulted in

a large shift of IS to the right, mainly
Interest rate i
because of the extra government

spending and increase in consumption

LM’ from the ex DDR
2. At the same time, the Bundesbank

drastically reduced money supply due
LM to inflation fears, as the ostmark/DM
exchange rate had been set at 1 for 1
i3 due to political reasons
i2 3. The end result of this lack of

IS’ coordination is that output was slightly
reduced, with a large increase in
i1 interest rates.
IS
Investment is not sensitive to the interest rate

If investment does not respond to interest rate changes

(the IS curve is steep),
monetary policy in ineffective in changing output.
Liquidity trap
If increases in the money supply
fail to lower interest rates,
monetary policy is ineffective in increasing output.
29
CURRENT LIQUIDITY TRAP?
1. The subprime-based financial crisis

has frozen credit markets as well as
Interest rate i
depressed consumption. This has

LM
caused a large fall in investment,

shifting IS to the left
2. The central bank have responded by

injecting large amounts of liquidity in
LM’ the markets, and making credit easily
available (“Quantitative easing”). This
pushes LM to the right.
i1 3. But these policies have had no

effect, and the rate of interest is
practically zero
i2
IS 3. The only way out is a large fiscal
IS’ policy push.
The U.S. Recession of 2001

The U.S. Growth Rate, 1999:1 to 2002:4
30
The Federal Funds Rate, 1999:1 to 2002:4

U.S. Federal Government Revenues and Spending (as

Ratios to GDP), 1999:1 to 2002:4
31

What happened in 2001 was the following:
The decrease in investment demand led to a sharp

shift of the IS curve to the left, from IS to IS’.
The increase in the money supply led to a downward

shift of the LM curve, from LM to LM’.
The decrease in tax rates and the increase in spending

both led to a shift of the IS curve to the right, from IS’’
to IS’.
32
Business Economics and Organization – prof. Francesco Venuti Other Theories
What is the Fed’s policy instrument?
What the newspaper says:

“the Fed lowered interest rates by one-half point today”

What actually happened:
The Fed conducted expansionary monetary policy to shift
the LM curve to the right until the interest rate fell 0.5
points.
The Fed targets the Federal Funds rate:

it announces a target value,
and uses monetary policy to shift the LM curve
as needed to attain its target rate.
33
What is the Fed’s policy instrument?
Why does the Fed target interest rates

instead of the money supply?

1) They are easier to measure than the money
supply
2) The Fed might believe that LM shocks are more
prevalent than IS shocks. If so, then targeting the
interest rate stabilizes income better than targeting
the money supply.
The Great Depression
240 30
Unemployment
(right scale)
220 25
billions of 1958 dollars
percent of labor force
200 20
180 15
160 10
Real GNP
140 (left scale) 5
120 0
1929 1931 1933 1935 1937 1939
34
The Spending Hypothesis:
Shocks to the IS Curve
Was the Great Depression caused by “shocks” to the IS curve or “shocks”

to the LM curve?
The “Spending Hypothesis” asserts that the Depression was largely

due to an exogenous fall in the demand for goods & services -- a
leftward shift of the IS curve
evidence:
output and interest rates both fell, which is what a leftward IS
shift would cause
A collapse in spending caused the IS curve to shift to the left.

The stock market crash of 1929. This reduced wealth and increased
uncertainty, inducing consumers to save more of their wealth and
consume less.
Over-investment in 1920s led to a fall in investment.
The Spending Hypothesis:

Reasons for the IS shift
Stock market crash ⇒ exogenous ↓C

Oct-Dec 1929: S&P 500 fell 17%
Oct 1929-Dec 1933: S&P 500 fell 71%
Drop in investment
“correction” after overbuilding in the 1920s
widespread bank failures made it harder to obtain financing for
investment
Contractionary fiscal policy
in the face of falling tax revenues and increasing deficits,
politicians raised tax rates and cut spending
35
The Money Hypothesis:
A Shock to the LM Curve
Friedman and Schwartz argue that contraction in the money

supply caused the LM curve to shift to the left.
The MONEY HYPOTHESIS asserts that the Depression was

largely due to huge fall in the money supply
evidence:
M1 fell 25% during 1929-33.
Prices fell from 1929 to 1933 by 25%.
But, two problems with this hypothesis:

1. P fell even more, so M/P actually rose slightly during 1929-
1931.
2. nominal interest rates fell, which is the opposite of what would
result from a leftward LM shift.
The Money Hypothesis Again:

The Effects of Falling Prices
asserts that the severity of the Depression was due to a huge

deflation:
P fell 25% during 1929-33.
This deflation was probably caused by

the fall in M, so perhaps money played
an important role after all.
In what ways does a deflation affect the economy?
36
Some exercises and revision (1)
Consider a closed economy, described by the following equations:

C = 200 + 0,8(Y-T) T = 200
I = 410 – 30i G = 200

L = 0,40Y – 20i M/P = 500
1) Find out the values of general equilibrium in terms

of income and interest rate.
2) What happens to the equilibrium if the Government
decides to increase its expenditure of 20 (billions)?
How much is the CROWDING OUT?
Explain both with words and with algebra.
In an economy we know that, according to the Central Bank, the

amount of money supply is 225.000 millions of Euro. We know
that money sensibility to income is 0,6 and to interest rate is
4.000.
Derive the LM equation and discuss the level of the interest rate
when income is 400.000.
What happens in the money market if income increase to 500.000?
Why? Explain detailed both with words and with algebra.
37
Consider a closed economy, described by the following equations:

C = 15.000 + 0,9(1-t)Y + 0,9TR t = 0,25
TR = 20.000 G = 80.000
I = 100.000 – 4.000i
1) Derive and define the IS equation.

2) Explain what happens if the Government decides to
increase unilateral transfer to families of 3.000.
In a country private saving is greater than

private investment for 10 billions and taxes
exceed government spending for 6 billions.

What happens to the trade balance?
38
The IS-LM model
in the OPEN ECONOMY
Openness in Goods and Financial Markets
Openness has three distinct dimensions:
1. Openness in goods markets. Consumers and

firms can choose between domestic goods and

foreign goods. In no country (except in some areas
as the EU) this choice is completely free of
restriction. Free trade restrictions include tariffs
(taxes on imported goods) and quotas (restriction
on the quantity of goods that can be imported).
39
1. Openness in goods markets.

2. Openness in financial markets. The possibility to

choose between domestic assets and foreign
assets. Capital controls place restrictions on the
ownership of foreign assets. These restrictions are
rapidly disappearing in many countries and the
world financial markets are becoming more and
more closely integrated.
1. Openness in goods markets.

2. Openness in financial markets.
3. Openness in factor markets. The ability of firms

to choose where to locate production, and workers
to choose where to work. The North American
Free Trade Agreement (NAFTA), signed in 1992,
is an example of this.
40
Openness in Goods Markets
Exports and Imports
The TRADE BALANCE is the difference

between export and import (X-IM)
Exports = imports ⇔ trade balance

Exports > imports ⇔ trade surplus
Exports < imports ⇔ trade deficit

Exports and Imports
There are 2 kinds of goods:

TRADEABLE GOODS: goods that can be exported (ex.

cars, computers, …)
NONTRADEABLE GOODS: goods that can NOT be
exported (mainly services. Ex.: housing, haircuts,
medical services…)
A good index of openness is the proportion of aggregate

output composed of tradable goods — or goods that
compete with foreign goods in either domestic markets or
foreign markets.
41
Exports and Imports
Ratios of Exports to GDP for Selected OECD Countries, 2006
Country Export Ratio (%) Country Export Ratio (%)
United States 11 Switzerland 54

Japan 18 Austria 62
United Kingdom 30 Netherlands 80
Germany 48 Belgium 92
The main factors behind differences in export ratios are

geography and country size:
- Distance from other markets.
- Size also matters: The smaller the country, the more it
must specialize in producing and exporting only a few products
and rely on imports for other products.
- Raw materials availability
Can Exports Exceed GDP?
Countries can have export ratios larger

than the value of their GDP because

exports and imports may include exports
and imports of intermediate goods.
42
The Choice between Domestic Goods and Foreign Goods
When goods markets are open, domestic consumers must

decide not only how much to consume and save, but also
whether to buy domestic goods or to buy foreign goods.
Central to the second decision is the price of domestic

goods relative to foreign goods, or the real exchange rate.

Nominal Exchange Rates
Nominal exchange rates between two currencies can be quoted
in one of two ways:
As the price of the domestic currency in terms of the

foreign currency (ex. for EU 1€ = 1,2 US$)
As the price of the foreign currency in terms of the

domestic currency (ex. for EU 1US$ = 0,8 €)
NOTE: there is no agreed-upon rule among economists or

newspapers as to which of the two definitions to use. You
will encounter both. Always check which definition is used!
43
WE use the nominal exchange rate as the price of the

foreign currency in terms of the domestic currency.
An appreciation of the domestic currency is an

increase in the price of the domestic currency in
terms of the foreign currency, which corresponds
to a increase in the exchange rate.
A depreciation of the domestic currency is a decrease

in the price of the domestic currency in terms of the
foreign currency, or a decrease in the exchange rate.

When countries operate under fixed exchange rates, that

is, maintain a constant exchange rate between them, two
other terms used are:
Revaluations, rather than appreciations, which are

increases in the exchange rate, and
Devaluations, rather than depreciations, which are

decreases in the exchange rate.
44
From Nominal to Real Exchange Rates
BUT…
if we are interested in the choice
between domestic goods and foreign goods,

the NOMINAL EXCHANGE RATE gives us only
part of the information we need, because tells
us only about movements in the relative price of
the two currencies.
The question is not only how many Dollars you

will get in exchange for your Euro, but how
much goods will cost in the USA relative to how
much they cost in Europe.

Let’s look at the real exchange rate between the United
States and Italy.
If the price of a Alfa Romeo in Italy is 50,000€,

and 1 Euro is worth 1,2 dollars, then the price of a
Alfa in dollars is 50,000€ X 1,2 = $60,000.
If the price of a Cadillac in the US is $40,000,

then the price of the Alfa in terms of Cadillac (that
is the real exchange rate between the United
States and Italy) would be $60,000 / $40,000 =
1,5
To generalize this example to all of the goods in the

economy, we use a price index for the economy, or the
GDP deflator.
45
The Construction of the Real Exchange Rate
Price of italian goods in Euro: P Price of italian goods in Dollars:

ExP Real Exchange
Rate
Price of US goods in Dollars: P*
EP
ε =
1. P = price of Italian goods in euro P *
2. P* = price of US goods in dollars
EP
ε =
P *

Like nominal exchange rates, real exchange rates move
over time:
An increase in the relative price of domestic goods in

terms of foreign goods is called a real appreciation,
which corresponds to an increase in the real exchange
rate, ε.
A decrease in the relative price of domestic goods in

terms of foreign goods is called a real depreciation,
which corresponds to a decrease in the real exchange
rate, ε.
46
Openness in Financial Markets

The Balance of Payments
The balance of payments account summarizes a

country’s transactions with the rest of the world.
Transactions above the line are current account

transactions. Transactions below the line are
capital account transactions.
The current account balance and the capital

account balance should be equal, but because of
data gathering errors they don’t. For this reason,
the account shows a statistical discrepancy.
47
Table 18-3 The U.S. Balance of Payments, 2006 (in billions of U.S. dollars)
Current Account
Exports 1,436
Imports 2,200
Trade balance (deficit = −) (1) -763
Investment income received 620
Investment income paid 629
Net investment income (2) -9
Net transfers received (3) -84
Current account balance (deficit = -) (1) + (2) + (3) -856
Capital Account
Increase in foreign holdings of U.S. assets (4) 1,764
Increase in U.S. holdings of foreign assets (5) 1,049
Capital account balance (deficit = -) (4) − (5) 715
Statistical discrepancy 141

The Current Account
The transactions above the line record payments to and
from the rest of the world are called current account

transactions:
The first two lines record the exports and imports of

goods and services (-> Trade BALANCE)
U.S. residents receive investment income on their

holdings of foreign assets and vice versa.
Countries give and receive foreign aid; the net value

is recorded as net transfers received.
48
The Current Account
The sum of net payments in the current
account balance can be positive, in which

case the country has a current account
surplus, or negative—a current account
deficit.

The Capital Account
Transactions below the line are called capital account
transactions.
The capital account balance, also known as net capital

flows can be positive (negative) if foreign holdings of U.S.
assets are greater (less) than U.S. holdings of foreign assets,
in which case there is a capital account surplus (deficit).
Negative net capital flows are called a capital account
deficit.
The numbers for current and capital account transactions are

constructed using different sources; although they should give
the same answers, they typically do not. The difference
between the two is call the statistical discrepancy.
49
The Choice between Domestic and Foreign Assets
The decision whether to invest abroad or at home

depends not only on interest rate differences, but
also on your expectation of what will happen to

the nominal exchange rate.
Figure 18 - 6
Expected Returns from
Holding One-Year U.S.
Bonds or One-Year U.K.
Bonds

If both U.K. bonds and U.S. bonds are to be held, they

must have the same expected rate of return, so that the
following arbitrage relation must hold:
 1 
(1 + i ) = ( E )(1 + i ) 
*
t t t e
E  t +1
Rearranging the equation, we obtain the uncovered

interest parity relation, or interest parity condition:
 E 
(1 + i ) = (1 + i ) 
*

t
t t e
E  t +1
50
The assumption that financial investors will hold

only the bonds with the highest expected rate of
return is obviously too strong, for two reasons:
It ignores transaction costs.
It ignores risk.
GDP versus GNP: The Example of Kuwait
Gross domestic product (GDP) is the measure that corresponds

to value added domestically.
Gross national product (GNP) corresponds to the value added by

domestically owned factors of production.
Table 1 GDP, GNP, and Net Factor
Payments in Kuwait, 1989-1994
Year GDP GNP Net Factor Payments
1989 7,143 9,616 2,473
1990 5,328 7,560 2,232
1991 3,131 4,669 1,538
1992 5,826 7,364 1,538
1993 7,231 8,386 1,151
1994 7,380 8,321 941
Note: All numbers are in millions of Kuwaiti dinars. 1 dinar =
$3.67 (2007).
Source: IMF International Financial Statistics.
51
Interest Rates and Exchange Rates
The relation between the domestic nominal interest rate,

the foreign nominal interest rate, and the expected rate of
depreciation of the domestic currency is stated as:
(1 + i ) *
(1 + i ) = t
[1 + ( E − E ) / E )]
t e
t +1 t t
A good approximation of the equation above is given by:
−E
e
i ≈i − E
*
t +1 t
t t
E t

−E
e
i ≈i − E
*
t +1 t
t t
E t
This is the relation you must remember:

Arbitrage implies that the domestic interest rate must be
(approximately) equal to the foreign interest rate plus the expected
depreciation rate of the domestic currency.
E =E i = i
e *
If t +1 t then t t
52
Should you hold U.K. bonds or U.S. bonds?

It depends whether you expect the pound to depreciate

vis-á-vis the dollar over the coming year.
If you expect the pound to depreciate by more then

3.0%, then investing in U.K. bonds is less attractive than
investing in U.S. bonds.
If you expect the pound to depreciate by less than 3.0%

or even to appreciate, then the reverse holds, and U.K.
bonds are more attractive than U.K. bonds.
Conclusions and a Look Ahead
We have set the stage for the study of an open economy:
The choice between domestic goods and foreign

goods depends primarily on the real exchange rate.
The choice between domestic assets and foreign

assets depends primarily on their relative rates of
return, which depend on domestic interest rates and
foreign interest rates, and on the expected
depreciation of the domestic currency.
53
The IS Relation in an Open Economy
Now we must be able to distinguish between the domestic

demand for goods and the demand for domestic goods.
Some domestic demand falls on foreign goods, and some

of the demand for domestic goods comes from foreigners.

The Demand for Domestic Goods
In an open economy, the demand for domestic goods is given
by:
Z ≡ C + I + G − IM / ε + X
The first three terms—consumption, C, investment, I, and

government spending, G—constitute the domestic demand for
goods.
Until now, we have only looked at C + I + G. But now

we have to make two adjustments:
First, we must subtract imports.
Second, we must add exports.
54
The Determinants of C, I, and G
Domestic Demand:
C + I + G = C (Y − T ) + I (Y , r ) + G
( + ) (+,-)
The real exchange rate affects the composition
of consumption and investment, but not the overall
level of these aggregates.

The Determinants of Imports
A higher real exchange rate leads to higher imports, thus:
IM = IM (Y , ε )
( + ,+ )
An increase in domestic income, Y, leads to an increase

in imports.
An increase in the real exchange rate, ε , leads to an

increase in imports, IM.
55
The Determinants of Exports
Let Y* denote foreign income, thus for exports we write:

X = X (Y * , ε )
( + ,− )
An increase in foreign income, Y*, leads to an increase

in exports.
An increase in the real exchange rate, ε , leads to a

decrease in exports.
Equilibrium Output and the Trade Balance
The goods market is in equilibrium when domestic output

equals the demand – both domestic and foreign – for
domestic goods:
Y =Z
Collecting the relations we derived for the components of

the demand for domestic goods, Z, we get:
Y = C (Y − T ) + I (Y , r ) + G − IM (Y , ε ) / ε + X (Y *, ε )
56
Increases in Demand, Domestic or Foreign
Fiscal Policy Revisited
We have derived two basic results so far:
An increase in domestic demand leads to an

increase in domestic output, but leads also to a
deterioration of the trade balance.
An increase in foreign demand leads to an

increase in domestic output and an improvement
in the trade balance.
Increases in Demand, Domestic or Foreign

Fiscal Policy Revisited
The so-called G7 – the seven major countries of
the world – meet regularly to discuss their
economic situation; the communiqué at the end of
the meeting rarely fails to mention coordination.

The fact is that there is very limited macro-
coordination among countries. Here’s why:
Some countries might have to do more than

others and may not want to do so.
Countries have a strong incentive to promise

to coordinate, and then not deliver on that
promise.
57
Depreciation, the Trade Balance, and Output
Recall that the real exchange rate is given by :

EP
ε≡
P *
In words:
The real exchange rate, ε
, is equal to the nominal
exchange rate, E, times the domestic price level, P,
divided by the foreign price level, P*.
Depreciation, the Trade Balance and Output

Depreciation and the Trade Balance:
The Marshall–Lerner Condition
NX = X (Y , ε ) − IM (Y , ε ) / ε
As the real exchange rate ε enters the right side of the

equation in three places, this makes it clear that the real
depreciation affects the trade balance through three
separate channels:
Exports, X, increase.
Imports, IM, decrease
The relative price of foreign goods in terms of domestic

goods, 1/e, increases.
58
Depreciation, the Trade Balance and Output
Depreciation and the Trade Balance:
The Marshall–Lerner Condition
The Marshall-Lerner condition is the condition

under which a real depreciation (a decrease in ε)

leads to an increase in net exports.
Depreciation, the Trade Balance, and Output

The Effects of a Depreciation
Let’s summarize: The depreciation leads to a

shift in demand, both foreign and domestic,
toward domestic goods. This shift in demand
leads in turn to both an increase in domestic
output and an improvement in the trade balance.
59
Looking at Dynamics: The J-Curve
A depreciation may lead to an initial deterioration of

the trade balance; ε increases, but neither X nor IM
adjusts very much initially.
Eventually, exports and imports respond, and

depreciation leads to an improvement of the trade
balance.
Looking at Dynamics: The J-Curve

The J-Curve
A real depreciation leads
initially to a deterioration and
then to an improvement of the
trade balance.
60
Saving, Investment, and the Trade Balance
The alternative way of looking at equilibrium from the

condition that investment equals saving has an important
meaning:
Y = C + I + G − IM / ε + X
Subtract C + T from both sides and use the fact that
private saving is given by S = Y – C – T to get
S = I + G − T − IM / ε + X
Use the definition of net exports, NX ≡ X − IM /ε , and
reorganize, to get:
NX = S + (T − G ) − I
Saving, Investment, and the Trade Balance
NX = S + (T − G ) − I
From the equation above, we conclude:
An increase in investment must be reflected in either

an increase in private saving or public saving, or in a
deterioration of the trade balance.
An increase in the budget deficit must be reflected in an

increase in either private saving, or a decrease in investment,
or a deterioration of the trade balance.
A country with a high saving rate must have either a high

investment rate or a large trade surplus.
61
The U.S. Trade Deficit: Origins and Implications
Table 1 Average Annual Growth Rates in the United States,

the European Union, and Japan since 1991
(percent per year)
1991 to 1995 1996 to 2000 2001 to 2003
United States 2.5 4.1 3.4
European Union 2.1 2.6 1.6
Japan 1.5 1.5 1.6

Figure 1 U.S. Net Saving and Net Investment since 1996 (percent of GDP)
62
What Happens Next?

There are three implications:
The U.S. trade and current account deficits will

decline in the future.
This decline is unlikely to happen without a real
depreciation.
Most likely, this depreciation will take place when
foreign investors become reluctant to lend to the
United States at the rate of $800 billion or so per
year.
Output, the Interest Rate and the Exchange

Rate
The model developed as an extension of the open

economy IS-LM model is known as the Mundell-
Fleming model.
The main questions we try to solve are:
What determines the exchange rate?
How can policy makers affect exchange rates?
63
Equilibrium in the Goods Market
Equilibrium in the goods market can be described by

the following equations:
Y = C (Y − T ) + I (Y , r ) + G − IM (Y , ε ) / ε + X (Y , ε ) *
( + ) ( + ,− ) ( + ,+ ) ( + ,− )
NX (Y , Y , ε ) ≡ X (Y , ε ) − IM (Y , ε ) / ε
* *
Y = C (Y − T ) + I (Y , r ) + G + NX (Y , Y , ε ) *
( + ) ( + ,− ) (− + − )
Equilibrium in the Goods Market
Consumption, C, depends positively on disposable

income, Y - T.
Investment, I, depends positively on output Y, and

negatively on the real interest rate, r.
Government spending, G, is taken as given.
The quantity of imports, IM, depends positively on both

output, Y, and the real exchange rate ε .
Exports, X, depend positively on foreign output Y*, and

negatively on the real exchange rate ε .
64
PRICE and EXPECTATION
The IS-LM model is:

- A short run model
- A fix-price model
What happen if we consider prices and expectation?
65
The IS-LM model is:

- A short run model
- A fix-price model
What happen if we consider prices and expectation?
W = P e F ( u, z )
P = (1 + µ )W
P = P e (1 + µ ) F (u, z )
In words, the price level depends on the expected

price level and the unemployment rate. We assume
that µ and z are constant.
66
Express the unemployment rate in terms of output:
U L− N N Y
u= = = 1− = 1−
L L L L
Therefore, for a given labor force, the higher is output,

the lower is the unemployment rate.
Replace the unemployment rate in the equation obtained in

step one gives us the aggregate supply relation:
 Y 
P = P e (1 + µ ) F  1 − , z
 L 
In words, the price level depends on the expected price

level, Pe, and the level of output, Y (and also µ, z, and L,
but we take those as constant here).
67
Two important considerations:
An increase in output leads to an increase in the price level. This is

the result of four steps:
• An increase in output leads to an increase in employment. Y↑ ⇒ N ↑

• The increase in employment leads to a decrease in unemployment
and therefore to a decrease in the unemployment rate.
N↑ ⇒ u ↓
• The lower unemployment rate leads to an increase in the nominal
wage.
• The increase in the nominal wage leads to an increase in the prices

set by firms and therefore to an increase in the price level.
W↑ ⇒ P ↑
The second consideration is that:
An increase in the expected price level leads, one for

one, to an increase in the actual price level. This effect

works through wages:
• If wage setters expect the price level to be higher, they set a

higher nominal wage.
• The increase in the nominal wage leads to an increase in

costs, which leads to an increase in the prices set by firms and
a higher price level.
68
Business Economics and Organization – prof. Francesco Venuti Aggregate Supply
The Aggregate Supply

Curve
Given the expected price level,
an increase in output leads to
an increase in the price level. If
output is equal to the natural
level of output, the price level is
equal to the expected price
level.
Aggregate Supply
The AS curve has three properties that will prove useful in

what follows:
The aggregate supply curve is upward sloping. Put
another way, an increase in output, Y, leads to an

increase in the price level, P.
The aggregate supply curve goes through point A,
where Y = Yn and P = Pe.
An increase in the expected price level, Pe, shifts the
aggregate supply curve up. Conversely, a decrease in
the expected price level shifts the aggregate supply
curve down.
69
Aggregate Supply
Let’s summarize:
Starting from wage determination and price determination

in the labor market, we have derived the aggregate supply

relation.
This means that for a given expected price level, the price
level is an increasing function of the level of output. It is
represented by an upward-sloping curve, called the
aggregate supply curve.
Increases in the expected price level shift the aggregate

supply curve up; decreases in the expected price level shift
the aggregate supply curve down.
70

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The IS-LM model

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti

1. We looked at the GOODS MARKET

… we now look at goods and financial markets together

We look at the IS-LM model as developed by Hicks and

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 2

We already know that:

• the GOODS MARKET is in equilibrium when production (Y)

is equal to the demand for goods (Z or D). This condition is

• The DEMAND for goods is the sum of consumption (C),

• We assumed that consumption was a (linear) function of

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 3

The Goods Market and the IS Relation

In the simple model developed in the first part,

The equilibrium condition was then given by:

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 4

The main simplification of this first model was

Now, it’s time to abandon this simplification

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 5

The Goods Market and the IS Relation

Investment depends primarily on two factors:

The level of sales (+)

Consider a firm facing an increase in sales.

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 6

Investment depends primarily on two factors:

The level of sales (+)

The interest rate (-) (i or r)

Consider a firm deciding whether to buy a new machine. Suppose

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 7

The Goods Market and the IS Relation

Investment depends primarily on two factors:

Taking into account the investment relation, the

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 9

The Goods Market and the IS Relation

Note two characteristics of Z:

Because it’s assumed that the consumption and

Z is drawn flatter than a 45-degree line because it’s

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 10

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 11

The Goods Market and the IS Relation

Note two characteristics of Z:

Because it’s assumed that the

Z is drawn flatter than a 45-

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 12

We have drawn the demand relation (Z) for a

given value of the interest rate.

We now want to draw the relation between

What happens if the interest rate changes?

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 13

The Goods Market and the IS Relation

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 14

(b) Equilibrium in the goods

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 15

The Goods Market and the IS Relation

the initials IS stand for "IInvestment and Saving equilibrium"

the IS curve is a locus of points of equilibrium in the "real" (non-financial)

Business Economics and Organization – A.A. 2013/2014 – prof. Francesco Venuti 16