ECOS3997
Interdisciplinary Impact in Economics
Stream 1: Implications of Macroeconomic Policies
Lecture 2: Basic Model and the short-run Effects
of Macroeconomic policies
Semester 2, 2024
1
This lecture
• Equilibrium in goods markets
1- Consumption function and multiplier
2- Investment/savings (IS) approach
3- Application: Government spending multipliers
• Equilibrium in the financial market
1- Money demand and monetary policy
2- Liquidity/money (LM) approach
• IS-LM model and its implications in the short-run
• Reading:
• Blanchard chapter 3, 4, 5
• Articles (next page)
2
This lecture, cont
• Articles:
• Christiano, L., Eichenbaum, M., & Rebelo, S. (2011). When is the
government spending multiplier large?. Journal of Political
Economy, 119(1), 78-121.
• Corsetti, G., Meier, A., & Mu¨ller, G. J. (2012). What determines
government spending multipliers?. Economic Policy, 27(72),
521-565.
3
Short-run Effects
Economy in the short-run
• Year-to-year movements in output are primarily driven
by movements in aggregate demand
• Unemployment is negatively related to output
• Changes in demand can lead to a decrease in output (a
recession) or an increase in output (an expansion)
• Many prices are sticky (not fully flexible) at a
predetermined level
4
The Goods market
5
Goods market: GDP components
• Consumption: purchases of goods and services, C
• Investment: purchases of capital goods, I
– non-residential investment (plant and equipment)
– residential investment (new houses, etc)
– Inventory investment = production − sales
• Government Spending: purchases of goods and services, G
– does not include transfer payments
– does not include interest payments on the government debt
• Net exports (or trade balance): exports minus imports,
X − IM
6
Composition of U.S. GDP, 2018
Source: Survey of Current Business, February 2019, Table 1-1-5
7
Basic model: Demand for goods (and services)
• Total demand for goods Z written
Z ≡ C + I +G+X − IM
• For simplicity, we often assume a closed economy
X = IM = 0 so
Z ≡ C + I +G
• C as a linear function with key behavioral assumption in
short-run (where YD = Y − T ):
C is a function of aggregate disposable income YD → C (YD)
• Take I as exogenous (I¯) or alternatively, endogenous
• Take G, T as exogenous where G and T describe fiscal policy
8
Consumption function
• For simple algebra, linear consumption function
C = C (YD) = c0 + c1YD, c0, c1 > 0 and c1 < 1
c1 is the marginal propensity to consume (MPC)
9
Investment function
• Case 1: Investment demand as an exogenous variable
(taken as given), I¯
or alternatively,
investment demand as an endogenous variable
• Case 2: Let investment depend on the aggregate level of
sales Y and interest rate i
I = I (Y, i) = b0+ b1Y − b2i, b0, b1, b2 > 0 and b1 < 1
I depends positively on Y and negatively on i
10
Equilibrium in the goods market
• In the short run, demand for goods Z determines
production/output Y
Z = Y
• Demand for goods is a function of aggregate income Y
Z ≡ c0 + c1(Y − T ) + I¯ or I(Y, i) +G
• Case 1: need to solve
Y = c0 + c1(Y − T ) + I¯ +G
(one equation in one unknown, Y )
11
Case 1: Equilibrium output, given I¯
• Solution
Y =
1
1− c1
(
c0 − c1T + I¯ +G
)
• Product of two terms
⋄ multiplier
1
1− c1
⋄ autonomous spending
c0 − c1T + I¯ +G
• Multiplier is the marginal effect of a change in autonomous
spending on output
12
Case 2: Equilibrium output, given I (Y, i)
• Case 2: Plugging in for consumption and investment
Z ≡ c0 + c1(Y − T ) + b0 + b1Y − b2i+G
• Solution
Y =
1
1− c1 − b1 (c0 − c1T + b0 − b2i+G)
(assume c1 + b1 < 1), Y depends negatively on i
• Two equivalent ways to state equilibrium in goods market:
output = demand
investment = savings (private + public)
13
IS curve
Investment/Savings (IS) curve
• combinations of {Y, i} consistent with goods market
equilibrium
• changes in fiscal policy G,T shift curve in or out
• one of two building blocks of IS-LM model
14
Equilibrium in the goods market
15
Effect of a change in autonomous spending
16
The multiplier
• Consider increase in G by one unit.
Differentiating gives
dY
dG
=
1
1− c1 > 1
• Intuition
– 1st round increase in demand (Direct effect)
* triggers equal increase in output
* triggers equal increase in income
– 2nd round increase in demand (Indirect effect)
* 1st round increase times c1 in output
– After n rounds:
1 + c1 + c
2
1 + · · ·+ cn−11
17
The multiplier
• Multiplier is the limit of this sum
lim
n→∞
(
1 + c1 + c
2
1 + · · ·+ cn−11
)
=
1
1− c1
• Examples:
– if c1 = 0.5, then multiplier is 1/0.5 = 2.00
– if c1 = 0.8, then multiplier is 1/0.2 = 5.00
– a reasonable estimate of c1 in Australia today: 0.5
• Increase in output is greater than increase in government
spending by factor equal to the multiplier
– multiplier is a key parameter in short-run macroeconomics
– the more sensitive consumption is to income, the larger the
multiplier
18
Application:
Government spending multipliers
• Corsetti, G., Meier, A., & Mu¨ller, G. J. (2012). What determines
government spending multipliers?. Economic Policy, 27(72), 521-565.
• Christiano, L., Eichenbaum, M., & Rebelo, S. (2011). When is the
government spending multiplier large?. Journal of Political Economy,
119(1), 78-121.
19
Application:
Government spending multipliers
• To stimulate the economy, an expansionary fiscal policy
may be effective in terms of boosting the economic activities
• Long-standing debate on the size of the fiscal multiplier (or
government spending multipliers)
20
Corsetti, Meier, and Muller (2012)
What determines government spending multipliers?
• This paper carries out
• an empirical exploration into
the determinants of government spending multipliers
by studying how the fiscal transmission mechanism
depends on the economic environment
21
Corsetti, Meier, and Muller (2012)
What determines government spending multipliers?
• The authors argue that the multipliers vary based on
• Economic environment:
1- Exchange rate regimes: flexible v.s. peg
2- State of public finances: strong v.s. weak public finances
(i.e., high government debt to GDP ratio)
3- Health of the financial sector: normal times v.s. financial crisis
22
Corsetti, Meier, and Muller (2012)
What determines government spending multipliers?
• Conduct an empirical analysis of 17 OECD countries
• Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Ireland, Italy, Japan, the Netherlands, Norway, Portugal, Spain,
Sweden, the United Kingdom, and the United States
• Sample period from 1975 to 2008
• Trace the effects of government spending in different
economic environments
23
Corsetti, Meier, and Muller (2012)
What determines government spending multipliers?
• Estimate a fixed-effects panel regression:
xt,i = αi + µitrendt + χixt−1,i + σ1ϵˆt,i + σ2ϵˆt−1,i + σ3ϵˆt−2,i
+σ4ϵˆt−3,i + κ1(ϵˆt,i × dt,i) + κ2(ϵˆt−1,i × dt−1,i)
+κ3(ϵˆt−2,i × dt−2,i) + κ4(ϵˆt−3,i × dt−3,i)
+λ1dt,i + λ2dt−1,i + λ3dt−2,i + λ4dt−3,i + ut,i
(1)
where
xi,t: macroeconomic variables of interest (e.g., output),
σ, κ: capture dynamic effect upto 3 years,
dt,i: dummy variable indicating a certain economic environment in a
particular year (e.g., currency peg or financial crisis)
24
Corsetti, Meier, and Muller (2012)
25
Corsetti, Meier, and Muller (2012)
26
Corsetti, Meier, and Muller (2012)
• In general, a positive government spending shock increases
output across 17 OECD countries (i.e., 0.7 on average)
• Government spending multipliers vary depending on
economic environment
1- Under the fixed (or peg) exchange regime, output multiplier is
positive and larger than the flexible exchange rate
• Mundell-Fleming model (more in Week 7)
• fiscal expansion → ↑ ex. rate → to keep from rising, CB ↑ Ms
27
Fixed v.s. Flexible exchange rate
28
Corsetti, Meier, and Muller (2012)
• In general, a positive government spending shock increases
output across 17 OECD countries
• Government spending multipliers vary depending on
economic environment
2- In the case of weak public finances (i.e., Govt debt > 100% of
GDP), the impact response of output is lower
• fiscal expansions at high levels of debt may increase the
likelihood of a sharp future retrenchment
29
Weak v.s. Sound Public Finances
30
Corsetti, Meier, and Muller (2012)
• In general, a positive government spending shock increases
output across 17 OECD countries
• Government spending multipliers vary depending on
economic environment
3- During the period of financial crisis, the response of output to
a fiscal expansion is positive and larger than normal times
• In deep recessions, when monetary policy is limited by the
zero lower bound on interest rates, fiscal policy becomes
more impactful
31
Financial Crisis v.s. Normal times
32
Christiano, Eichenbaum, and Rebelo (2011)
When Is the Government Spending Multiplier Large?
• Barro (1981): 0.8, Ramey (2011): 1.2
• Investigate the size of the multiplier in a dynamic stochastic
general equilibrium (DSGE) model
• This paper argues that the government spending multipliers
can be much larger than one when the zero lower bound on
the nominal interest rate binds
33
Christiano, Eichenbaum, and Rebelo (2011)
34
The Financial market
35
Financial market: Money demand
• Money M (e.g. currency, checkable deposits) pays no interest.
• Bonds B pay interest i. Cannot be used for transactions
• Two assumptions
1- demand increasing in level of transactions; transactions
proportional to nominal income $Y ≡ PY
2- demand decreasing in opportunity cost i of holding money
• Money demand Md ($Y, i)
Md = PY︸︷︷︸
≡$Y(+)
×L(i)︸︷︷︸
(−)
where L(i) function is decreasing in the interest rate i
dL
di
< 0
36
Equilibrium in the financial market
• Money supply M s =M given by Reserve Bank
• Equilibrium in money markets Md =M s so
M︸︷︷︸
Money supply
= PY × L(i)︸ ︷︷ ︸
Money demand
Determines interest rate i for given M & nominal income PY
or equivalently,
• Money supply (in real terms) = Money demand (in real terms)
M
P
= Y L(i) [sometimes,
M
P
= L(Y, i) instead]
• Reserve Bank sets i = i¯ (i.e., Horizontal LM curve)
37
LM curve
Liquidity/Money (LM) curve
• combinations of {Y, i} consistent with financial market
equilibrium
• changes in money demand and money supply
Md,Ms shift curve in or out
• one of two building blocks of IS-LM model
38
The IS-LM Model and Implications
39
Equilibrium in goods and financial markets
When the IS curve intersects the LM curve, both goods and financial markets
are in equilibrium. Simultaneously determines Y and i.
40
The IS and LM curves
• IS curve
Any point on the IS curve is consistent with equilibrium in
the goods market
• LM curve
Any point on the LM curve is consistent with equilibrium in
financial markets
• Each curve is an aggregate equilibrium relationship, not
analogous to micro demand and supply curves
• General equilibrium achieved at the intersection of IS and LM
curves
41
Fiscal policy
• Fiscal contraction, decrease in G and/or increase in T
• Fiscal expansion, increase in G and/or decrease in T
• Affects the position of the IS curve, not the LM curve
• NOTE: still affects financial markets, through money demand
42
Fiscal contraction and the goods market
Increase in taxes from T to T ′, shifts IS curve to left from IS to IS′.
43
Fiscal contraction and the goods market
• Start at point A. Output Y and interest rate i¯ such that
supply of goods equals demand for goods
• Taxes increase from T to T ′
• Increase in taxes lowers disposable income, lowers
consumption and so output (reinforced by multiplier effect)
• IS curve shifts to left from IS to IS′
• Position of LM curve unchanged. Movement along LM curve
• In new general equilibrium at point A′ output is lower
44
Monetary policy
• Monetary contraction, increase in i¯
• Monetary expansion, decrease in i¯
• Affects the position of the LM curve, not the IS curve
• NOTE: still affects goods markets, through demand for goods
45
Monetary expansion and general equilibrium
Decrease in interest rate from i¯ to i¯′, shifts LM curve down from LM to LM′.
46
Monetary expansion and general equilibrium
• Position of LM curve changes. Shifts down following decrease
in interest rate from i¯ to i¯′
• Position of IS curve unchanged. Movement along IS curve
• Fall in interest rates increases investment and so demand for
goods, output rises from Y to Y ′
47
Effectiveness of monetary and fiscal policy
• Generally, comparative effects of monetary or fiscal policy
depend on IS and LM curves
• Slope of IS curve: determines effectiveness of monetary policy
• Slope of LM curve: flat
48
Effectiveness of monetary policy



IS
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Output, Y

IS
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Output, Y
IS
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LM
LM’
Output, Y
LM
IS
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LM’
Output, Y
Left: Steep IS curve. Expansionary monetary policy reduces interest rates
from i to i′; only increases output by a small amount, from Y to Y ′.
Right: Flatter IS curve. Same expansionary monetary policy leads to a larger
increase in output.
49
Intuition for monetary policy effects
• IS curve is steep when investment demand is very
interest-insensitive
• If so, a given decrease in i leads to a small increase in
investment demand I and a small increase in output Y
• Effectiveness of monetary policy depends on
interest-sensitivity of investment demand
50
Fiscal policy or monetary policy
• Which policy tool is the most effective: G, T , or i?
• Fiscalists (Keynes, nowadays Krugman)
– Shifts in IS curve are more important in driving fluctuations
– Close to a liquidity trap, monetary policy is ineffective, but
fiscal policy is powerful
• Monetarists (Friedman)
– IS curve is relatively flat, monetary policy is powerful
– Consumption (durable) may also depend negatively on the
interest rate
• 1970s’ debate, back in 2010s
51
How well does the IS-LM model fit the facts?
Effects of an increase in the federal funds rate in US data.
In the short run, increase in interest rate leads to decrease in output and increase in
unemployment, but has little effect on the price level.
52
How well does the IS-LM model fit the facts?
Effects of an increase in government spending in US data.
In the short run, an increase in aggregate demand from higher government spending
induces output and consumption to go up.
53
Prompt for Week 3
• In no more than 500 words, explain the concept of the fiscal
multiplier (or government spending multiplier) as covered in
class. Discuss the factors that might cause variations in the
multiplier’s value, providing examples such as different
economic environments.