Lecture: US Economy and IS-LM Model

Overview of the US Economy

• Net Worth Trends: Generally a steady trend but declines during recessions.
  • During early COVID recession, net worth declined sharply due to falling asset prices.
  • Post-COVID, a dramatic rise in wealth due to asset price rallies (equity, housing).
• 2022 Asset Values: Decline in equity market but small relative to previous wealth buildup.

Relation to Aggregate Demand

• Increased Wealth: Consumers feel richer, tend to consume more, increasing aggregate demand.
• Corporate Investment: High real investment due to increased wealth.
• Income During COVID: Did not decline significantly; large government transfers increased savings.
• Saving Rates:
  • Spiked during COVID due to less spending opportunities.
  • Excess savings amounted to ~$2.7 trillion.
  • Current trend: Saving rates declining as people spend more now.

Current Economic Conditions

• Demand for Goods/Services: Strong demand due to pent-up savings and increased borrowing.
  • Credit card borrowing rising as excess savings deplete.
• Overheating Economy: High demand relative to supply leads to inflation pressures.
• Monetary Policy Reaction: FED tightens interest rates to cool the economy.

Understanding the IS-LM Model

• Purpose: To model aggregate demand and its reaction to policy.
• IS-LM Framework: Analyzes joint determination of output and interest rates in goods and financial markets.

IS Relation (Goods Market)

• Definition: Investment equal to Savings (I = S).
• Factors Influencing IS Curve:
  • Increased output leads to increased investment.
  • Higher interest rates lead to decreased investment.

LM Relation (Financial Market)

• Modern LM Curve: Horizontal, reflecting central banks' targeting of interest rates.
• Money Demand and Supply: Equilibrium achieved by adjusting money supply to maintain set interest rates.

Interaction of IS and LM Curves

• Equilibrium: Intersection of IS and LM curves determines the equilibrium output and interest rates.
• Shifts in Curves:
  • IS Curve shifts due to changes in fiscal policy, consumer sentiment, wealth, etc.
  • LM Curve shifts when central bank changes interest rate targets.

Policy Implications

• Fiscal Policy:
  • Contractionary policy (increased taxes, decreased government spending) shifts IS left, reducing output.
  • Expansionary policy shifts IS right, increasing output.
• Monetary Policy:
  • Central banks adjust money supply to maintain set interest rates, affecting equilibrium conditions.

Key Takeaway

• Understanding IS-LM dynamics is crucial for analyzing and predicting macroeconomic policy impacts on consumption, investment, and overall economic stability.