Macroeconomic Analysis and Policy

IS-LM Model

Sessions:17-18
Prof. Biswa Swarup Misra
 Learning Objectives
▪ Derive the IS curve
▪ Derive the LM curve
▪ How equilibrium is achieved simultaneously in
the Goods market and the Money market
▪ How equilibrium is restored when the economy
is not in equilibrium.

IS-LM Model Biswa Swarup Misra slide 1

 The IS curve

def: a graph of all combinations of r and Y that

result in goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:
Y = C (Y − T ) + I (r ) + G

IS-LM Model Biswa Swarup Misra slide 2

IS-LM Model Biswa Swarup Misra slide 3
 Deriving the IS curve
E E =Y E =C +I (r )+G
2

r  I E =C +I (r1 )+G

 E I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

IS-LM Model Biswa Swarup Misra slide 4

 Why the IS curve is negatively
sloped
▪ A fall in the interest rate motivates firms to
increase investment spending, which drives up
total planned spending (E ).
▪ To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.

IS-LM Model Biswa Swarup Misra slide 5

 Deriving IS Curve from Loanable Funds Model
▪ The IS curve can also be derived from the (hopefully now
familiar) loanable funds model .
▪ Recall, S = Y-C-G
▪ A decrease in income from Y1 to Y2 causes a fall in national
saving.
The fall in saving causes a reduction in the supply of loanable
funds. The interest rate must rise to restore equilibrium to the
loanable funds market.
Now we can see where the IS curve gets its name:
▪ When the loanable funds market is in equilibrium, investment
= saving.
▪ The IS curve shows all combinations of r and Y such that
investment (I) equals saving (S). Hence, “IS curve.”
IS-LM Model Biswa Swarup Misra slide 6
 The IS curve and the loanable funds
model
(a) The L.F. model (b) The IS curve

r S2 S1 r

r2 r2

r1 r1
I (r )
IS
S, I Y2 Y1 Y

IS-LM Model Biswa Swarup Misra slide 7

 Fiscal Policy and the IS curve
▪ We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
▪ Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…

IS-LM Model Biswa Swarup Misra slide 8

 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, 1 2

G  E  Y E =C +I (r1 )+G1
…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
IS shift equals r1

Y =
1
G Y
1− MPC IS1 IS2
Y1 Y2 Y

IS-LM Model Biswa Swarup Misra slide 9

 Shifting the IS curve: G
▪ The previous slide has two purposes. First, to show
which way the IS curve shifts when G changes. Second,
to actually measure the distance of the shift.
▪ We can measure either the horizontal or vertical distance
of the shift. The horizontal distance of the IS curve shift
is the change in Y required to restore goods market
equilibrium AT THE INITIAL INTEREST RATE when G is
raised.
▪ Since the interest rate is unchanged at r1, investment will
also be unchanged. This is why, in the upper panel, we
write “I(r1)” in the E equation for both expenditure curves
– to remind us that investment and the interest rate are
not changing.

IS-LM Model Biswa Swarup Misra slide 10

 Exercise: Shifting the IS curve
▪ Use the diagram of the Keynesian cross or
loanable funds model to show how an increase in
taxes shifts the IS curve.

▪ In case you are not too sure, you will

get a clear picture when we derive the
IS curve algebraically and discuss what
factors can shift the IS curve when we
discuss the effectiveness of fiscal and
monetary policy.
IS-LM Model Biswa Swarup Misra slide 11
 The Theory of Liquidity Preference

▪ Due to John Maynard Keynes.

▪ A simple theory in which the interest rate
is determined by money supply and
money demand.

IS-LM Model Biswa Swarup Misra slide 12

 Money supply
r
(M P)
s
The supply of interest
real money rate
balances
is fixed:

(M P) =M P
s

M/P
M P
real money
balances
IS-LM Model Biswa Swarup Misra slide 13
 Money demand
r
(M P)
s
Demand for interest
real money rate
balances:

(M P)
d
= L (r )

L (r )

M/P
M P
real money
balances
IS-LM Model Biswa Swarup Misra slide 14
 Equilibrium
r
(M P)
s
The interest interest
rate adjusts rate
to equate the
supply and
demand for
money: r1

M P = L(r ) L (r )

M/P
M P
real money
balances
IS-LM Model Biswa Swarup Misra slide 15
 How the Fed raises the interest rate
r
interest
To increase r, rate
Fed reduces M
r2

r1
L (r )

M/P
M2 M1 real money
P P balances
IS-LM Model Biswa Swarup Misra slide 16
CASE STUDY:
Monetary Tightening & Interest Rates
▪ Late 1970s:  > 10%
▪ Oct 1979: Fed Chairman Paul Volcker
announces that monetary policy
would aim to reduce inflation
▪ Aug 1979-April 1980:
Fed reduces M/P 8.0%
▪ Jan 1983:  = 3.7%
How do you think this policy change
would affect nominal interest rates?
IS-LM Model Biswa Swarup Misra slide 17
 Monetary Tightening & Rates, cont.
The effects of a monetary tightening
on nominal interest rates

short run long run

Quantity theory,
Liquidity preference
model Fisher effect
(Keynesian)
(Classical)

prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%

outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
 Real vs. Nominal Interest Rates

▪ Real Interest Rate = Nominal Interest Rate

- Inflation
▪ If inflation is positive, which it generally is,
then the real interest rate is lower than the
nominal interest rate.
▪ If we have deflation and the inflation rate is
negative, then the real interest rate will be
larger.

IS-LM Model Biswa Swarup Misra slide 19

 Nominal Interest Rates Rises or Falls
Following a Monetary Contraction?
▪ Since prices are sticky in the short run, the Liquidity
Preference Theory predicts that both the nominal and
real interest rates will rise in the short run. And in fact,
both did. (However, the inflation rate was not zero, and
in fact it increased, so the real interest rate didn’t rise as
much as the nominal interest rate did during the period
shown.)
▪ In the long run, the Quantity Theory of Money says that
the monetary tightening should reduce inflation. The
Fisher Effect says that the fall in  should cause an
equal fall in i.

IS-LM Model Biswa Swarup Misra slide 20

 Nominal Interest Rates Rises or Falls
Following a Monetary Contraction?
By January of 1983 (which is “the long run” from the
viewpoint of 1979), inflation and nominal interest rates
had fallen.
– (However, they did not fall by equal amounts. This
doesn’t contradict the Fisher Effect, though, as other
economic changes caused movements in the real
interest rate.)
▪ Lesson: The liquidity preference theory predicts the
movement of the nominal interest rates better in the short
run and the Fisher effects predicts the movements of the
nominal interest rates better in the medium to long run.

IS-LM Model Biswa Swarup Misra slide 21

 The LM curve

Now let’s put Y back into the money demand

function:
(M P)
d
= L (r ,Y )
The LM curve is a graph of all combinations of
r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
M P = L (r ,Y )

IS-LM Model Biswa Swarup Misra slide 22

 Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P
IS-LM Model Biswa Swarup Misra slide 23
 Why the LM curve is upward sloping

▪ An increase in income raises money demand.

▪ Since the supply of real balances is fixed, there
is now excess demand in the money market at
the initial interest rate.
▪ The interest rate must rise to restore equilibrium
in the money market.

IS-LM Model Biswa Swarup Misra slide 24

 How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L ( r , Y1 )

M2 M1 M/P Y1 Y
P P
IS-LM Model Biswa Swarup Misra slide 25
 Exercise: Shifting the LM curve

▪ Suppose a wave of credit card fraud causes

consumers to use cash more frequently in
transactions.
▪ Use the liquidity preference model
to show how these events shift the
LM curve.

IS-LM Model Biswa Swarup Misra slide 26

 Answer
This causes an increase in money demand. In
the Liquidity Preference diagram, the money
demand curve shifts up. Hence, at the initial
value of income, the interest rate must rise to
restore equilibrium in the money market.
As a result, the LM curve shifts up: each value of
income (such as the initial income) is associated
with a higher interest rate than before.

IS-LM Model Biswa Swarup Misra slide 27

 The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y
LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:

Y = C (Y − T ) + I (r ) + G IS
M P = L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income
IS-LM Model Biswa Swarup Misra slide 28
 The IS-LM Framework

▪ The equilibrium levels of real GDP and the

interest rate occur at the point where the IS and
LM curves intersect
▪ the economy is in equilibrium in both the goods
market and the money market

IS-LM Model Biswa Swarup Misra slide 29

 Figure - The IS-LM Diagram

Real
Interest
Rate, r
LM curve

Equilibrium
interest rate

IS curve

Equilibrium Real GDP, Y

real GDP
IS-LM Model Biswa Swarup Misra slide 30
 Figure - Off of the IS Curve

Real interest A relatively high real interest

rate, r rate means that planned
expenditure < production;
inventories are growing;
production is about to fall

S>I

A relatively low real

interest rate means
that planned expenditure
> production; inventories
are falling; production is IS Curve
about to rise
I>S
Equilibrium
real GDP

IS-LM Model Biswa Swarup Misra slide 31

 Figure - Off of the LM Curve
At this point money
demand Would be less
as interest rate remaining
Real interest the same, a lower income
rate, r level would dampen the
Transactions Demand
for money
Md<Ms
At this point money demand
Would be more as interest rate
remaining the same, a higher
income level would increase the
Transactions Demand for money
Md>Ms

LM Curve

Equilibrium
real GDP

IS-LM Model Biswa Swarup Misra slide 32

 Off-Equilibrium to Equilibrium in the
IS-LM framework
▪ Please refer to the distributed material from
Shapiro (Chapter-12) to supplement the class
room discussion on how starting from a
disequilibrium position the system moves
towards the equilibrium combination of Y and r

IS-LM Model Biswa Swarup Misra slide 33

 The Big Picture

Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve
IS-LM Model Biswa Swarup Misra slide 34
Effectiveness of Monetary and
Fiscal Policy in IS-LM
Framework
Learning Objectives

▪ The algebraic derivation of IS and LM curves.

▪ The factors which govern the slope of the IS and
LM curves
▪ The factors which shift the IS and LM curves.
▪ How to use the IS-LM model to analyze the
effects of shocks, fiscal policy, and monetary
policy
▪ How to derive the aggregate demand curve from
the IS-LM model
IS-LM Model Biswa Swarup Misra slide 36
 The IS Curve
▪
By definition, the IS curve is simply a plot in (i, Y) space
(with interest rates and GDP growth on the two axes)
comprising points where the goods market is in equili-
brium-here there is no shortage, or excess supply
(inventory) in the goods market.
▪ Ignoring the trade sector, the condition for equilibrium in
the goods market is IS: Y=C+I+G
▪ Substituting the expressions discussed earlier for
consumption, C = C + b*Y and capital investment, I = I0 –
f*i , we obtain:
▪ Y = (C0+ bY) + (I0 – f*i) + G
IS-LM Model Biswa Swarup Misra slide 37
 The IS Curve
▪ Simplifying, and solving for i, we get the IS curve:
▪ i=A/f - Y(1-b) / f -----------------(1)
▪ where A is simply a term for notational convenience
comprising consumer confidence C0, investor confidence
I0, and government spending, G (say G0).
▪ On close examination, we find equation (1) to be a
straight line presented in slope-intercept form in Fig. 1
(next slide) with intercept (A/f) and slope (1- b)/f.

IS-LM Model Biswa Swarup Misra slide 38

 Figure-1
IS Curve - Graphical Depiction
Interest
Rate

GDP

IS-LM Model Biswa Swarup Misra slide 39

 Some IS Exercises
1. How will the IS curve respond to a collapse in
investor confidence?
▪ As I0 falls, the intercept term (A/f) will fall. With
no change in the slope (b and f are held
constant), the IS undergoes a parallel drop from
ISo to IS1.
▪ The opposite holds true: a surge in investor
confidence (perhaps due to news of an
impending tax cut, or some such uplifting
announcement or expectation) will cause the IS
to shift up from ISo to IS2, again, without any
change in slope.
IS-LM Model Biswa Swarup Misra slide 40
 Some IS Exercises
2. How would the IS shift with a collapse in consumer
confidence ?
▪ The intercept term falls, dropping the IS curve from ISo to
ISj with no change in slope, since b and f are constants.
Similarly, a surge in consumer confidence results in the
IS shifting up from ISo to IS2 with no change in slope.
3. How will changes in government spending affect the IS
curve?
▪ Increases in government spending G will also increase
the intercept term (A/f), thereby shifting the IS up from
ISo to IS2. Cutbacks in government spending outlays will
cause the IS to shift down from ISo to 1St as G drops,
decreasing the intercept component. Once again, neither
of these shifts will cause the slope of the IS to vary.

IS-LM Model Biswa Swarup Misra slide 41

 Introducing Taxes into the IS Curve

▪ Let t be some average tax rate prevailing in the economy under

consideration.
▪ We now define CT as the after-tax consumption function given
by:
CT = C0 + bYD -------------(2)
▪ Where YD is the disposable (after-tax) income defined as:
▪ YD= Y(I- t)
▪ Substituting this expression for after-tax income into ( 2), we
obtain the consumption function incorporating a tax rate t:
▪ CT = C0 + bYD bY(1 - t)
IS-LM Model Biswa Swarup Misra slide 42
 Introducing Taxes into the IS Curve

▪ Using the equilibrium condition for the goods market and

the after-tax consumption function, we obtain the
expression for the IS curve with taxes.
i = A/f- [1- b(1- t) Y] /f (3)
We can see that the intercept term Alf is exactly the
same as with the ISo curve presented earlier in
expression in (1). But the slope in expression (3), [1- b(1
- t)] / f, now includes the tax rate t.
▪ The slope of the IS curve will be now larger with the
incorporation of the tax rate.

IS-LM Model Biswa Swarup Misra slide 43

 Some IS Exercises
4. If the tax rate were to be increased from some to = 35%. to
a higher rate t1 = 43%, how would the IS be affected?
▪ An increase in the tax rate with all other variables held
constant would increase the absolute value of the slope,
making the IS steeper from IS(to) to IS(t1). The intercept
term, however, does not specifically incorporate the tax
rate t; so, in the absence of any additional macroeconomic
changes, the intercept will remain the same. The final
result here will be a clockwise pivot in the IS
▪ A tax-cut from to to some lower rate t2 (30%, perhaps)
would decrease the absolute value of the slope term
causing the IS to be flatter without changing the intercept
term. In this case, the IS pivots counter-clockwise from
IS(to) to IS(t2) with the cut in taxes.
IS-LM Model Biswa Swarup Misra slide 44
 Some IS Exercises
▪ 5. How would the IS react to increases in tax rates in an
economy struggling to recover from a prolonged
recession? Or how would an economy, nervously eyeing
an approaching slowdown, react to tax increases?
▪ This extremely important IS exercise helps to explain part
of the problem faced by the Japanese economy in the
2000s. After struggling to recover from years of stagnation
and collapsed equity prices, the Japanese economy was
showing a glimmer of recovery in the mid-1990s when the
government, despite strong advice from policy makers
worldwide, increased tax rates in 1996 in a desperate
attempt to increase tax revenues. Consumer and investor
confidence, just about to stage a comeback, promptly
went into free-fall!

IS-LM Model Biswa Swarup Misra slide 45

 Some IS Exercises
▪ The IS curve in these circumstances experiences a
"double whammy" caused by increasing taxes at a time
when the economy is exceedingly vulnerable to adverse
macroeconomic policy. The intercept term falls as fragile
consumer and investor confidence plunges, and the
slope gets steeper due to the increase in the tax rate as
discussed, with IS shifting from ISo to IS1
▪ The opposite may also hold true. The euphoria
generated by a perfectly timed tax-cut may cause the
confidence terms to soar, lifting up the intercept, and
causing the IS to flatten.

IS-LM Model Biswa Swarup Misra slide 46

 The Slope of the IS Curve

▪ The steepness of the IS curve depends on:

▪ How sensitive investment spending is to changes in i
▪ The multiplier, G
▪ Suppose investment spending is very sensitive to i → the
slope, b, is large
▪ A given change in i produces a large change in AD
(large shift)
▪ A large shift in AD produces a large change in Y
▪ A large change in Y resulting from a given change in i
→ IS curve is relatively flat
▪ If investment spending is not very sensitive to i, the IS
curve is relatively steep
IS-LM Model Biswa Swarup Misra slide 47
Factors Affecting Slope of IS Curve

Slope of IS curve
Value of f Slope of IS curve
High Flat
Low Steep
Value of MPC Slope of IS curve
High Flat
Low Steep
Value of t Slope of IS curve
High Steep
Low Flat
Value of Multiplier Slope of IS curve
High Flat
Low Steep

IS-LM Model Biswa Swarup Misra slide 48

 LM Curve
▪ Equating real money supply with money
demand, we obtain the equilibrium
▪ condition in the money market as:
▪ M/P= kY -hi
▪ Simplifying and solving for i, we obtain the LM
curve:
i = (k/h)Y - (l/h)M/P
Once again, this is an equation of a straight line
with slope (k/h), and negative intercept -
(l/h)M/P, as presented.

IS-LM Model Biswa Swarup Misra slide 49

 LM Curve
▪ All points on this line represent points in (i, Y)
space where the money market is in equilibrium.
The slope is positive, and will be held fixed here
since k and h are constants.
▪ The negative intercept is an algebraic construct,
devoid of macroeconomic meaning per se but
vitally important in determining how the LM shifts
when the nominal money stock or prices
change.

IS-LM Model Biswa Swarup Misra slide 50

 LM Curve

▪ Interest Rates LM
▪

▪ Y(GDP)

▪ -(l/h)M/P
▪ IS-LM Model Biswa Swarup Misra slide 51
 Factors that Shift the LM
▪ What will be the effect on the LM curve of an increase in
the nominal money stock, M?
▪ The change in M by the central bank will affect the
intercept term. Since this is a negative term, the increase
in M would lead the intercept to become a larger
negative number (for example, from -40 to -48), thereby
decreasing the intercept. With no change in the slope
(there is no M in the slope term), the result of an
increase in M is a parallel downward, or rightward, shift
in LM from LMo to LM1.
▪ A decrease in money growth (decrease in M) results in
an upward (leftward) shift in LM and, once again, will not
affect the slope.

IS-LM Model Biswa Swarup Misra slide 52

 Factors that Shift the LM

▪ What will be the effect in the LM curve of an increase in

the price level P (an increase in inflation)?
▪ An increase in the price level will cause the ratio M/P to
fall, and given the minus sign that precedes the intercept
term, we now find the intercept to be "less negative"
(increasing from say, -40 to -30). Again, with no change
in the slope, an increase in P results in an upward, or
leftward, shift in LM from LMo to LM2•
▪ A decrease in P would cause the LM to incur a parallel
shift down (right) as the intercept term decreases

IS-LM Model Biswa Swarup Misra slide 53

 Important "Rules" for Shifting LM
▪ (1) If the ratio (M/P) decreases due to either a
decrease in M and/or an increase in P, the LM
shifts up (to the left).
▪ (2) If the ratio (M/P) increases due to an
increase in M and/or a decrease in P, the LM
shifts down (to the right).
▪ Basically, if the real money supply (M/P),
increases, the LM shifts right, and vice-versa.
▪ (3) The slope does not change in either case.

IS-LM Model Biswa Swarup Misra slide 54

Applying the IS -LM Model
 Equilibrium in the IS -LM model
The IS curve represents r
equilibrium in the goods LM
market.
Y = C (Y − T ) + I (r ) + G
r1
The LM curve represents
money market equilibrium.
M P = L (r ,Y ) IS
Y
The intersection determines Y1
the unique combination of Y and r
that satisfies equilibrium in both markets.
IS-LM Model Biswa Swarup Misra slide 56
 Policy analysis with the IS -LM model
Y = C (Y − T ) + I (r ) + G r
LM
M P = L (r ,Y )

We can use the IS-LM

model to analyze the r1
effects of
• fiscal policy: G and/or T IS
• monetary policy: M Y
Y1

IS-LM Model Biswa Swarup Misra slide 57

 An increase in government purchases
1. IS curve shifts right r
1 LM
by G
1− MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the
1. IS2
interest rate to rise… IS1
Y
3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than G
1− MPC
IS-LM Model Biswa Swarup Misra slide 58
 A tax cut
Consumers save r
(1−MPC) of the tax cut, LM
so the initial boost in
spending is smaller for T
r2
than for an equal G… 2.
r1
and the IS curve shifts by
1. IS2
−MPC
1. T IS1
1− MPC
Y
Y1 Y2
2. …so the effects on r 2.
and Y are smaller for T
than for an equal G.
IS-LM Model Biswa Swarup Misra slide 59
 Monetary policy: An increase in M
r
1. M > 0 shifts LM1
the LM curve down
(or to the right) LM2

2. …causing the r1
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y 2
output & income to
rise.

IS-LM Model Biswa Swarup Misra slide 60

 Why Increase in M shifts the LM Curve to the Right?

▪ The increase in M causes the interest rate to fall. [People like to

keep optimal proportions of money and bonds in their portfolios; if
money is increased, then people try to re-attain their optimal
proportions by “exchanging” some of the money for bonds: they
use some of the extra money to buy bonds. This increase in the
demand for bonds drives up the price of bonds -- and causes interest
rates to fall (since interest rates are inversely related to bond prices).
▪ The fall in the interest rate induces an increase in investment
demand, which causes output and income to increase.
▪ The increase in income causes money demand to increase, which
increases the interest rate (though doesn’t increase it all the way
back to its initial value; instead, this effect simply reduces the total
decrease in the interest rate).

IS-LM Model Biswa Swarup Misra slide 61

 Interaction between
monetary & fiscal policy
▪ Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
▪ Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
▪ Such interaction may alter the impact of the
original policy change.
IS-LM Model Biswa Swarup Misra slide 62
 The Fed’s response to G > 0

▪ Suppose Government increases G.

▪ Possible RBI responses:
1. hold M constant
2. hold r constant
3. hold Y constant

▪ In each case, the effects of the G

are different:

IS-LM Model Biswa Swarup Misra slide 63

 Response 1: Hold M constant

If Government raises G, r
the IS curve shifts right. LM1

If RBI holds M constant,

r2
then LM curve doesn’t
r1
shift.
IS2
Results:
IS1
Y = Y 2 − Y1 Y
Y1 Y2
r = r2 − r1

IS-LM Model Biswa Swarup Misra slide 64

 Response 2: Hold r constant

If Government raises G, r
the IS curve shifts right. LM1
LM2
To keep r constant,
r2
RBI increases M r1
to shift LM curve right.
IS2
Results: IS1
Y = Y 3 − Y1 Y
Y1 Y2 Y3

r = 0
IS-LM Model Biswa Swarup Misra slide 65
 Response 3: Hold Y constant

If Government raises G, r LM2

the IS curve shifts right. LM1

To keep Y constant, r3
r2
RBI reduces M
r1
to shift LM curve left.
IS2
Results: IS1
Y = 0 Y
Y1 Y2
r = r3 − r1

IS-LM Model Biswa Swarup Misra slide 66

 IS-LM and aggregate demand
▪ So far, we’ve been using the IS-LM model to
analyze the short run, when the price level is
assumed fixed.
▪ However, a change in P would
shift LM and therefore affect Y.
▪ The aggregate demand curve
(introduced earlier) captures this
relationship between P and Y.

IS-LM Model Biswa Swarup Misra slide 67

 Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y
IS-LM Model Biswa Swarup Misra slide 68
 Deriving the AD curve

▪ The position of the LM curve depends on the value of

M/P. M is an exogenous policy variable. So, if P is low
(like P1 in the lower panel of the diagram), then M/P is
relatively high, so the LM curve is over toward the right in
the upper diagram. If P is high, like P2, then M/P is
relatively low, so the LM curve is more toward the left.
▪ Because the value of P affects the position of the LM
curve, we label the LM curves in the upper panel as
LM(P1) and LM(P2).

IS-LM Model Biswa Swarup Misra slide 69

Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
P
 I
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y
IS-LM Model Biswa Swarup Misra slide 70
Monetary Policy and the AD curve

▪ To find out whether the AD curve shifts to the left or right,

we need to find out what happens to the value of Y
associated with any given value of P.
▪ This is not to say that the equilibrium value of P will
remain fixed after the policy change (though, in fact, we
are assuming P is fixed in the short run). We just want to
see what happens to the AD curve.
▪ Once we know how the AD curve shifts, we can then add
the AS curves (short- or long-run) to find out what, if
anything, happens to P (in the short- or long-run).

IS-LM Model Biswa Swarup Misra slide 71

 Fiscal Policy and the AD curve
r LM
Expansionary fiscal
policy (G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
Y1 Y2 Y
 IS shifts right P
 Y at each
value P1
of P AD2
AD1
Y1 Y2 Y
IS-LM Model Biswa Swarup Misra slide 72
Figure - From the IS-LM Diagram to the Aggregate
Demand Curve

IS-LM Model Biswa Swarup Misra slide 73

 Session Summary

1. Keynesian cross
▪ basic model of income determination
▪ takes fiscal policy & investment as exogenous
▪ fiscal policy has a multiplier effect on income.
2. 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 with
actual expenditure on goods & services

slide 74
 Session Summary

3. 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
4. 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

slide 75
 Session Summary

5. 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.

6. Effectiveness of monetary and fiscal policy in the IS-

LM framework.
▪ Factors governing slope of IS and LM curves

IS-LM Model Biswa Swarup Misra slide 76

 Session Summary

7. AD curve
▪ shows relation between P and the IS-LM model’s
equilibrium Y.
▪ negative slope because
P  (M/P )  r  I  Y
▪ expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right.
▪ expansionary monetary policy shifts LM curve right,
raises income, and shifts AD curve right.
▪ IS or LM shocks shift the AD curve.
IS-LM Model Biswa Swarup Misra slide 77