HKAL Economics 5.

The ISLM Model

( HSSC, Daniel Yu, Fred Chan Economics)

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HKAL Economics 5. The ISLM Model

The IS Curve If r is the main term IS equation

r= AE 1 c + ct Y b b

If Y is the main term IS equation

Y = AE b r 1 c + ct 1 c + ct

r =

1 c G ; r = T b b

Y =

1 c G ; Y = T 1 c + ct 1 c + ct

Slope
1 c + ct 1 or b k b

(not accounted for crowding out effect) Slope

b or b k 1 c + ct

Y-intercept
A E b

Y-intercept
AE E or k ( A ) 1 c +ct

X-intercept
A E E or k ( A ) 1 c

X-intercept
A E b

k is the multiplier b is the interest elasticity of investment

I r

Fiscal policy multiplier

Y 1 Y c = = bd ; T bd G (1 c + ct ) + (1 c + ct ) + e e

When , b equals to zero (vertical IS curve) or e tends to infinity (horizontal LM curve), fiscal policy multiplier is the same with Keynesian expenditure multiplier. Shifting numerical factors I. Changes in any autonomous variables (parallel shift) II. Changes in b (pivoted shift) III. Changes in k (pivoted shift)

Derivation of IS curve

r r1 r2

S (Y=100) S (Y=200)

IS S/I -2 Y

Assumption - Investment is inversely proportional to interest rate - Saving is proportional to income

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HKAL Economics 5. The ISLM Model

r r1 r2 I I1 I2

AE

E =Y E (I2) E (I1) r1 r2

IS S/I Y1 Y2 Y Y1 Y2 Y

Changes in slope of IS curve 1.

1 b k I ) r

Changes in b (Interest elasticity of investment;

r

y-intercept:
A E b
IS IS Y

Higher b Flatter Higher k Flatter For MCQ, the changes in slope of IS curve can be regarded as shifts of curves (pivoted shifts)

2.

Changes in k (Expenditure multiplier; k)

r

x-intercept:
k A ) ( E

IS

IS

Shifts of IS curve (Y-intercept:

r

A E E ; X-intercept: k ( A ) ) b

1. Changes in autonomous variables

k G; keynesian multiplying effect

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HKAL Economics 5. The ISLM Model

Remark: Such shifts can be caused by changes in: - Changes in government expenditure - Changes in tax - Balanced budget changes - Changes in transfer payment (TP >Yd > C> AE> Y) 2. Factors that shift the IS curve Raising the real interest rate that clears the goods market IS shifts up and right (i.e. at the same national income, the equilibrium interest rate is higher) Lowering the real interest rate that clears the goods market IS shifts down and left (i.e. at the same national income, the equilibrium interest rate is lower) An increase in Shifts the IS curve Reason Expected future output Upwards and rightwards Desired saving falls or desired consumption rises. Wealth Upwards and rightwards Desired saving falls or desired consumption rises. Government expenditure (G) Upwards and rightwards Desired pubic saving falls. Taxes Downwards and leftwards Disposal income and thus consumption decreases. Expected future marginal Upwards and rightwards Desired investment increases. product of capital Effective tax rate on capital Downwards and leftwards Desired investment decreases

The LM curve If r is the main term LM equation

r= Ma Ms d + Y e e 1 e

If Y is the main term LM equation

Y = Ms Ma e + r d d 1 d

r = Ms

Y = Ms

Slope
d e

(not accounted for the adjustment process) Slope

e d
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HKAL Economics 5. The ISLM Model

Y-intercept
Ma Ms (must be negative) e

Y-intercept
Ms Ma d

X-intercept
Ms Ma Ma Ms or d d

X-intercept
t M Y Ms Ma Ma Ms or e e

d is the income elasticity of money demand e is the interest elasticity of money demand

a M r

Monetary policy multiplier

Y 1 = e(1 c + ct ) Ms d+ b

When e is zero (vertical LM curve) or b tends to infinity (horizontal IS curve), monetary policy multiplier is the same with the one not accounting for the adjustment process Shifting numerical factors I. Changes in Ma (Parallel shift) II. Changes in Ms (Parallel shift) III. Changes in e (Pivoted shift) IV. Changes in d (Pivoted shift) Derivation of LM curve
r r2 r1 Md (Y2=200) Md (Y1=100) M Y1 Y2 Y Ms r LM

Assumption - Money demand (Ma) is inversely related to interest rate. - Money demand is proportional to output. - Along the LM curve, money demand is constant (varying are the asset demand ()and transaction demand ()

Changes in slope of LM curve 1.

d e t M ) Y

Changes in d (Income elasticity of money demand;

r

LM LM Y

x-intercept:
Ma Ms d

Higher d Steeper Higher e Flatter - For MCQ, the changes in slope of LM curve can be regarded as shifts of curves (pivoted shifts)
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HKAL Economics 5. The ISLM Model

2.

Changes in e (Interest elasticity of money demand;

r LM LM

a M ) r

y-intercept:
Ma Ms e

Shifts of LM (Y-intercept:
r

Ma Ms Ma Ms ; X-intercept: ) d e

Reasons to shift the LM rightwards when an expansionary monetary policy is in practice

Ms1 Ms2

r1 r2 Md (Y) M

With an increase in money supply, given the same real output, interest rate (r) lowers to attain money market equilibrium. Therefore, LM curve shifts rightwards; every level of output corresponds to a lower level of interest rate.

1. Changes in Ms (Money supply) - Larger Ms LM curve shifts downwards [Y-intercept ] and rightwards [X-intercept] - Smaller Ms LM curve shifts upwards [Y-intercept ] and leftwards [X-intercept] - Ms Ms > Md to restore equilibrium Mt/ Y or Ma/ r 2. Changes in Ma (Asset demand for money) - Larger Ma LM curve shifts upwards [Y-intercept ] and leftwards [X-intercept] - Smaller Ma LM curve shifts downwards [Y-intercept ] and rightwards [X-intercept] - Ma Ms < Md to restore equilibrium Mt/ Y or Ma/ r
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HKAL Economics 5. The ISLM Model r LM LM Y r r Y Y LM

Changes in Y (Y)
Y = Ms 1 d

Changes in r (r)
r = Ms 1 e

3. Changes in d (Income elasticity of money demand; 4. Changes in e (Interest elasticity of money demand;

t M ) Y a M ) r

Factors affecting effectiveness of fiscal policy (T & G) - Gor T, E, Y - Mt, Md>Ms, Ma, r (Sell bond, bond price, r) - I, Y 1. Slope of IS curve
r IS2 r3 r2 r1 IS1 IS2 IS1 LM

(effects on good market) (effects on money market) (crowding out effect)

Government expenditure increases. National income increases. Transaction demand for money increases. Excess demand for money is resulted. To restore equilibrium, asset demand (Ma) has to fall or interest rate (r) has to rise.

Y1 Y2 Y3 Reference points

I.

Interest elasticity of investment (b) - If b is smaller (larger), the increase in r causes less (greater) decrease in investments; crowding out effect becomes less (more) significant.

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HKAL Economics 5. The ISLM Model

II.

Income multiplier (k) - Given expansionary fiscal policy (i.e. Gor T), aggregate expenditure rises, so does national income. With greater income multiplier (k), the multiplying effect of an increase in G is stronger, thus leading to a greater rise in national income. - However, a bigger k entails a flatter IS curve, implying a greater crowding out effect in which private investment decreases greatly because of a rise in interest rate (r). - Yet, as denoted by fiscal policy multiplier*, the expansionary effect is greater than the contractionary effect brought about by a greater multiplier. - Therefore, it is still justified to say that the greater the income multiplier is, the more effective a fiscal policy is. - One more point to note is that the steeper the IS curve is, the more effective a fiscal policy is is not necessarily true unless we hold income multiplier (k) constant in both cases in comparison.
Y 1 = bd *Fiscal policy multiplier: G (1 c + ct ) + e

Important implication on an increase in income multiplier (k) - More effective will a fiscal policy is. 2. SlopeMore effective will a monetary policy is. This is due to a flatter IS curve. - of LM curve
r r3 r2 r1 IS IS LM2 LM1

Government expenditure increases. National income increases. Transaction demand for money increases. Excess demand for money is resulted. To restore equilibrium, asset demand (Ma) has to fall or interest rate (r) has to rise.

Y1 Y3 Y2

I.

Income elasticity of money demand (for transaction) (d) - If d is large (small), when national income increases with the rise in government expenditure, transaction demand for money (Mt) rises to a greater (smaller) extent. - The level of excess demand for money is greater (smaller). - A greater (smaller) fall in asset demand is required and therefore a greater (smaller) rise in interest rate (r) is needed. - People will sell more (less) bonds. Bond price will fall to a higher level (lower level). Interest rate will increase to a greater level (lower level). - With greater (lower) rise in interest rate (r), investment and thus national income will fall more (less) significantly. - Crowding out effect becomes greater (smaller); fiscal policy becomes less effective.
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HKAL Economics 5. The ISLM Model

II.

Interest elasticity of money demand (for assets) (e) - If e is small (large), the increase in interest rate (r) to restore equilibrium causes smaller (greater) fall in asset demand for money. - Given constant level of excess demand for money, a greater (smaller) increase in r is needed for the case that e is small (large). - With greater (lower) rise in interest rate (r), investment and thus nation income will fall more (less) significantly. - Crowding out effect becomes greater (smaller); fiscal policy becomes less effective.

Factors affecting effectiveness of monetary policy (Ms & r) (effects on money market) - Ms, Ms>Md, r (effects on good market) - I, E, Y - Mt, Md, Ms<Md, r, I, Y (adjustment process) 1. Slope of IS curve
r LM LM

r1 r2 r3 IS2 Y1 Y2 Y3 IS1 Y

Money supply increases. Excess supply for money is resulted. To restore equilibrium, money demand (Md) has to rise. Increase in money demand can be done by i. Increase in asset demand (Ma) by lowering the interest rate (r) Interest rate decreases. Investment increases. National income increases.

I.

Interest elasticity of investment (b) - A higher (lower) b induces a higher (lower) level of investment once interest rate decreases. - National income will rise to a greater (smaller) extent; monetary policy becomes more (less) effective.
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HKAL Economics 5. The ISLM Model

II.

Expenditure multiplier (k) - A higher (lower) k induces a higher (lower) level increase of aggregate expenditure and thus national income once investment increase. This is because the multiplying effect upon an increase in investment is higher (lower) when k is larger (smaller). - Monetary becomes more (less) effective.

2.

Slope of LM curve
r LM1 LM2 LM1 LM2

r1 r2 r3 IS Y1 Y2 Y3 Y

Money supply increases. Excess supply for money is resulted. To restore equilibrium, money demand (Md) has to rise. Increase in money demand can be done by i. Increase in asset demand (Ma) by lowering the interest rate (r) Interest rate decreases. Investment increases. National income increases.

III. Interest elasticity of money demand (for asset) (e) - If e is larger (small), it will result in greater (smaller) increase in asset demand (Ma) with the same decrease in interest rate. - Therefore, in case of large (small) e, a small (great) fall in interest rate is needed to induce a higher increase in asset demand (Ma) to clear the excess supply in money market. - With smaller (higher) decrease in interest rate (r), it induces investment to rise to a smaller (larger) extent. - Aggregate expenditure and thus national income will rise to a smaller (larger) extent; monetary policy becomes less (more) effective. IV. Income elasticity of money demand (for transaction) (d)
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HKAL Economics 5. The ISLM Model

Effects are uncertain. On one hand, when the effect of an increase in money supply passes to the good market, national income increase. If money demand is highly income elastic (high d), the excess money supply may then be instantly cleared by the income-induced increase in money demand. As excess supply is cleared, the interest rate will stop falling; the effectiveness of monetary policy lowers. The situation is opposite when money demand is highly income inelastic (low d). On the other hand, higher (lower) income elasticity for money demand (d) will lead to stepper (flatter) LM curve, reducing (increasing) effectiveness monetary policy.

MC reminders 1. About the neutrality of money - If money is neutral, it means that any increase in money supply will only result in an increase in general price level (i.e. inflation but not real output.) - Therefore, monetary does anything but contributes to the rise in real output (Y). 2. Effects on changes on thrift of households
r Ms

Md (Y1) Md (Y2) M

An increase in the thrift of households means that saving increases. National income will decrease due to a larger withdrawal and transaction money demand, which is positively related to national income will also decrease. Therefore, the money demand curve will shift leftwards with r being the y-axis and M being the x-axis.

3.

About extreme cases of LM curve and IS curve

r LM - 11 r2 r1

IS

IS

LM

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HKAL Economics 5. The ISLM Model

IS Y1 Y2

IS Y

When LM is horizontal (d = 0 or e ) - Fiscal policy (real force) will not result in changes in interest rate. - The changes in national income are only due to real forces only.

When IS is vertical (b or k ) - Fiscal polict (monetary force) will result in changes in interest rate. - The changes in naitonal income are due to both real forces and monetary ones.

When LM is horizontal, When IS is vertical, - Both good market and money market can - Only good market is able to affect still affect national income. national income. (i.e. changes in LM curve does not result in changes in - Shifting of IS curve and LM curve (money market) affects national income. national income.)

4.

Implication questions (important for other topics as well!!) 1. Which of the following situations implies an economy with a horizontal LM curve? A. There is no crowding out effect. (WRONG! possibility of vertical IS) B. An expansionary fiscal policy is accommodated by an expansionary monetary policy so that interest rate remains unchanged. C. The Central Bank uses interest rate as the target for monetary policy. D. Asset demand for money is irrespective to changes in interest rate and income.

5.

About new conditions upon IS curve and LM curve 1. If consumption expenditure does not only depend positively on income but also negatively on interest rate, the IS curve will become ____ and the crowding out effect of fiscal policy will be _____ (assuming that the LM curve is upward sloping). A. flatter ... smaller B. flatter ... bigger C. steeper ... smaller D. steeper ... bigger (99-07) 2. If the money demand, which was independent of interest rate before, now becomes inversely proportional to the interest rate, the LM curve will become A. vertical. B. horizontal. C. flatter.
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HKAL Economics 5. The ISLM Model

D. -

steeper.

(01-06)

Replace the old b, d or e with the new condition For Q1, replace b with (b + ) IS curve becomes flatter For Q2, replace d with (d ) LM curve becomes flatter

LQ reminders 1. An increase in money supply leads to a proportional increase in nominal income. 2. If the government uses interest rate as an instrument of monetary policies, given r, the reduction in money demand has to be matched by an equal reduction in money supply. 3. For more current questions, always think of the relative change is IS and LM effect.

6.

About calculation 1. Suppose C= I Mt Ma Ms

= consumption Y = national income I = investment r = interest rate Mt = transaction demand for money Ma = asset demand for money Ms = money stock If the full employment income is $600, the deflationary income gap will be A. $20. B. $50. C. $100. D. $500. (92-25) Y = C + I (Equilibrium) Ms = Md + Ma 200 = 100 100 r + 0.25 (750 1000 r ) Y = 60 + 0.8Y + 90 200 r
(1 0.8)Y =150 200 r

$60 + 0.8Y = $90 200r = 0.25Y = $100 100r = $200

200 = 287 .5 350 r r = 0.25

Y = 750 1000 r

When r = 0.25, Y = 500. Deflationary income gap: 600 500 = 100 2. Given Md = C = I = 0.2Y 60 + 0.75Y 40 10r Md C I Y
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= = = =

money demand consumption expenditure investment expenditure income

HKAL Economics 5. The ISLM Model

r = interest rate Suppose government spending increases by 100. By how much should the government increase the money supply in order to keep the interest rate constant? A. 20 B. 40 C. 80 D. 100 (02-12)
r LMY = 400 LM

Y =

1 100 = $400 1 0.75

Y = Ms

1 d

Ms = Y d
IS IS Y

Ms = 400 0.2 = $80

(No crowding out effect and the adjustment process both curves shift!) where Y = income r = interest

3.

Consider the following information about an economy: IS curve: Y = 140 600r LM curve: Y = 40 + 200r

What can be said about this economy when Y = 80 and r = 10%? A. There is an excess demand in the money market. B. There is an excess supply in the money market. C. There is an excess demand in the product market. D. There is an excess supply in the product market. When r = 10% IS equation: Y = 140 600 (0.1) = $80 (Equilibrium income (r = 10%))
r LM

(98-05)

When r = 10% LM equation: Y = 40 +200 (0.1) = $60 (Equilibrium income (r = 10%))

10%

a IS 60 80 Y

At point A (Y = $80, r = 10%) - Good market is in equilibrium; - Money market is in excess demand

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HKAL Economics 5. The ISLM Model

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HKAL Economics 5. The ISLM Model

Additional SQ reminders: 1. Liquidity trap 2001 Q2 Under the liquidity trap, the impact of fiscal policy on equilibrium income is the largest. On the other hand, monetary policy under liquidity trap has not impact on equilibrium income. Discuss these statements with the aid of IS-LM diagram. (8 marks)
Definition

Economic Reasons

Mechanical Reasons

Liquidity trap describes the situation where a segment of the money demand is perfectly interest elastic. This is because in an economy, all people expect a rise in market interest rate and thus a fall in bond price. Therefore, all people hold all assets as cash to avoid capital losses irrespective of changes in money supply. At a given amount of money supply, any rise in the transaction demand for money induced by an increase in income, at money market equilibrium, has to be totally offset by a fall in asset demand for money with a very, very small rise in interest rate. Therefore, the LM curve becomes horizontal/ or the slope of LM becomes zero. The increase in government expenditure will raise the aggregate expenditure and thus income through multiplying effect. The transaction demand for money (Mt) will increase as a result. Given an unchanged amount of money supply, the rise in Mt has to be offset by a fall in asset demand (a rise in r). In the presence of liquidity trap, the rise in Mt can be offset by a fall in Ma without causing the interest rate to rise. As a result, private investment will not be reduced or no crowding out effect occurs. The multiplying effect remains its strength as in the elementary Keynesian model. As the increase (or decrease) in money supply will be absorbed by an increase (or a decrease) in asset demand for money without a very, very small fall (or a rise) of market interest rate. Thus, no investment will be induced to increase (or decrease), so does the equilibrium income.

Effective fiscal policies

Ineffective monetary policies

2.

Explanation of downward sloping IS curve - The IS curve shows different combinations of interest rates and income levels that will keep product market in equilibrium, i.e. aggregate demand equals to aggregate supply. - As investment is assumed to be inversely related to interest rate, when there is a fall in interest rate, the level of investment will rise. - With a rise in investment demand, there will be an excess demand at the prevailing output level. - Hence, output will rise to meet the increased demand. Through the multiplier effect, income rise by a multiple of the increase in investment. - As a fall in interest rate will be accompanied with a rise in income, the IS curve slopes downwards.

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HKAL Economics 5. The ISLM Model

3.

Explanation of changes in slope of IS curve - An increase in the marginal propensity to consume will make the IS curve flatter. - For a given fall in interest rate, investment will increase. - With a larger marginal propensity to consume, the increase in income will be larger. - The IS curve is flatter.

Explanation of upward sloping LM curve - Given the money supply, a rise/fall in the transaction demand for money (induced by, say, an LM curve for increase/decrease in real income) has to be offset by a fall/rise in the asset demand for money normal cases (induced by, say, an increase/decrease in the interest rate) in order to maintain money market equilibrium. - This means that the LM curve, which is a locus of (r, Y) combinations that clear the money, is in general upward sloping. 5. Explanation of shifting of LM curve 2005 Q5(b) Explain why, in the modern world today, the demand for money is continuously shrinking. Then show how this reduction in money demand would affect the LM curve. (4 marks) The introduction of money substitutes (e.g. credit cards, e-cash) is the main cause of the continuous shrinkage of money demand in the modern world today. Given Ms, the reduction in money demand has to be matched by either an increase in transactions demand (which requires a rise in real income) or an increase in asset demand (which requires a fall in the interest rate). 6. The LM curve will thus shift down/right-ward.

4.

There is only transaction demand for money 1997 Q5 Explain how each of the following events affects the LM curve:

There is an increase in the money supply and there is only transactions demand for money. (4 marks)
The transactions demand for money is totally a function of income; this means that it is independent of the level of interest rates. Hence, if there is an only transaction demand for money, the LM curve is a vertical line. If there is an increase in the money supply, the LM curve will shift to the right, showing that only at higher income level will the demand for money will rise so as to attain money market equilibrium.

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HKAL Economics 5. The ISLM Model

7. About shifting of IS and LM in relative sense (07Q6b; 06Q5c) - If both curves (i.e., IS and LM) shift together, there MUST be either one of the variable (i.e., Y or r) that is in uncertain result.
r LM r LM LM

LM

IS

IS Y

IS

IS Y

Increase in Y; Uncertain change in r

r

Increase in r; Uncertain change in Y

r LM

LM

LM

LM

IS

IS Y

IS

IS Y

Decrease in r; Uncertain change in Y

Decrease in Y; Uncertain change in r

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