IS & LM Model

Presented by MUHAMMAD HASEEB Assistant Professor Department of Economics DA COLLEGE FOR WOMEN PH-VIII, KARACHI

In this topic you will learn:

the IS curve, and its relation to:
the Keynesian cross

the LM curve, and its relation to:

the theory of liquidity preference

how the IS-LM model determines income and the interest rate in the short run when P is fixed

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:

Deriving the IS curve

PE

PE =Y PE =C +I (r )+G 2

I PE Y
I
r
r1

PE =C +I (r1 )+G

Y1

Y2

r2

IS Y1 Y2

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 (PE ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.

Factors affecting the slope of IS curve

Interest sensitivity of investment demand (responsiveness of investment demand due to change in interest rate). Higher the interest sensitivity of investment demand flatter the IS curve
Multiplier = 1/(1 mpc) (for three sector closed economy model with lump sum tax) Higher the mpc (lower mps) higher the multiplier flatter the IS curve

Factors that shift the IS Curve

Government purchases Taxes Investment Wealth Exchange rate (for an open economy)

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. Lets start by using the Keynesian cross to see how fiscal policy shifts the IS curve

Shifting the IS curve:

At any value of r, G PE Y so the IS curve shifts to the right.
PE

PE =Y PE =C +I (r )+G 1 2

PE =C +I (r1 )+G1

The horizontal distance of the IS shift equals

r
r1

Y1

Y2

Y Y1

IS1

Y2

IS2 Y

The Theory of Liquidity Preference

Reasons for holding money classified by KEYNES according to motive. He identified the TRANSACTIONS, PRECAUTIONS and SPECULATIVE DEMAND FOR MONEY. A simple theory in which the interest rate is determined by money supply and money demand.

Money supply
r

The supply of real money balances is fixed:

interest rate

M/P
real money balances

Money demand
r

Demand for real money balances:

interest rate

L (r )
M/P
real money balances

Equilibrium
r

The interest rate adjusts to equate the supply and demand for money:

interest rate

r1

L (r )
M/P
real money balances

How central bank raises the interest rate

r
To increase r, Central bank reduces M
interest rate

r2 r1

L (r )
M/P
real money balances

The LM curve
Now lets put Y back into the money demand function: 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:

Deriving the LM curve

(a) The market for

real money balances

(b) The LM curve

r LM

r2 r1 L ( r , Y2 ) L ( r , Y1 )
M/P

r2 r1 Y1 Y2
Y

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.

Factors affecting the slope of LM curve

Interest sensitivity of money demand (responsiveness of money demand due to change in interest rate). Higher the interest sensitivity of money demand flatter the LM curve

Factors that shift the LM Curve

Nominal Money Supply Price level Expected Inflation All those factors that change the money demand (increase/decrease of wealth, increase/decrease in the risk of alternative assets, increase/decrease in liquidity of alternative assets and increase and decrease in the efficiency of payment technologies

How Money supply shifts the LM curve

(a) The market for

real money balances

(b) The LM curve

LM2 LM1

r2
r1 L (r , Y1 )
M/P

r2
r1 Y1
Y

The short-run equilibrium

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

IS

Y
Equilibrium interest rate Equilibrium level of income

Fiscal Policy
An increase in Government Spending

We begin by examining how changes in fiscal policy (taxes and spending) alter the economys short-run equilibrium.

An increase in government spending is represented in the next slide.

The equilibrium of the economy moves from point A to point B. Income rises from Y1 to Y2 and the real interest rate rises from r1 to r2. When the government increases its spending, total income Y begins to rise (from the Keynesian cross model). As Y rises, the economys demand for money rises and so, assuming that the supply of real balances is fixed, the interest rate r begins to rise. As r rises, I falls thus partially offsetting the effects of the increased government spending.

Fiscal Policy
An increase in Government Spending

Fiscal Policy
An increase in Government Spending

The increased government spending has crowdedout some of the investment spending in the economy. The case of a tax cut is similar. This is represented in the next slide.

Fiscal Policy
A decrease in Government Tax

Monetary Policy
An increase in Money Supply

We now examine the effects of monetary policy. This is represented in the next slide.

Consider an increase in the money supply. An increase in M leads to an increase in M/P since we are assuming that P is fixed. The LM curve shifts downward and the economy moves from point A to point B. The increase in the money supply lowers the interest rate and raises the level of income. This is because the increase in M/P lowers r and this causes I to increase since I is inversely related to r. This, in turn, increases planned expenditure, production and income Y. This process is called the monetary transmission mechanism.

Monetary Policy
An increase in Money Supply

Fiscal And Monetary Interaction

We can now consider simultaneous fiscal and monetary policy in the IS/LM model in the next slide.

Slide (a) shows the effects of a tax increase, holding the real money supply constant. Slide (b) shows the effects of a tax increase, accompanied by a contraction in the real money supply. This keeps the interest rate constant in the economy. Slide (c) shows the effect of the tax cut combined with an expansion of the real money supply. The effect of this policy is to keep the level of income constant in the economy.

Fiscal And Monetary Interaction

The Big Picture

Keynesian Cross IS curve

Theory of Liquidity Preference

LM curve

IS-LM model

Explanation of short-run fluctuations

Agg. demand curve Agg. supply curve

Model of Agg. Demand and Agg. Supply

REFERENCES

Macroeconomics 4th Edition by Gregory Mankiw Macroeconomics by 7th Edition Dornbusch & Fisher Macroeconomics by 5th Edition Richard T Froyan Economics 3rd Edition by John Sloman Internet

Thank You