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Goods and

Financial Markets Together:


The IS-LM Model

The Goods Market


and the IS Relation
Equilibrium in the goods market
exists when production, Y, is equal
to the demand for goods, Z.
In the simple model (in chapter 3),
the interest rate did not affect the
demand for goods. The equilibrium
condition was given by:

Y C (Y T ) I G

Investment, Sales (Y), and the


Interest Rate (i)
Now, we no longer assume I (investment)
is constant
We capture the effects of two factors
affecting investment:
The level of sales/income (+)
The interest rate (-)

I I (Y ,i)

The Determination of
Output
Taking into account the investment
relation above, the equilibrium
condition in the goods market
becomes:

Y C (Y T ) I (Y ,i) G

The Determination of
Output
Equilibrium in the Goods
Market
The demand for goods is
an increasing function of
output. Equilibrium
requires that the demand
for goods be equal to
output.

Deriving the IS Curve


The Effects of an
Increase in
the Interest Rate on
Output
An increase in the
interest rate decreases
the demand for goods
at any level of output.

The IS Curve
Shifts of the IS
Curve

An increase
in taxes...

Financial Markets
and the LM Relation
The interest rate is determined by
the equality of the supply of and
the demand for
M money:
$ Y L (i)
M = nominal money stock
$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate

Real Money, Real Income,


and the Interest Rate
The LM relation: In equilibrium, the
real money supply is equal to the real
money demand, which depends on real
M interest rate, i:
income, Y, and the

Y L (i)

Recall: before, we had the same equation but in nominal instead of real
terms (nominal income and nominal money supply). Dividing both
sides by P (the price level) gives us the equation above.

Deriving the LM Curve


The Effects of an
Increase in Income on
the Interest Rate

Shifts of the LM Curve


Shifts of the LM
Curve

An
increase
in
money...

The IS and the LM Relations


Together
The IS-LM Model

Equilibrium in the
goods market (IS).
Equilibrium in financial
markets (LM).
When the IS curve
intersects the LM
curve, both goods and
financial markets are
in equilibrium.

IS r e la tio n : Y C (Y T ) I (Y ,i ) G
L M r e la tio n :

M
Y L (i)
P

Fiscal Policy, the Interest Rate and


the IS Curve
Fiscal contraction: a fiscal policy
that reduces the budget deficit.
Reducing G or increasing T

Fiscal expansion: increasing the


budget deficit.
Increasing G or decreasing T

Taxes (T) and government


expenditures (G) affect the IS curve,
not the LM curve.

Fiscal Policy, the Interest Rate and


the IS Curve
The Effects of an
Increase in Taxes

Monetary Policy, the Interest Rate,


and the LM Curve

Monetary contraction
(tightening) refers to a
decrease in the money supply.
An increase in the money supply
is called monetary expansion.
Monetary policy affects only the
LM curve, not the IS curve.

Monetary Policy, the Interest Rate,


and the LM Curve
The Effects of a
Monetary Expansion

Using a Policy Mix


The Effects of Fiscal and Monetary Policy.
Shift of IS

Shift of
LM

Movement of
Output

Movement in
Interest Rate

Increase in taxes

left

none

down

down

Decrease in taxes

right

none

up

up

Increase in spending

right

none

up

up

Decrease in spending

left

none

down

down

Increase in money

none

down

up

down

Decrease in money

none

up

down

up

Crowding Out
Given Md = 0.25 + 62.5i; IS -----> Y = 4250 125i
and LM -------> Y = 2000 + 250i. Is there crowding out
if government spending increases 1500? How much?
IS0 ------> Y = 4250 125i
LM -----> Y = 2000 + 250i
IS1 ------> Y = 5750 125i
Initial equilibrium IS0 = LM at Y = 3500 and r 0 = 6%.
If government spending increases, then IS1 = LM at Y
= 4500 and r1 = 10%.
If interest rate is unchanged (6%), then after
government spending increases:
Y = 5750 125r
= 5750 125(6)
= 5000
So, crowding out is 5000 4500 = 500

r
IS1
LM0
IS0
10

3500
Y

4500 5000