© 2008 Pearson Education Canada22.1 Chapter 22 The ISLM Model.

© 2008 Pearson Education Canada 22.1

Chapter 22Chapter 22The ISLM Model

1. Overview: IS-LM Model• Includes money and interest rates in the

Keynesian framework

• Examines an equilibrium where aggregate output equals aggregate demand

• Assumes fixed price level where nominal and real quantities are the same

• IS curve is the relationship between equilibrium aggregate output and the interest rate in the Goods Market

• LM curve is the combinations of interest rates and aggregate output for which MD = MS in the Money Market


2. Goods Market: IS Curve


The total quantity demanded of an economy's

output is the sum of four types of spending

Y ad C I G NX

Equilibrium occurs in the economy

when the total quantity of output supplied

equals the total quantity of output demanded

Y Y ad

Analysis assumes the price level is fixed

(1) Consumption Expenditures


Consumption is an increasing function of

1) Disposable/After-tax Income(=Y-T), and

2) Wealth (=Value of Properties, Financial Assets, and Income Possibility(Human Wealth).

C = f( Y - T, W)

*Current Financial Crisis has a negative Wealth Effect: Value of Wealth down and Consumption down.

(2) Investment Spending = Fixed investment + Inventory investment

• Investment is a function of

(Ex-post real) Interest rates, and

Expectations.

I = f(i, Exp)


(3) Government Expenditures• Expansionary Fiscal Policy

• Contractionary Fiscal Policy

These are up to the government’s discretion

G


(4) Net ExportsNX = Exports – Imports

• Exports depend on ‘Their’ Foreign Demands, which depends on Y of foreign country‘Our’ Competitiveness• Imports depends on ‘Our Income’.• Foreign Exchange Rage affects NX as well

*The Current Financial Crisis originating from the U.S. has a serious impact on Canada through a decline in Exports.

NX = f(Y, Yforeign), FOREX rates)


(5)Equilibrium in the Goods Market: The IS Curve

• Interest rates and investment spending– Negative relationship

• Investment and National Income

- Positive relationship

Thus, Interest rates(i) and National Income(Y)– Negative relationship


(6)Deriving the IS Curve


3. The LM Curve: Equilibrium in the Market for Money

• It is the combinations of (i,Y) that satisfy

the equilibrium condition in the money market:

Money supply = Money Demand


(1) Money Supply

We have learned that the money supply curve is Vertical:Government’s supply decision does not depend on interest rate-

in other words, interest rate is a result of government decision, and not a factor that affects government decision.

22.11

(2) Money Demand

Demand for money called liquidity preference

• Md/P depends on income (Y), interest rates (i),

and Random Shocks/Diturbances (u)

• Positively related to income– Raises the level of transactions– Increases wealth

• Negatively related to interest rates


(3) Equilibrium in the Market for Money: The LM Curve (Cont’d)

• Connects points that satisfy the equilibrium condition that MD = MS

• For each level of aggregate output, the LM curve tells us what the interest rate must be for equilibrium to occur

• The economy tends to move toward points on the LM curve


(4)Deriving the LM Curve


*Different Slopes of LM curves:


1

2

3

*Note that the slope of LM curve is the mirror image of the Md curve:

• When real money demand is perfectly elastic with respect to interest rate, the corresponding LM curve is almost horizontal.

• This is the case of ‘Liquidity Trap’.


4. Combining IS-LM curves: Determination of Output and Interest Rate


• In this chapter, we simply derive IS and LM curves.

• In the next chapter, we will talk about the shift of IS and LM curves.


© 2008 Pearson Education Canada22.1 Chapter 22 The ISLM Model.

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