IS & LM Model Presented by MUHAMMAD HASEEB Assistant Professor Department of Economics DA COLLEGE FOR WOMEN PH-VIII, KARACHI.

IS & LM ModelIS & LM ModelPresented

by

MUHAMMAD HASEEBAssistant Professor

Department of EconomicsDA COLLEGE FOR WOMEN PH-VIII, KARACHI

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

In this topic you will In this topic you will learn:learn:

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:

The IS curve

r I

Deriving the IS curve

Y2Y1

Y2Y1Y

PE

r

Y

PE =C +I (r1 )+G

PE =C +I (r2 )+G

r1

r2

PE =Y

IS

IPE

Y

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.

Why the IS curve is negatively sloped

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 affecting the slope of IS curve

• Government purchases• Taxes• Investment• Wealth• Exchange rate (for an open

economy)

Factors that shift 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…

Fiscal Policy and the IS curve

At any value of r, G PE Y

Shifting the IS

curve: G

Y2Y1

Y2Y1Y

PE

r

Y

PE =C +I (r1 )+G1

PE =C +I (r1 )+G2

r1

PE =Y

IS1

The horizontal distance of the IS shift equals

IS2

…so the IS curve shifts to the right.

Y

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.

The Theory of Liquidity Preference

The supply of

real money balances is fixed:

Money supply

M/P real money

balances

rinterest

rate

Demand forreal money balances:

Money demand

M/P real money

balances

rinterest

rate

L (r )

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

Equilibrium

M/P real money

balances

rinterest

rate

L (r )

r1

To increase r, Central bank reduces M

How central bank raises the interest rate

M/P real money

balances

rinterest

rate

L (r )

r1

r2

Now let’s put Y back into the money demand function:

The LM curve

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

M/P

r

L (r , Y1 )

r1

r2

r

YY1

r1

L (r , Y2 )

r2

Y2

LM

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

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.

Why the LM curve is upward sloping

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 affecting the slope of 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

M/P

r

L (r , Y1 ) r1

r2

r

YY1

r1

r2

LM1

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

LM2

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

The short-run equilibrium

Y

r

IS

LM

Equilibriuminterestrate

Equilibriumlevel ofincome

Fiscal PolicyAn increase in Government

Spending We begin by examining how changes in fiscal policy (taxes and spending) alter the economy’s 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 economy’s 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 PolicyAn increase in Government Spending

Fiscal PolicyAn increase in Government

Spending

The increased government spending has “crowded-out” some of the investment spending in the economy.

The case of a tax cut is similar. This is represented in the next slide.

Fiscal PolicyA decrease in Government Tax

Monetary PolicyAn 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 PolicyAn 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 PictureKeynesianCross

Theory of Liquidity Preference

IScurve

LM curve

IS-LMmodel

Agg. demand

curve

Agg. supplycurve

Model of Agg.

Demand and Agg. Supply

Explanation of short-run fluctuations

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

REFERENCES

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