Islm

*IS-LM ModelThis topic is organised into 4 partsIntroduction Goods Market Equilibrium Asset Market Equilibrium Synthesis and utility

*MONEY, INTEREST, AND INCOMEOur preceding topic must have given a general impression that stock of money, interest rates, the RBI, and the Government DO NOT matter in income determination.All these play a critical role in the economy. AD is influenced by rate of interest, RBI faces challenge when there is a recession.So, we use Money and Monetary policy to build a framework to analyse interaction of goods and assets markets.

*The Purpose of ExtensionHelps to analyse working of monetary policyPrevious income determination can be called a partial approach in the absence of asset market. It treats as if economy consists merely of Goods (& services) market.Enables to visualise expansionary fiscal policy effect on increasing the consumption through multiplier; but reduces investment as high interest rate discourages private investments

*Nominal and Real VariablesNominal variables are those, which are measured in current years prices and cannot be directly comparable over years. Examples: price level (P), nominal wage rate (W), inflation rate, and nominal interest rate (i). Real variables are those which will be, expressed either in physical units or will be expressed in money terms on the basis of some constant (base year) prices. Examples for real variables include output, Consumption, Investment, Saving, real wage rate, population, etc.

*The IS LM ModelMoney, Interest, and Income are dealt hereThe Classical DichotomyKeynes General Theory (published in 1936)J.R. Hicks summarised (in 1937) Mr. Keynes and the Classics: A Suggested InterpretationThis popularised the Keynesian Theory via the ISLM ModelIt provides a framework for integrating the real and monetary sectors

*The ISLM MechanismMonetary policy targets on Assets MarketsInterest rate affected; and it causes changes in goods marketpeoples income changes and it will affect both marketsFiscal Policy targets Goods Market and the incomes are affected. The income allocation influences Asset, Goods markets and interest

* The Structure of the IS-LM Model

*Meanings and DefinitionsMoney Market Equilibrium (LM Curve)Goods Market Equilibrium (IS Curve)LM Curve: Locus of pairs of interest rate and income that give equilibrium in the money mkt. for a fixed MS.IS Curve: Locus of pairs of interest rate and income that give equilibrium in the commodity mkt. for a given level of autonomous spending.LM= Liquidity preference for Money;IS= Equality of Investment and Saving

*Rate of interestA sensitive variable not only in economics but also equally sensitive politicallyNo single rate ( T-bill, CP, Bonds, Saving Bank deposit rate, P.O. deposits, NSC, Vikas Patras, EPF, etc). One rate for convenience.Determinants of rdefault riskexpected inflationtime preference

*The Investment Schedule

*Derivation of IS CurveAt higher interest rate i1, equilibrium in the goods market is at E1 in Fig (a). This is recorded as E1 in the Fig (b) also.A fall in interest rate to i2 increases AD, and a new equilibrium is at E2 in Fig (a). The corresponding point in Fig (b) is also noted as E2.In the Fig (b) join E1 and E2 to obtain IS schedule

*Derivation of the IS Curve

*The IS CurveCombination of interest rates and levels of output such that planned spending equals income (Equilibrium in goods market).

Slope of IS: Sensitiveness of the spending to change in i, and size of the spending multiplier (ratio of change in output to change in autonomous spending)

* Effect of the Multiplier on the Slope of the IS Curve

*A Shift in the IS Curve Caused by a Change in Autonomous Spending

*Demand for Real Balances as a Function of r and Y

*Money Supply -India M3 is the widely used money supply variableIt comprises of (1 to 4):1 Currency with Public2 Deposit money of the public3 Post office, savings bank deposits4 Time DepositsM1=1+2M2= M1+3M3 = 1 to 4M4=M3+ TOTAL Post Office deposits

*Supply of MoneyCommercial Banks in India report to RBI every Friday, which will be collated by RBIThe WSS is uplinked on every Friday by noon; and can be obtained at www.rbi.org.inThe latest data as on Feb 28, 2014 are:The Indian Scenario (Source: WSS)Money Supply (As on Feb 07, 2014 ) Rs. 93,48,930 CrCurrency With Public Rs 12,37,010CrDD deposits with banks Rs. 7,73,210 CrTime Dep with banks Rs. 73,37,570 CrOther deposits with RBI Rs 11,500 CrAssumption: RBI can determine MS with certainty

*Rate of InterestNominal r: The interest rate charged by the lending institutionsReal r: The difference between nominal int. rate and rate of inflation.Eg: If Nominal int. is 15% and expected inflation for the next 12 months is 7%, the real int. rate is 15-7 = 8%In India, though the nominal lending rate is high, high inflation of 7-8% made the real interest rate still lowA 10% inflation rate, for example, makes the real interest much lower (with same nominal lending rate)

*Expansion & Contraction of MS

The exogenous MS is a vertical line in the real int. rate and money balances space.An increase in Supply will shift the MS curve to the right; and a decrease will shift it to the left. We take r on Y axis and M/P on X axis.

*Derivation of the LM CurveLet the income vary to shift DD for moneyLet Supply of money remain fixed (M/P)Two eqbm points (E1 and E2) help locate interest rates in the money market.The corresponding points help us to identify the equilibrium income & output The line passing through the two points gives us the LM Curve

*Derivation of the LM Curve

*Demand for MoneyClassicals: Money is demanded only for transaction motive; as peoples income rises, they demand more money to buy more and if inflation to rise, to offset costs.Keynes added:Precautionary Motive (unforeseeable needs)Speculative Motive (comparison between interest rates and liquidity preference)

*Liquidity TrapDerived from speculative DD for moneyNormal Vs Expected interest ratePlungers: Either hold all finances in the form of Bonds or all in Money form (little empirical validity for this behaviour). Normally, people allocate between themIf r falls too low, increase in MS will be retained, rather than being used to buy bonds. It is called liquidity trap

*Equilibrium in Money MktSupply of money= Demand for moneySymbolically, MS/P = MD/PMo/P =L1 (Q) + L2 (r) , where L1 is transaction DD and L2 speculative DD, r interest rate and Q is Supply of moneyHigher the interest rate over eqbm. rate, less is the transaction demand (rise in Sp.DD) along the same DD, and vice versa.

* Rise in M3 Shifts the LM to the Right

*Eqbm in Money and Goods MktsInteraction of the IS and LM The two curves represent loci, points away from the equilibrium cannot persist. The money and goods markets reach equilibrium at point E This model is useful for policy changes

*Eqbm in Money and Goods Mkts

*Rise in Autonomous Spending Shifts the IS Curve to the Right

*Derivation of the Aggregate Demand Schedule

*Policy ImplicationsIdea about firms& individuals spending pattern Fiscal Expansion, and Crowding outOutput increases to sub-optimal level of Q1 only; and pushes up interest rate. If IS were vertical, Hence, Pvt. sector is forced to cut investment plans. (shaded area in fig.b) (we will have a detailed discussion on this during MFPOL)Monetary Expansion: Increase in MS leads the interest rates to fall from I0 to I1; output rises from Q0 to Q1

*ConclusionsGoods and Assets markets respond differently to changes in interest rateBoth markets must reach a balance to keep economy in equilibriumIS and LM refer to loci of equilibriums of Goods and Assets marketsThe ISLM Model helps the RBI and Ministry of Finance to take expansionary or contractionary policies. Generally, a judicious Policy Mix is adopted to keep economy in equilibrium.Business firms tracking fiscal and monetary policy variables help them to take appropriate and timely decisions.

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