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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