IS-LM Model

Income Asset Markets Money Market Bond Demand Supply Good Market Aggregate Demand Output Fiscal Policy Monetary Policy Interest Rates

A full macroeconomic model includes four different markets: (1) goods market, (2) money market, (3) bond market and (4) labour market. When the money market is in equilibrium, the bond market must also be in equilibrium. So we can omit the bond market. In this section and the next, we consider the IS-LM model, which is used to explain how income and interest rate are determined simultaneously in the goods market and the money market. However, when the goods and the money markets are in equilibrium, the labour market may not be in equilibrium; there may be excess demand (labour shortage) for or excess supply (unemployment) of labour.

The simple Keynesian model is a model of the goods market Financial Market The simple Keynesian model is a model of the goods market To add realism (and monetary policy), we can add a financial market The financial market is a money market--the demand for and supply of money determine the interest rate

The IS-LM is an extension of the simple Keynesian model IS-LM Model The IS-LM is an extension of the simple Keynesian model It is still a Keynesian model it is a short run model of the economy price level is assumed to be fixed It adds the aforementioned investment function and a financial market

The IS-LM model has a goods market (IS) and a financial market (LM) The IS-LM model determines output and interest rates The IS-LM model has fiscal policy (government spending and taxation) and monetary policy (money supply)

ISLM analysis Deriving the IS curve

r r1 Y1 S1 I1 r2 Y2 S2 I2 I Y S Figure 5(a) - (d) (c) (d) r1 Y1 S1 I1 r2 Y2 S2 I2 IS I I Y 45o S (b) S (a) Figure 5(a) - (d) Deriving the IS curve

r J Y W Figure 1(a) - (d) The IS curve with G and T (c) (d) G IS J=I+G J Y 45o T W=T+S (b) W (a) Figure 1(a) - (d) The IS curve with G and T

Y S I S 45 degree line S2 Y2 S1 Y1 Y r r1 r2 I r r1 I1 r2 I2 IS

Y W W = S+T INJ 45 degree line r r1 r2 J = I + G W1 Y1 W2 Y2 I1 I2 IS

Income-Expenditure Approach Y r 45 degree line E (r2) Y2 IS r1 Y1 x E (r1) Y1 r2 Y2 x Y

The effect of a fall in interest rate on equilibrium income I2 (r2) I1 (r1) Y1 Y2 Y Figure 1 The effect of a fall in interest rate on equilibrium income

r r1 r2 IS Y1 Y2 Y Figure 2 The IS curve

Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 Injections, Withdrawals S1 (W1) I1 (J1) O r1 Rate of interest O

Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 Injections, Withdrawals S1 (W1) I1 (J1) O Y1 r1 Rate of interest O

Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 Injections, Withdrawals S1 (W1) I1 (J1) O Y1 r1 Rate of interest O Y1

Goods market equilibrium: deriving the IS curve Assume that an interest rate of r1 gives investment of I1 and saving of S1 Injections, Withdrawals S1 (W1) I1 (J1) O Y1 a r1 Rate of interest O Y1

Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 Injections, Withdrawals S1 (W1) S2 (W2) I2 (J2) I1 (J1) O Y1 Y2 a r1 Rate of interest r2 O Y1

Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 Injections, Withdrawals S1 (W1) S2 (W2) I2 (J2) I1 (J1) O Y1 Y2 a r1 Rate of interest r2 O Y1 Y2

Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 Injections, Withdrawals S1 (W1) S2 (W2) I2 (J2) I1 (J1) O Y1 Y2 a r1 Rate of interest b r2 O Y1 Y2

Goods market equilibrium: deriving the IS curve Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2 Injections, Withdrawals S1 (W1) S2 (W2) I2 (J2) I1 (J1) O Y1 Y2 a r1 Rate of interest b r2 IS (J = W) O Y1 Y2

r Y (steeper, larger MPS) (flatter, smaller MPS) IS IS Figure 16(a) Y Figure 16(a) The slope of the IS curve

r Y (steeper, smaller interest elasticity of I) (flatter, larger b) IS Y Figure 16(b) The slope of the IS curve

Y E Y E E2(r2) E2 (r2) E1(r1) E1 (r1) Y r Country A Y r Country B r1 x 45 degree line Y E Y E 45 degree line E2(r2) E2 (r2) E1(r1) E1 (r1) Y r Country A Y r Country B r1 x r1 x r2 x r2 x IS IS

Shift of IS Curve If G increase G x K E Y 45 degree line E2(r1)

The effect of autonomous increase in investment on the IS curve LM r1 IS2 I2 IS1 I1 I Y 45o S S Figure 11 The effect of autonomous increase in investment on the IS curve

ISLM analysis Deriving the LM curve

The money market, like any market, will have a supply and demand Supply of Money The money market, like any market, will have a supply and demand The supply of money in our model will be determined by the monetary authority (central bank, Fed) We will assume that it is fixed at any point in time but may be changed to achieve the objectives of the monetary authority

Money Market i Ms M

There are two sources of the demand for money Since the money supply is fixed at any point in time, the demand for money will determine the interest rate There are two sources of the demand for money transactions demand speculative/asset demand

Money market equilibrium: deriving the LM curve Assume that at a level of national income, Y1, the demand for money is L' Rate of interest Rate of interest L' O O Y1 Money National income

Money market equilibrium: deriving the LM curve Assume that at a level of national income, Y1, the demand for money is L' MS Rate of interest Rate of interest L' O O Y1 Money National income

Money market equilibrium: deriving the LM curve MS Rate of interest Rate of interest r1 r1 L' O O Y1 Money National income

Money market equilibrium: deriving the LM curve MS Rate of interest Rate of interest c r1 r1 L' O O Y1 Money National income

Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS Rate of interest Rate of interest c r1 r1 L" L' O O Y1 Y2 Money National income

Money market equilibrium: deriving the LM curve Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS r2 r2 Rate of interest Rate of interest c r1 r1 L" L' O O Y1 Y2 Money National income

Money market equilibrium: deriving the LM curve MS d r2 r2 Rate of interest Rate of interest c r1 r1 L" L' O O Y1 Y2 Money National income

Money market equilibrium: deriving the LM curve MS LM d r2 r2 Rate of interest Rate of interest c r1 r1 L" L' O O Y1 Y2 Money National income

r M1 r2 r1 L2 (Y2) L1 (Y1) Y Figure 3 The effect of a rise in income on equilibrium interest rate

r LM r2 r1 Y Y1 Y2 Figure 4 The LM curve

Derivation of LM Curve r M Ms r Y LM Md(Y2) r2 Md(Y1) r1 x Y2 x Y1

Figure 10.4 Deriving the LM curve

r Y2 Mt2 r2 r1 Y1 Mt1 Ma Y Mt Figure 6(a) - (d) Deriving the LM curve 45o M1 Mt (b) Mt (a) Figure 6(a) - (d) Deriving the LM curve

Y Mt Ma Mt 45 Mt1 Y1 Mt2 Y2 Y r r1 r2 Ma r LM r1 Ma1 r2 Ma2

r Y (income elasticity of transaction money demand = d) LM (steeper, larger d) LM (flatter, smaller d) Y Figure 17(a) The slope of the LM curve

r Y (interest elasticity of asset money demand = e) LM (steeper, smaller e) LM (flatter, larger e) Y Figure 17(b) The slope of the LM curve 47

Figure 10.5 An increase in the real money supply shifts the LM curve down

Figure 10.6 An increase in real money demand shifts the LM curve up

r LM1 LM2 r1 Ma IS Ma Y 45o Mt2 Mt1 Mt Figure 14 The effect of decrease in transactions demand for money on the LM curve

The effect of decrease in asset demand for money on the LM curve IS Ma2 Ma Y 45o Mt1 Mt Figure 15 The effect of decrease in asset demand for money on the LM curve

ISLM analysis Equilibrium

r Y D B r2 A C r1 IS Y1 Y2 Figure 7 Disequilibrium in the goods market I<S(or E<Y) D B r2 A C r1 I>S (or E>Y) IS Y1 Y2 Y Figure 7 Disequilibrium in the goods market

r Y LM A C r1 D B r2 Y1 Y2 Figure 8 Disequilibrium in the money market Md<Ms A C r1 Md>Ms D B r2 Y1 Y2 Y Figure 8 Disequilibrium in the money market

r Y re Ye LM IS Figure 9 The IS-LM model I<S Md<Ms I>S re Ye I<S Md<Ms LM I>S Md<Ms I<S Md>Ms IS I>S Md>Ms Figure 9 The IS-LM model

The relationship between goods market and money market i.e. Y = E Y = C + I Equilibrium: i.e. Ms = Md Ms = Mt + Md Equilibrium: C or I Md or Ms Y≠E affects Mt affects I Ms≠ Md There will be unintended inventory investment or disinvestment People will buy bonds or sell bonds Y r Until Y = E and Md = Ms Figure 10 The relationship between goods market and money market

Equilibrium in both the goods and money markets LM Rate of interest IS O National income

Equilibrium in both the goods and money markets LM Assume that national income is currently at a level of Y1 Rate of interest a IS O Y1 National income

Equilibrium in both the goods and money markets LM This gives a rate of interest of r1 (point a) Rate of interest a r1 IS O Y1 National income

Equilibrium in both the goods and money markets LM But at r1, national income is below the goods market equilibrium level (Y2) Rate of interest a b r1 IS O Y1 Y2 National income

Equilibrium in both the goods and money markets But as income rises, so there will be a movement up the LM curve. The interest rate will rise, thereby reducing national income below Y2. LM Rate of interest a b r1 IS O Y1 Y2 National income

Equilibrium in both the goods and money markets LM Rate of interest re IS O Ye National income

Crowding-out effect

The effect on Y when r is kept constant E Y 45 degree line E2(r1) x G x  G x K r Y r1 The effect on Y when r is kept constant LM IS2 IS1

Crowding out effect E 45 degree line E2(r1) E1(r1) G  G x K Y r r1 x IS1 IS2 LM  G x K G Crowding out effect

The flatter the IS curve, the higher the crowding out effect Y r IS1 LM IS2 Y r IS1 LM IS2

The crowding-out effect LM r2 r1 IS2 IS1 Y Y1 Y2 Yf crowding-out effect Figure 14 The crowding-out effect

The flatter the LM, the lower the increase in r, the smaller the crowding out effect Y r Y r IS2 IS1 LM1 IS2 IS1 LM1

fiscal and monetary policy ISLM analysis ISLM analysis of fiscal and monetary policy

ISLM analysis of fiscal and monetary policy Rate of interest r1 IS O Y1 National income

ISLM analysis of fiscal and monetary policy Expansionary fiscal policy Rate of interest r2 r1 IS2 IS1 O Y1 Y2 National income

r LM G × k IS2 IS1 Y Figure 2 The effect of a change in G

r r Y Y LM LM IS2 IS2 IS1 IS1 (a) Fall in lump-sum tax Y (a) Fall in lump-sum tax (b) Fall in marginal tax rate Figure 3 The effect of a change in T

r LM G × kb IS2 IS1 Y Figure 4 The effect of changes in both G and T

ISLM analysis of fiscal and monetary policy Expansionary monetary policy Rate of interest r1 r3 IS O Y1 Y3 National income

The effect of increase in money supply on the LM curve Ma LM2 r1 M2 M1 IS Ma Y 45o 45o Mt Mt Figure 13 The effect of increase in money supply on the LM curve

r Y r Y (a) LM1 LM2 LM2 LM1 IS IS (b) Figure 6 (a) r LM1 LM2 LM2 LM1 M × V M × V IS IS Y (b) Figure 6 The effect of changes in money supply

ISLM analysis of fiscal and monetary policy Expansionary fiscal and monetary policy LM2 Rate of interest r1 IS2 IS1 O Y1 Y4 National income

r LM1 LM2 IS2 IS1 Y Figure 5 The effect of changes in both G and Ms

The Effectiveness of Fiscal Policy How effective will fiscal policy be? It depends on the policy goal In general, fiscal policy is concerned with output and/or employment The effectiveness of fiscal policy is determined by the nature of the LM curve

The Effectiveness of Fiscal Policy When fiscal policy changes the IS curve shifts This shift causes a movement along the LM curve If the LM is relatively flat, fiscal policy will be more effective for changing output If the LM is steeper, fiscal policy will not be so effective for output/employment changes

r LM’ LM IS2 IS1 Y Figure 9 The slope of the LM curve and the effectiveness of fiscal policy

r Y LM IS2’ IS1’ IS1 IS2 Figure 7 Y Figure 7 The slope of the IS curve and the effectiveness of fiscal policy (with the same horizontal shift, i.e., same ΔGxk, same income elasticity of saving = Fig.7.2, P.194)

r IS1 IS2 LM Y Figure 11(a) The IS curve is vertical

r LM IS2 IS1 Y Figure 11(b) The LM curve is horizontal

autonomous change in AD Y r IS3 Steeper IS curve Larger MPS = Smaller k IS2 IS1 Smaller horizontal Shift of IS curve Effect of any autonomous change in AD (e.g. change in G) on income is smaller

Monetary Policy Effectiveness When monetary policy changes the LM curve shifts This shift causes a movement along the IS curve If the IS is relatively flat, monetary policy will be effective for changing output/employment The opposite if the IS is steep

r LM1 LM2 IS IS’ Y Figure 7.7 The slope of the IS curve and the effectiveness of monetary policy

The flatter the IS, the higher the effectiveness of monetary policy LM1 IS2 LM2

r Y LM*0 LM*1 LM0 LM1 IS Figure 7.9 Y Figure 7.9 The slope of the LM curve and the effectiveness of monetary policy (with the same horizontal shift, i.e., same ΔMxV, same income elasticity of transaction money demand, less interest elastic, more effective MP)

LM, the less the decrease in r , the lower the Y r LM2 LM4 r1 The flatter the LM, the less the decrease in r , the lower the effectiveness of monetary policy r2 r3 Y2 Y3 lS2 Y1

r LM1 LM2 IS Y Figure 7.16(a) The IS curve is horizontal, YES = 0 or rEI = infinity, MP is the most effective

r LM1 LM2 IS Y Figure 7.16(d) The LM curve is vertical, rEMa = 0, MP is the most effective

r IS LM1 LM2 Yf Y Figure 7.16(b) Monetary policy and perfectly inelastic investment, YES = infinity or rEI = 0 & MP is completely ineffective

r LM1 LM2 IS Yf Y Figure 19 Monetary policy and liquidity trap & MP is completely ineffective

Larger Income Elasticity of Money Demand (d) Smaller V Steeper LM curve Smaller horizontal Shift of LM curve Effect of any autonomous change in Ms on income is smaller

fiscal and monetary policy ISLM analysis Keynesian analysis of fiscal and monetary policy

Keynesians Keynesians believe that money holdings are very sensitive to interest rate changes Some even believe that a liquidity trap may exist--at low levels of interest rates individuals will hold their wealth in money rather than bonds Keynesians believe that the LM curve is very flat and fiscal policy will be effective

Keynesian analysis of fiscal and monetary policy LM Expansionary fiscal policy Rate of interest IS2 IS1 O Y1 Y2 National income

Keynesian analysis of fiscal and monetary policy Expansionary monetary policy LM1 Rate of interest LM2 IS O Y1 Y2 National income

Monetarist analysis of fiscal and monetary policy ISLM analysis Monetarist analysis of fiscal and monetary policy

Monetarists Monetarists believe that people hold money for transactions and that the interest rate will not affect the demand for money This implies a zero value for interest elasticity of asset money demand and a vertical LM curve Monetarists believe that fiscal policy will be very ineffective for Y control

Monetarist analysis of fiscal and monetary policy LM Expansionary fiscal policy Rate of interest IS2 IS1 O Y1 Y2 National income

Monetarist analysis of fiscal and monetary policy LM1 LM2 Expansionary monetary policy Rate of interest IS O Y1 Y2 National income

Monetary Policy Effectiveness: What’s the slope? The controversial part of the IS slope is the sensitivity of investment demand to interest rate changes Keynesians believe that investment is not sensitive to interest rate changes. This leads them to the conclusion that the IS curve is steep and monetary policy is not effective at changing Y. They believe fiscal policy should be the primary policy tool.

Monetarists believe differently Slope Debate (cont’d) Monetarists believe differently They believe that firms will act rationally with regard to investment The autonomous component will be relatively stable and interest rate will play an important role in determining investment

IS-LM? Keynesian Monetarist LM i i LM LM IS IS IS Y Y