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

In this topic you will learn: 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

The IS curve 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:

Deriving the IS curve r I PE Y PE =C +I (r2 )+G PE =C +I (r1 )+G I Y1

Why the IS curve is negatively sloped 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.

Factors affecting the slope of IS curve 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 that shift the IS Curve Government purchases Taxes Investment Wealth Exchange rate (for an open economy)

Fiscal Policy and 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…

Shifting the IS curve: G PE =Y Y PE PE =C +I (r1 )+G2 At any value of r, G PE Y PE =C +I (r1 )+G1 …so the IS curve shifts to the right. The horizontal distance of the IS shift equals Y1 Y2 r Y r1 Y IS2 IS1 Y1 Y2

The Theory of Liquidity Preference 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.

Money supply The supply of real money balances is fixed: r M/P interest rate The supply of real money balances is fixed: We are assuming a fixed supply of real money balances because P is fixed by assumption (short-run), and M is an exogenous policy variable. M/P real money balances

Money demand Demand for real money balances: L (r ) r M/P interest rate Demand for real money balances: L (r ) M/P real money balances

Equilibrium r interest rate The interest rate adjusts to equate the supply and demand for money: r1 L (r ) M/P real money balances

How central bank raises the interest rate To increase r, Central bank reduces M r2 r1 L (r ) M/P real money balances

The LM curve Now let’s put Y back into the money demand function: 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 r r L (r , Y2 ) LM Y1 Y2 L (r , Y1 ) r2 r2 r1 r1 (a) The market for real money balances (b) The LM curve M/P r r Y L (r , Y2 ) LM Y1 Y2 L (r , Y1 ) r2 r2 r1 r1

Why the LM curve is upward sloping 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.

Factors affecting the slope of LM curve 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 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 (a) The market for real money balances (b) The LM curve M/P r r Y LM2 L (r , Y1 ) Y1 LM1 r2 r2 r1 r1

The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y r LM IS Equilibrium interest rate Equilibrium level of income

Fiscal Policy An 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 Policy An increase in Government Spending

Fiscal Policy An 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 Policy A decrease in Government Tax

Monetary Policy An 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 Policy An 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 Picture Keynesian Cross IS curve IS-LM model Explanation of short-run fluctuations Theory of Liquidity Preference LM curve Agg. demand curve Model of Agg. Demand and Agg. Supply Figure 10-14, p.307. This schematic diagram shows how the different pieces of the theory of short- run fluctuations fit together. Agg. supply curve

REFERENCES 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

Thank You