IS - LM Model By Wong Chuen-Ping

2 markets Goods Market Equilibrium: E = Y C + I = C + S I = S Money Market Equilibrium: Md = Ms

The Goods Market S = 0.2Y - 40 I = 260 - 2000r 0.2Y - 40 = 260 - 2000r In equilibrium: S = I 0.2Y - 40 = 260 - 2000r Y = 1500 - 10000r IS equation Y S I r 60 0.10 700 100 0.08 900 140 1100 180 0.04 1300 220 0.02 260 500 0.06 1500

The Goods Market Y = 1500 - 10000r

IS curve IS curve shows all the combinations of real national income (Y) and real interest rate (r) at which the goods market is in equilibrium.

How to derive IS curve? r r1 r2 I IS I2 I1 Y1 Y2 I 450 Y S1 S2 S S

ED & ES in product market I=S E=Y ES S>I Y>E ED C A B (Y , S ) (Y . S ) S<I IS Y<E Y

Disequilibrium in product market E=Y ES I<S E<Y ED I>S E>Y IS Y

r r The IS Curve IS r1 r2 I Y I1 I2 Y1 Y2 I S S 45 S2 S S1 Y I

IS Curve IS r S, I S I2 I1 Y Y at r1, investment = I1 Lower r, higher I r IS S, I r1 S r2 I2 I1 Y Y Y1 Y2 Y1 Y2

The Money Market Ms =400 Mt = 0.25Y Ma = 250 – 2000r In equilibrium: Ms = Mt + Ma 400 = 0.25Y + 250 - 2000r Y = 600 + 8000r LM equation Y Ms Mt Ma r 400 150 250 1000 1600 600 0.05 0.125

The Money Market Y = 600 + 8000r Y R 600 1000 05 1400 0.1

LM curve LM curve shows all the combinations of real national income (Y) and real interest rate (r) at which the money market is in equilibrium.

How to derive LM curve? LM r r2 r1 Ma Y Mt Ma A1 A2 Y1 Y2 H O T1 Ms=OH=OK T2 Mt K Mt

ED & ES in Money market ES ED LM Md<Ms Md>Ms Md=Ms r (Y . Mt ) C B (Y , Mt ) Md>Ms ED Y

Disequilibrium in Money market LM Md<Ms Md=Ms ES Md>Ms ED Y

r r The LM Curve LM Mt r2 r1 Y Ma Mt T2 T1 Y Ma Ma A2 A1 Y1 Y2 H Mt Ms=OH=OK Y Ma O K

LM Curve LM r r M Y at Y1, Md = Md1 at Y2, Md = Md2 Higher Y, higher Md LM r r Ms r2 r2 r1 r1 Md2 Md1 M Y Y1 Y2

Equilibrium in Product & Money Market LM A r1 IS Y1 Y

Disquilibrium in Product & Money Market < I S r Ms Md > LM F > I S > < Ms Md I S J G < Ms Md H > < IS I S Ms Md Y

IS-LM Equations Goods Market Money Market C = 100 + 0.8Y I = 200 - 400r In equilibrium: Y = E = C + I IS equation: Y = 1500 - 2000r Money Market Ms = 300 Mt = 0.2Y Ma = 50 - 100r In equilibrium: Ms = Md =Mt + Ma LM equation: Y = 1250 + 500r R = 0.1 i.e. 10% Y = 1300

IS-LM Equations r = 0.05 i.e. 5% Y = 1475 Goods Market Money Market C = 100 + 0.75Yd I = 300 - 7000r G = 525 T = 20%(Y-100) IS equation ? Money Market Ms = 800 Mt = 120 + 0.4Y Ma = 240 - 3000r LM equation ? Y = 2350 - 17500r Y = 1100 + 7500r r = 0.05 i.e. 5% Y = 1475

Shifts in the IS curve I r1 r2 I2 I1 Y1 Y2 S1 S2 r IS2 I2 I1 IS1 I 450

Increase in Investment ( or↑G) ↑I, at same r, Y↑, IS shifts to the right r △Y =△I x A B r1 IS2 IS1 Y1 Y2 Y

Shifts in the IS curve S r r1 IS2 I1 I1 Y1 Y2 IS1 I 450 Y S1 S2 S S1

Decrease in Saving ( or↓T) ↓S, at same r, E↑, Y↑, IS shifts to the right r A B r1 IS2 IS1 Y1 Y2 Y

Shifts in the LM curve LM1 r Ms LM2 r1 Ma A1 Y1 Ma Y T1 Mt Mt

Increase in Money Supply at same Y, ↑Ms, Ms > Md, r↓ LM1 r LM2 A r1 B Y1 Y LM shifts to the right

Increase in Money Supply ↑Ms, at same r, Y↑, LM shifts to the right r LM1 △Y =△Ms x LM2 A r1 B Y1 Y2 Y

Shifts in the LM curve LM1 r Mt LM2 r1 Ma A1 Y1 Ma Y O T1 Mt2 Mt1 Mt

Decrease in Mt LM shifts to the right at same Y, Mt↓, Ms > Md, r↓ B Y1 Y LM shifts to the right

Shifts in the LM curve LM2 r Ma LM1 r1 Ma2 Ma1 A1 Y1 Ma Y O T1 Mt1 Mt

Increase in Ma LM shifts to the left at same Y, Ma↑, Ms < Md, r↑ B A r1 Y1 Y LM shifts to the left

Increase in Investment (↑G, ↑C) LM B r2 A r1 IS2 IS1 Y1 Y2 Y

Increase in Saving (↑Tax) LM A r1 B r2 IS1 IS2 Y2 Y1 Y

Increase in Money Supply (↓Md) LM1 LM2 A r1 B r2 IS Y1 Y2 Y

Increase in demand for Money (↓Ms) LM2 r LM1 B r2 A r1 IS Y2 Y1 Y

Slope of the IS curve & MPS r↓, I↑→↑Y (ΔY = ΔI x ) r larger MPS, steeper IS r1 Smaller MPS, flatter IS r2 IS2 IS1 Y Y1 Y2 Y3 Smaller MPS, greater multiplier, flatter IS

Slope of IS & Interest elasticity of I r↓, I↑, more interest elastic, larger ΔI, largerΔY Less interest elastic I, steeper IS r r1 More interest elastic I, r2 flatter IS IS2 IS1 Y Y1 Y2 Y3 more interest elastic investment, flatter IS

Slope of LM & Income elasticity of Mt Y↑, Mt↑, more income elastic Mt, larger ↑in Mt, largerΔr more income elastic Mt, steeper LM r Less income elastic Mt, r1 flatter LM LM1 LM2 Y Y1 Y2 more income elastic Mt, steeper LM

Slope of LM & Interest elasticity of Ma Y↑, Mt↑, Md > Ms, r↑to ↓Ma, less r elastic Ma, largerΔr less interest elastic Ma, steeper LM r more interest elastic Ma, r1 flatter LM LM1 LM2 Y Y1 Y2 less interest elastic Ma, steeper LM

Fiscal Policy - ↑G IS2 AF =ΔG x IS1 LM r B r2 A F r1 Crowding-out effect Y1 Y2 Y

The crowding-out effect The crowding-out effect refers to the reduction in income resulting from an increase in interest rate. G  E  E >Y  Y  Mt Md > Ms r  r   I  Y  (crowding-out effect)

The crowding-out effect IS2 AF =ΔG x r IS1 LM B r2 A F r1 Crowding-out effect Y1 Y2 Y

Factors affecting the crowding-out effect condition of employment (unemployment, ? crowding-out effect) (full employment, ? Crowding-out effect) interest elasticity of demand for money, more interest elastic, smaller change in r, crowding-out effect ? . interest elasticity of investment, less interest elastic, when r , smaller  in I, crowding-out effect ? . smaller larger smaller smaller

Fiscal Policy - ↑Tax LM LM IS1 IS1 IS2 IS2 Lump sum tax ↑, r LM r LM A A r1 r1 B B r2 r2 IS1 IS1 IS2 IS2 Y2 Y1 Y Y2 Y1 Y Lump sum tax ↑, IS shifts left Tax rate↑, IS steeper

Fiscal Policy - Equal↑in G & T AF =ΔG = ΔT r IS1 LM B r2 A F r1 Crowding-out effect Y1 Y2 Y

Monetary Policy - ↑Ms r LM1 LM2 A r1 B r2 IS Y1 Y2 Y

Fiscal & Monetary Policies - ↑Ms + ↑G B r1 A IS2 IS1 Y1 Y2 Y

Effectiveness of Monetary Policy & slope of IS Ms ↑→r↓→I↑, LM →right , more interest elastic (flatter IS), larger ↑I, larger↑Y smaller MPS (flatter Y), larger ↑Y r LM1 LM2 A r0 B r1 r2 C IS1 IS2 Y0 Y2 Y1 Y Monetary Policy is more effective if IS is flatter

Effectiveness of Fiscal Policy & slope of LM r↑smaller, crowding-out smaller G↑, IS →right , Y↑ → Mt↑, Mt less income elastic, Ma more interest elastic, r LM2 C r3 LM1 B r2 A r1 IS2 Crowding-out effect IS1 Y1 Y3 Y2 Y Fiscal Policy is more effective if LM is flatter

The LM Curve with liquidity trap Ma – perfectly interest elastic Horizontal LM LM r1 Ma Y1 Y2 Y Ma Mt Mt H Mt T1 Y Ma O K

The LM Curve with Ma perfectly interest inelastic vertical LM r2 Ma r1 Y1 Y Ma Mt Mt H Mt Y Ma O K

The IS Curve with perfectly interest inelastic I r r Investment perfectly interest elastic IS IS vertical r1 r2 I1 Y1 Y I S S 45 S S1 I Y

Horizontal LM G↑ Ms↑ IS2 IS1 IS1 LM Fiscal Policy effective B r1 r1 LM LM Y1 Y2 Y Y1 Y Fiscal Policy effective Monetary Policy ineffective

Vertical LM G↑ Ms↑ LM1 LM2 IS2 IS1 IS1 Fiscal Policy ineffective B IS2 A r1 r1 A B r2 IS1 IS1 Y1 Y Y1 Y2 Y Fiscal Policy ineffective Monetary Policy effective

Vertical IS G↑ Ms↑ LM1 IS1 IS2 LM2 IS Fiscal Policy effective B r2 r1 r1 B r2 A Y1 Y2 Y Y1 Y Fiscal Policy effective Monetary Policy ineffective

Horizontal IS G↑ Ms↑ LM1 LM2 IS Fiscal Policy ineffective B Y1 Y2 Y1 Y Y Fiscal Policy ineffective Monetary Policy effective