1. IS-LM Model

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

3. 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.

4. 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

5. 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

6. 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)

7. ISLM analysis
Deriving the IS curve

8. 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

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

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

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

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

13. 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

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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

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

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

25. 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

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

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

28. ISLM analysis
Deriving the LM curve

29. 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

30. Money Market i Ms M

31. 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

32. 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

33. 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

34. Money market equilibrium: deriving the LM curveMS
Rate of interest
Rate of interest r1 r1 L' O O Y1
Money
National income

35. Money market equilibrium: deriving the LM curveMS
Rate of interest
Rate of interest c r1 r1 L' O O Y1
Money
National income

36. 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

37. 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

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

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

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

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

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

43. Figure 10.4 Deriving the LM curve

44. 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

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

46. 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

47. 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

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

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

50. 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

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

52. ISLM analysis
Equilibrium

53. 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

54. 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

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

56. 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

57. Equilibrium in both the goods and money marketsLM
Rate of interest IS O
National income

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

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

60. Equilibrium in both the goods and money marketsLM
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

61. 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

62. Equilibrium in both the goods and money marketsLM
Rate of interest re IS O Ye
National income

63. Crowding-out effect

64. 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

65. 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

66. The flatter the IS curve, the higher the crowding out effect Y r IS1LM
IS2 Y r
IS1 LM
IS2

67. The crowding-out effectLM r2 r1
IS2
IS1 Y Y1 Y2 Yf
crowding-out effect
Figure 14
The crowding-out effect

68. 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

69. fiscal and monetary policy
ISLM analysis
ISLM analysis of
fiscal and monetary policy

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

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

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

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

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

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

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

77. 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

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

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

80. 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

81. 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

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

83. r Y LM IS2’ IS1’ IS1 IS2 Figure 7Y
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)

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

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

86. autonomous change in ADY 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

87. 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

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

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

90. r Y LM*0 LM*1 LM0 LM1 IS Figure 7.9Y
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)

91. LM, the less the decrease in r , the lower theY 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

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

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

94. 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

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

96. 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

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

98. 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

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

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

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

102. 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

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

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

105. 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.

106. 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

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