1. Goods and of Financial Market : The IS-LM Model
The Goods Market and The IS Relation
Y = C (Y-T) + I + G
Investment, Sales, and The Interest Rate
I = I (Y, i)
(+, -)
Where : Y = Production
i = Interest rate

2. The IS Curve
Y = C (Y-T) + I (Y, i) + G
The supply of goods (the left side) must be equal to the demand for goods (the right side)

3. The Effects of an Increase in The Interest rate on OutputZZ
Demand, z
For interest rate, i A
ZZ’
For interest rate I’>i A’ Y’ Y
Output, Y

4. The Derivation of the IS CurveZZ
ZZ’ A A’ Y’ Y
Output, Y
Interest rate, i A’ i’ A i
IS curve Y’ Y
Output, Y

5. The Shifts in the IS Curve
Interest rate, i i
IS ( For taxes T)
IS ( for T’>T) Y’ Y
Output, Y

6. Financial Markets and The LM Relation
MS = M d
M = $ YL (i)
Variable M on The left side is the nominal money stock
M/P = Y L (i) ………….. LM Relation

7. The effects of an increase in Income on the interest rate
M d (for Income Y) A A’ i’ i
Interest rate, i
M/P
Real Money, M/P)
M d’ (for Y’> Y)

8. The Derivation of The LM Curve
M d’ (for Y’> Y)
M d (for Income Y) A’ A
M/P
(Real Money, M/P) i I’ Y Y’
Interest rate, i LM
Income, Y

9. Shifts in The LM Curve LM (for M/P) Interest rate, i
Income, Y
Interest rate, i i’ i Y
LM (for M/P)
LM ‘ (for M’/P > M/P)
An Increase in Money

10. The IS-LM Model : Exercises
IS Relation Y = C(Y-T)+I(Y, i) + G
LM Relation M/P = Y L( i )

11. The IS-LM Model Interest rate, i Equilibrium in Financial Market (LM)
Income, Y Y i
Interest rate, i
Equilibrium in Goods Market (IS)

12. Fiscal Policy, Activity, and The Interest Rates
Decrease in
G-T
Fiscal contraction/
Fiscal Consolidation
Increase in
G-T
Fiscal Expansion

13. In answering this or any question about the effects of Changes in policy, always follow these three steps :
Ask how this change affects good and financial market equilibrium relations , how its shifts the IS or/and the LM Curve
Characterize the effects of these shifts on the equilibrium
Describe the effects in the words

14. How The Increase in Taxes
The Increase in taxes affects equilibrium in the goods market (IS)
The increase in taxes affects decreases consumption ( because people have less disposable income ) and through the multiplier, decreases output
What Happens to the LM Curve ? nothing

15. The effects of an Increase in Taxes
IS (for T)
IS’ (for T’> T)
Output, Y
Interest rate, i i’ i LM Y’ Y
An Increase in taxes shifts the IS curve to the left, and leads to a decrease in equilibrium output and the equilibrium interest rate

16. Monetary Contraction/ Monetary Tightening
Monetary Policy, Activity, and The Interest Rates
Increase in
Money (M)
Monetary
expansion
Decrease in
Money (M)
Monetary Contraction/
Monetary Tightening

17. How The Central Bank Increases Nominal Money, through open market operation (Price level is fixed)
The Increase in Nominal money affects equilibrium in the Financial market (LM)
An increase in money shifts the LM down
What Happens to the IS Curve ? Nothing 18

18. The effects of a monetary ExpansionIS
LM (for M/P)
LM’ (for M’/P) > M/P)
Interest rate, i
Output, Y Y Y’ i I’
A monetary expansion leads to higher output and a lower interest rate

19. The Effects of Fiscal and Monetary Policy
Shifts in IS
Shifts in LM
Movement in Output
Movement in Interest Rate
Increase in Taxes
Left
None
down
Decrease in taxes
Right Up
Increase in Spending
Decrease in Spending
Increase in money
Decrease in money

20. Using a Policy Mix
Some times monetary and fiscal policies is used to offset the adverse on the demand for goods of fiscal contraction
Some times the monetary-fiscal mix emerges from tensions or even disagreements between the government (which is in charge of fiscal policy) and the central bank (which is in charge of monetary policy)

21. Table : Selected Macro Variables for USA, 1991-1998
1991
1992
1993
1994
1995
1996
1997
1998
Budget Surplus (% of GDP)
(minus sign : deficit)
-3.3
-4.5
-3.85
-2.7
-2.4
-1.04
-0.3
0.8
GDP Growth (%)
-0.9
2.7
2.3
3.4 2
3.9
3.7
Interest Rate (%)
7.3
5.5
3.3 5
5.6
5.2
4.8
Source : Bureau of economic Analysis

22. Deficit Reduction and Monetary Expansion
Output, Y
Interest rate, i
IS’ IS LM
LM’ A A’ B i I’ Y
The Right Combination of deficit reduction and monetary expansion can achieve a reduction in the deficit without adverse effects on output

23. Adding Dynamics Source of dynamics in goods market :
Production adjusts slowly to demand
Demand (consumption and investment) adjusts slowly to income (production)
Slow adjustment of Y in goods market
Fast adjustment of i in financial market

24. Output, Y A B YA YB iA
IS’ IS
Output decreases slowly
Output Increases slowly
LM’ LM iB
Interest rate, i
Goods Market
Financial Market
Interest rate
Adjust
Instantaneously
Interest rate, i

25. The Dynamic effects of a Monetary contraction
Interest rate, i IS
LM’ LM A A’
A’’ i’
i’’ i Y Y’
A monetary contraction leads
To an increase in the interest
Rate. The Increase in the
Interest rate leads, over time
To decline in output
Output, Y

26. Monetary and Fiscal Policy : an Example
Consider the following IS-LM Model :
C = YD
I = Y – 1000 I
G = 250
T = 200
(M/P) d = 2Y i
M/P = 1,600

27. Derive the equation for the IS curve
Derive the equation for LM curve
Solve for equilibrium real output
Solve equilibrium interest rate
Solve for equilibrium values of C and I
Now Suppose that the money supply increases to M/P = Solve Y, i, C and explain in words the effects of expansionary monetary policy
Set M/P equal its initial value of 1600, Now suppose that government spending increase to G = 400. Summarize the effects of expansionary fiscal policy on Y, i and C. and why if government spending decrease to G = 100