1. IS - LM Model
By Wong Chuen-Ping

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

3. The Goods Market S = 0.2Y - 40 I = 260 - 2000r 0.2Y - 40 = 260 - 2000r
In equilibrium: S = I
0.2Y - 40 = r
Y = r
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

4. The Goods Market
Y = r

5. 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.

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

7. 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

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

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

10. 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

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

12. The Money Market
Y = r Y R
600
1000 05
1400
0.1

13. 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.

14. 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

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

16. Disequilibrium in Money marketLM
Md<Ms
Md=Ms ES
Md>Ms ED Y

17. 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

18. 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

19. Equilibrium in Product & Money MarketLM A r1 IS Y1 Y

20. 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

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

22. IS-LM Equations r = 0.05 i.e. 5% Y = 1475 Goods Market Money Market
C = Yd
I = r
G = 525
T = 20%(Y-100)
IS equation ?
Money Market
Ms = 800
Mt = Y
Ma = r
LM equation ?
Y = r
Y = r
r = i.e. 5% Y = 1475

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

24. 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

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

26. 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

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

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

29. 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

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

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

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

33. 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

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

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

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

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

38. 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

39. 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

40. 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

41. 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

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

43. 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)

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

45. 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

46. 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

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

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

49. Fiscal & Monetary Policies - ↑Ms + ↑GB r1 A
IS2
IS1 Y1 Y2 Y

50. 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

51. 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

52. 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

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

54. 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

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

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

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

58. Horizontal IS G↑ Ms↑ LM1 LM2 IS Fiscal Policy ineffectiveB Y1 Y2 Y1 Y Y
Fiscal Policy ineffective
Monetary Policy effective