What are we going to discuss?

 The IS-LM model – the core of short-run

macroeconomics.
 The IS curve describes the combinations of income
and interest rates at which goods market is in
Money, Interest, and Income equilibrium.
 The term IS is actually representing the relationship
between investment (I) and saving (S) when the
goods market is in equilibrium.
Dr. Sanjay K. Singh  The LM curve describes the combinations of income
and interest rates at which the money market is in
IIM Lucknow equilibrium.
 The term LM is actually representing the relationship
between money demand (L) and money supply (M)
when the money market is in equilibrium.

1 2

What are we going to discuss? … The Goods Market and the IS Curve
 The IS and LM curves together give aggregate  The IS curve shows the relationship between
demand. interest rate and output (income) when goods
 The IS-LM model finds the values of GDP and the market is in equilibrium.
interest rate at which both goods and money markets
are cleared.  Two steps to derive the IS curve:
The Structure of the IS-LM Model
 Derive the relationship between investment and
interest rates.
 Derive the relationship between investment and AD
and find out the combinations of income and
interest rates that keep the goods market in
equilibrium.

3 4
 Investment and Interest Rate Investment and Interest Rate …
 Now, let us make investment spending (I)  So, investment spending function can be written as:
endogenous. I  I  bi; b  0
 You know that the desired or planned rate of where i is the rate of interest.
investment will be lower if interest rate is higher.
Why?
 Typically, firms borrow to purchase investment
goods (machines, buildings, …). If cost of
borrowing goes up, expected profit goes down.
 So, firms will want to borrow and invest less when
interest rates are higher.
 Conversely, firms will want to borrow and invest
more when interest rates are lower.

5 6

The Interest Rate and Aggregate Demand: The Interest Rate and Aggregate Demand:
The IS Curve The IS Curve …
 You know that AD = C+I+G+NX, where  Equation (1) shows that an increase in the interest
rate reduces aggregate demand for a given level of
C  C  cYD  C  c (Y  TR  TA) income (because a higher interest rate reduces
C  C  c(Y  T R  tY ) investment spending).
C  C  cT R  c(1  t )Y A which includes I is the autonomous spending.
and, I  I  bi  Autonomous spending is independent of the interest
Therefore, AD  C  I  G  NX rate (and income).
AD  [C  cT R  c(1  t )Y ]  [ I  bi ]  G  N X  At any given level of the interest rate, we can
determine the equilibrium level of income and output.
 [C  cT R  I  G  N X ]  c(1  t )Y  bi
 As the interest rate changes, equilibrium level of
 A  c(1  t )Y  bi (1)
income changes. We get the IS curve.

7 8
 Derivation of the IS Curve The Interest Rate and Aggregate Demand:
The IS Curve …
 We can also derive the IS curve by using the goods
The IS curve shows the
negative relationship between market equilibrium condition, Y = AD.
interest rates and income.
Y  AD  [C  cT R  c(1  t )Y ]  [ I  bi ]  G  N X
Since IS curve represents  [C  cT R  I  G  N X ]  c(1  t )Y  bi
combinations of interest rates
and income at which goods  A  c(1  t )Y  bi
market clears, it is called the
goods market equilibrium Hence, Y [1  c(1  t )]  A  bi
schedule. 1
So, Y  ( A  bi)   G ( A  bi ) (2)
1  c(1  t )
1
where  G is the multiplier (recall previous lecture, Y  A)
1  c(1  t )

9 10

The Slope and Position of the IS Curve The Role of the Multiplier
 The coefficient c’ (dashed
 The IS curve is negatively AD curve) > c (solid AD
sloped because as interest curve).
rate , investment spending ,
thereby AD  and thus the  So, multiplier G = 1/[1-
equilibrium level of income . c(1-t)] is larger for
 If b in (2) is large, IS curve will dashed AD curve.
be flat (since investment  You can see, if multiplier is
spending is very sensitive to larger then the IS curve is
the interest rate; change in i flatter.
shifts AD curve by large  That is, the larger the
amount and thus large change multiplier, the larger the
in equilibrium income). change in income
 If b in (2) is small, IS curve will produced by a given
be steep. change in the interest rate.

11 12
 The Role of the Multiplier … The Role of the Multiplier …
 So, smaller the sensitivity of  Since slope of the IS curve
investment spending to the depends on the multiplier,
interest rate (i.e., b) and
smaller the multiplier (i.e., fiscal policy can affect the
G), the steeper the IS curve. slope. How?
 That is, interest rate change  The multiplier G is affected
doesn’t change the income by the tax rate: an increase
significantly.
in tax rate reduces the
 (2) can be written as: multiplier.
A Y
i  (3)  Therefore, the higher the
b  Gb tax rate, the steeper the IS
 Thus, for a given change in Y, curve (interest rate change
the associated change in i will doesn’t change the income
be larger if b is smaller G is
smaller. significantly).

13 14

The Position of the IS Curve The Money Market and the LM Curve
 What might cause the IS
curve to be at IS’ rather than  The LM curve shows the relationship between
at IS? interest rate and output (income) when money
 The answer is an increase in demand equals money supply.
the level of autonomous
spending.  Two steps to derive the LM curve:
 Thus, an increase in  Derive the relationship between demand for money
autonomous spending shifts and interest rates.
the IS curve out to the right.
 Equate money demand with money supply – set by
 Since A  C  cT R  I  G  N X
the central bank – and find the combinations of
an  in govt. purchase or income and interest rates that keep the money
transfer payments shifts the market in equilibrium.
IS curve rightward. Due to
this, change in income = G A.

15 16
 The Demand for Money The Demand for Money …
 Real demand for money (the demands for real balances)
 Nominal demand for money is the individual’s depends on the real income and the interest rate. Why?
demand for a given number of Rs.  It depends on real income because individuals hold
 Real demand for money is the demand for money to pay for their purchases, which, in turn, depend
on income.
money expressed in terms of the number of  So, if income is higher, the demand for real balances will be
units of goods that money will buy. higher.

 So, real demand for money is equal to the  It depends on interest rate because interest rate
determines cost of holding money.
nominal demand for money divided by the price
 The higher the interest rate, the more costly it is to hold money
level. and, accordingly, the less cash will be held at each level of
income.
 Because people care about the purchasing Therefore, the demand for real balances increases with

power of money, the demand for money is a the level of real income and decreases with the interest
theory of real rather than nominal demand. rate.

17 18

The Demand for Money … The Supply of Money, Money Market

Equilibrium, and the LM Curve
 So, the demand for real
balances (L) can be  How supply of money is determined?
expressed as:  The nominal quantity of money, M, is controlled by the
L = kY – hi, k, h > 0 RBI.
 The parameters k and h  So, we can take nominal quantity of money as given at
reflect the sensitivity of the some level, say at M .
demand for real balances
to the level of income and  Assume that price level is constant at the level P.
the interest rate,
M
respectively.  So, the real money supply is at the level .
P
 Figure shows the shift in
demand curve when real
income changes.

19 20
 Derivation of the LM Curve The LM Curve
 Objective is to find out the relationship between interest rate and
output (income) when money market is in equilibrium.  The LM curve is positively sloped.
 Change the income and see what would be interest rate when money
demand = money supply.  That is, money market equilibrium implies that an
 Then, draw the relationship between interest rate and output increase in the interest rate is accompanied by an
(income). This is called the LM curve. increase in the level of income.
 This is because an increase in the interest rate
reduces the demand for real balances and to maintain
the demand for real balances equal to the fixed
supply, the level of income has to rise.

 The LM curve can also be derived directly from

M 1 M
 kY  hi  i  (kY  )
P h P

21 22

The Slope of the LM Curve The Position of the LM Curve

1 M
 From i  (kY  ),  The real money supply is held constant along the LM curve.
h P  What will happen if money supply is changed?
one can see that the greater the responsiveness of the demand  LM curve will shift (rightward if money supply is increased).
for money to income (k) and the lower the responsiveness of
the demand for money to the interest rate (h), the steeper the 1 M
LM curve will be.  This can be seen from i  ( kY  ) .
h P

23 24
 Equilibrium in the Goods Market and the The IS-LM Diagram
Money Market  There is a value of
 An increase in
output (income) (Y) and
a level of the interest government spending
rate (i) that is consistent or any component of
with the existence of
equilibrium in both goods autonomous spending
as well as money shifts the IS curve to
markets. the right.
 The point at which the IS
and the LM curves • This increases the
intersect corresponds to
the equilibrium outcome. value of both income
and interest rate.
 In this analysis, the price
level is assumed as fixed
and no inflation is taken
into consideration.

25 26

The IS-LM Diagram … The IS-LM Diagram …

• Note – increase in income
is less than the increase in  An increase in the
income when interest rate is money supply shifts
unchanged (i.e.,Y0   G I ). the LM curve to the
Why?
right.
• Explanation is slope of the
LM curve. • In turn, the value of
 But what is the economics
income increases and
of what is happening?
the value of interest
An increase in autonomous spending  level of income, rate decreases.
which  demand for money. Since supply of money is fixed,
this will  the interest rate, which will  the investment
spending. Therefore, equilibrium change in income <
horizontal shift of the IS curve i.e., Y0   G I .

27 28
 The IS-LM Diagram … A Formal Treatment of the IS/LM Model
 The goods market equilibrium equation is:
It is easy to use the IS/LM 1

IS schedule : Y  ( A  bi )   G ( A  bi ) (4)
diagram to see how there 1  c(1  t )
can be a monetary and
fiscal policy mix that leads  The money market equilibrium is:
to a particular outcome. 1 M
LM schedule: i  (kY  ) (5)
• Here, an increase in the h P
money supply accompanied  When both the markets are in equilibrium, then
by an increase in b M
government spending leads Y   G [A  (kY  )]
to an increase in aggregate h P
output, with no change in h G b G M
Y  A (6)
the interest rate. h  kb G h  kb G P

29 30

A Formal Treatment of the IS/LM Model … A Formal Treatment of the IS/LM Model …
 Or equivalently  One can find out equilibrium rate of interest, i, by
G  Gb / h M substituting equilibrium level of income from (7) into the
Y  A equation of the LM schedule (given below)
1   G kb / h 1   G kb / h P
bM 1 M
 Y  A   (7) i (kY  )
h P h P
G k G 1 M
where   i  A
1   G kb / h h  kb G h  kb G P
k 1 M
 Equation (7) shows that the equilibrium level of income i  A   (8)
depends on (i) autonomous spending ( A ) including h h G P
autonomous consumption and investment and fiscal M bM G
policy parameters (G, TR), and (ii) real money stock ( ). since Y  A   , where  
P h P 1   G kb / h

31 32
 A Formal Treatment of the IS/LM Model … The Fiscal Policy Multiplier
 Equation (8) shows that the equilibrium interest rate   is the fiscal or government spending multiplier once
depends on the parameters of fiscal policy captured in the interest rate adjustment is taken into account.
multiplier and autonomous spending and on the real
 This multiplier is different from G (=1/[1-c(1-t)], simple
money stock.
multiplier under constant interest rates).
 The Fiscal Policy Multiplier  Which one is larger?
 How much an increase in government spending changes  G >  . Why?
the equilibrium level of income, holding the real money G
supply constant?  Since   G
1   G kb / h
bM
sin ce Y  A   1
h P since 1
Y G 1   G kb / h
hence   , where  
G 1   G kb / h Re member, all the parameters are  ve.

33 34

The Fiscal Policy Multiplier … The Monetary Policy Multiplier

 This represents the dampening effect of  How much an increase in the real money supply
increases the equilibrium level of income, keeping fiscal
increased interest rates associated with a fiscal policy unchanged?
expansion in the IS-LM model. bM
sin ce Y  A  
 Note that if h (sensitivity of the demand for real h P
balances to the interest rate) is very small,  → 0 Y b G
hence   , where  
and if h → ,  → G since M h 1   G kb / h

P
G Y b G
  
1   G kb / h 
M h  kb G
P
 If h and k are smaller and b and G are larger,
expansionary monetary policy will be very effective (to
increase the real income).

35 36
 Deriving the Aggregate Demand Schedule Deriving the Aggregate Demand …
 We have already discussed AD/AS curves in detail.  In other words, a
 In IS/LM framework, we can get AD schedule by holding higher price level
autonomous spending and the nominal money supply
constant and allowing prices to vary. means a lower real
 Recall equilibrium condition of IS/LM framework money supply, an
h G b G M LM curve shifts
Y A leftward, and results
h  kb G h  kb G P
in lower aggregate
 This is AD schedule if P is allowed to vary. Therefore, AD demand.
schedule can be written as:
h G b G M
Y A
h  kb G h  kb G P
 Since P is in the denominator, AD curve slopes downward.

37 38

Monetary and Fiscal Policy Monetary and Fiscal Policy …

 These are the two main macroeconomic policy  Recall IS/LM framework. IS curve represents equilibrium
tools used to keep the economy growing at in goods market. LM curve represents equilibrium in
money market.
reasonable rate, with low inflation.
 Intersection of these two determines output and interest
 They are also used to shorten recessions and to rates in the short-run (for a given level of price).
prevent booms from getting out of hand.
 Fiscal policy has its initial impact in the goods
market whereas monetary policy has its initial
impact mainly in the asset market.
 Since both the markets are interconnected, both
monetary and fiscal policies have effects on
both the level of output and interest rates.

39 40
 Monetary and Fiscal Policy … Monetary Policy
 Expansionary monetary policy shifts the LM curve to the  Central bank can change money stock (money supply)
right (Y, i).
 Contractionary monetary policy shifts the LM curve to the through various ways including open market operation.
left (Y, i).  If central bank buys bonds, it increases stock of money;
 Expansionary fiscal policy shifts the IS curve to the right
(Y, i). if central bank sells bonds, it reduces the money stock.
 Contractionary fiscal policy shifts the IS curve to the left  Let us see how an open market purchase works.
(Y, i).
 It  nominal quantity of money.
 For given price level, real quantity of money is also .
 Consequently, LM schedule will shift rightward.
 At equilibrium, income will  whereas interest rate will .

41 42

Monetary Policy … Monetary Policy …

 Equilibrium level income rises because open market  How the process of
purchase reduces the interest rate and thereby increases adjustment takes place?
investment spending.  At E, when money supply ,
people adjusts by trying to buy
other assets.
 So, asset prices  and yield .
 Equilibrium level income rises
because open market
purchase reduces the interest
rate (since more money is
available in the market; goods’
price goes down when supply
increases) and thereby
increases investment
spending.

43 44
 Few Questions … 1 Few Questions … 2
 "Fiscal policy is more effective when money demand is more  “With a decrease in the marginal propensity to save,
interest inelastic." True or false? Why?
the IS-curve will become steeper.” True or false?
 False. Why?
 For example, if money demand is completely independent of the
interest rate, the LM-curve is vertical.  False.
 This is the classical case, and a change in government spending  A decrease in the marginal propensity to save (s = 1 - c)
has no effect on output at all, since there is total crowding out due
to a large increase in the interest rate and a subsequent decrease is equivalent to an increase in the marginal propensity to
in investment. consume (c), which, in turn, will cause the expenditure
 Less than total crowding out will occur, if we have a normal multiplier () to increase.
(upward-sloping) LM-curve since the interest rate will not increase
by quite as much.  But with a larger expenditure multiplier, any increase in
 Therefore the government spending increase will cause income to investment spending that is caused by a decrease in the
increase. But the less sensitive money demand is to changes in the interest rate will lead to a larger increase in income.
interest rate, the steeper the LM-curve. Steeper LM-curve implies a Therefore the IS-curve will become flatter and not
larger crowding out effect (by lowering the level of investment when
interest rate increases). steeper.

45 46

Few Questions … 3 Few Questions … 3 Answer

 a. Y = C + I + G + NX = 110 + (2/3)(Y - TA + TR) + 250 - 5i + 130 - 30
 Assume the following IS-LM model:  = 460 + (2/3)[Y - (1/4)Y - 20 + 80] - 5i = 460 + (2/3)(3/4)Y + (2/3)60 -
 expenditure sector: money sector: 5i
 Y = C + I + G + NX M = 500 = 500 + (1/2)Y - 5i
 From Y = 500 + (1/2)Y - 5i ==>Y = 2(500 - 5i) ==> Y = 1,000 - 10i
 C = 110 + (2/3)YD P =1 IS-curve
 YD = Y - TA + TR md = (1/2)Y + 400 - 20i  From (M/P) = md ==> 500/1 = (1/2)Y + 400 - 20i ==> (1/2)Y = 100
 TA = (1/4)Y + 20 + 20i
 TR = 80  ==> Y = 2(100 + 20i) ==> Y = 200 + 40i LM-curve
 I = 250 - 5i  From IS = LM ==> 1,000 - 10i = 200 + 40i ==> i = 16 ==> Y =
840
 G = 130  ==> I = 250 - 5*16 = 170 and TA = (1/4)840 + 20 = 230
 NX = -30  Since (M/P) = md ==> md = 500
  Check: md = (1/2)840 + 400 - 20*16 = 500
a. Calculate the equilibrium values of private domestic  b. If government purchases are increased by G = 100, the IS-curve
investment (I), real money demand (md), and tax revenues will shift by IS = α(∆G) = 2*100 = 200. That is, Y = 1,200 - 10i New IS-
(TA). curve
 b. How much of private domestic investment (I) will be  Therefore, from IS = LM ==> 1,200 - 10i = 200 + 40i ==>1,000 = 50i
crowded out if government purchases are increased by G = ==> i = 20 ==> Y = 1,000
100?  Since i = 4 ==> I = - 4*5 = - 20
 Check: I = 250 - 5*20 = 150

47 48
 Few Questions … 4 Few Questions … 4 Answer
 Assume money demand (md) and money supply (ms)  ms = md ==> 600 = (1/4)Y + 400 - 15i ==> (1/4)Y = 200 + 15i
 ==> Y = 4(200 + 15i) ==> Y = 800 + 60i LM-curve
are defined as: md = (1/4)Y + 400 - 15i and ms = 600,  Y = C + I + G + NX ==> Y = 400 + (3/4)Y - 10i ==>
and intended spending is of the form: AD = C + I + G  (1/4)Y = 400 - 10i ==> Y = 4(400 - 10i) ==>
+ NX = 400 + (3/4)Y - 10i.  Y = 1,600 - 40i IS-curve
 Calculate the equilibrium levels of Y and i, and  From IS = LM ==> 1,600 - 40i = 800 + 60i ==> 800 = 100i ==>
i = 8 ==> Y = 1,280
indicate by how much the central bank would have  If government purchases increase by 50, the IS-curve will shift
to change money supply to keep interest rates to the right by IS = 4*50 = 200.
constant if government purchases are increased by  Therefore the equation for new IS-curve is: Y = 1,800 – 40i.
 If the central bank wants to keep the interest rate constant,
(G =) 50. money supply has to be increased by an amount that shifts the
LM-curve to the right by the same amount as the IS-curve, that
is, (LM) = 200.
 From Y = 4(200 + 15i) ==> (Y) = 4(ms) ==> 200 = 4(ms) ==>
(ms) = 50, so money supply has to be increased by 50.
 Check: IS1 = LM1 ==> 1,800 - 40i = 1,000 + 60i ==> 800 = 100i
==> i1 = 8 and Y1 = 1,480

49 50

Few Questions … 5 Few Questions … 5

 "Monetary policy cannot change real output as long  "Combining income tax cuts with restrictive
as investment is independent of the interest rate." monetary policy is counterproductive, since it will
What is your view?
 That’s right. When investment spending is not lead to a higher budget deficit and higher interest
affected by changes in the interest rate but is rates. What we need instead is a tax increase in
determined solely by changes in business combination with expansionary monetary policy; the
expectations, then monetary policy is ineffective. tax increase will lower the budget deficit while the
 Expansionary monetary policy may reduce interest money expansion will stimulate the economy." What
rates, but this will not increase the level of is your view?
investment spending and the economy will not be
stimulated.  Neither policy mix described above is likely to
 In the IS-LM framework, we will have a vertical IS- significantly affect the level of output, but the
curve. Thus, when the LM-curve shifts, we will composition of output will be different for each
simply see a change in the interest rate, while the policy option.
output level will remain constant.

51 52
 Few Questions … 5 Few Questions … 5
 A combination of expansionary fiscal policy and  The tax increase will lead to a decrease in
restrictive monetary policy will lead to an increase consumption, but the decrease in interest rates will
in interest rates but it will not significantly affect lead to an increase in investment and a higher
output. (The IS-curve will become flatter and shift to potential for future economic growth. The budget
the right, and the LM-curve will shift to the left.) deficit will decrease due to the higher tax rates.
 The budget deficit will increase due to the tax cut, Lower interest rates may also help to finance the
consumption will increase, but investment will existing national debt and even stimulate net
decrease due to higher interest rates. exports, since a capital outflow may occur that will
 If restrictive fiscal policy is used in combination result in a depreciation of the currency.
with expansionary monetary policy, the level of
output will not change significantly, but interest
rates will be reduced. (The IS-curve will become
steeper and shift to the left, and the LM-curve will
shift to the right.)

53 54

Few Questions … 6 Few Questions … 6 Answer

 Assume the money sector can be described by the  a. From ms = md ==> 400 = (1/4)Y - 10i ==>
equations: ms = 400 and md = (1/4)Y - 10i. In the  Y = 1,600 + 40i LM-curve
expenditure sector only investment spending (I) is
affected by the interest rate (i), and the equation of  From IS = LM ==> 2,000 - 40i = 1,600 + 40i ==> 80i =
the IS-curve is: Y = 2,000 - 40i. 400 ==> i = 5 ==> Y = 2,000 - 40*5 ==> Y = 1,800
 (a) Assume the size of the expenditure multiplier is  Since the expenditure multiplier is  = 2, ==> IS =
 = 2. What is the effect of an increase in 2*200 = 400 ==> IS1: Y = 2,400 - 40i
government purchases by G = 200 on income and
the interest rate?  IS1 = LM ==> 2,400 - 40i = 1,600 + 40i ==> 80i =
 (b) Can you determine how much investment is 800 ==> i = 10
crowded out as a result of this increase in  ==> Y = 1,600 + 40*10 ==> Y = 2,000
government purchases?  Therefore i = + 5 and Y = + 200
 (c) If the money demand equation were changed to
md = (1/4)Y, how would your answers in (a) and (b)
change?

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 Few Questions … 6 Answer Few Questions … 6 Answer
 b. IS-curve is:  c. If money demand is defined as md = (1/4)Y, we have the
classical case, that is, a vertical LM-curve. In this case, fiscal
 Y = 2,000 - 40i ==> Y = 2(1,000 - 20i), since = 2 expansion will not change income at all, because the increase
 So, we can conclude that the investment function is in G will be offset by a decrease in I of equal magnitude due to
an increase in the interest rate.
of the form I = Io – 20i .
 (M/P) = md ==> 400 = (1/4)Y ==> Y = 1,600, which is the formula
 Since the interest rate went up by i = 5, investment for the new (vertical) LM-curve
changes by I = - 20*5 = - 100.  IS = LM1 ==> 2,000 - 40i = 1,600 ==> 40i = 400 ==> i = 10 ==> Y
= 1,600
 If government purchases are increased by ∆G = 200, we get

 IS1 = LM1 ==> 2,400 - 40i = 1,600 ==> 40i = 800

 ==> i = 20 ==> Y = 1,600 ==> I = - 200.
 In this case, we have total crowding out, that is, the level of
output does not change and the level of private spending
decreases by the same amount as the increase in the level of
public spending.

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Thanks

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