15-11-2023

The World of IS-LM

• While studying simple multiplier model, we consider only

MACROECONOMICS the goods market.

• However, there are other markets to be considered; money
SESSIONS 8 and 9
market, labour market.
IS-LM Model • In what follows we will bring in money market and see

The Simultaneous Equilibrium in how determination of income/GDP is influenced by the

the Goods and Financial Markets presence of it.
• In Macroeconomics, one of the important information is the
interest rate; how it is determined and how it affects
planned expenditures of different agents.
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The World of IS-LM Revisiting the Simple Model of Income Determination

• Assumptions • E = C(Y – T) + I + G; Y = E in equilibrium

Short run
• Given T, I and G we could determine Y.
Fixed installed capacity of physical capital: Y = F(K, L).
Prices of goods and services do not change • We did not consider money market explicitly.
Closed economy  no international capital mobility and
• Interest rate was taken to be fixed.
trade.
No explicit labour market.
The output is demand determined (the economy is demand
constrained).

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Revisiting the Simple Model of Income Determination The Investment Schedule

Interest rate, r
• Now we have money and an earning asset (bond). The schedule is
drawn for a
• How are the presence of money and interest rate given state of
expectation
likely to affect different expenditure components? at a given A fall in
r
level of investors’
expectation
• The easiest way: I = I(r) interest rate
shifts the
• The cost of resources for investing is r, and higher schedule to
the left
the r the lower the I.
I2 I1 Investment, I
reducing the
level of
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Investment and Interest rate The Market for Goods and Services
• Y = C(Y – T) + I(r) + G
 …. during the Lok Sabha debate on government action on
• Output (income) is determined by the level of aggregate
inflation, finance minister Pranab Mukherjee said, “If interest
demand.
rates are hiked abnormally, naturally there will no investment,
• We continue to assume that T and G are given
there will be no growth, there will be no job creation.” [Eco
• How many unknowns?
Times (06/08/2010)]
• We now have two unknowns (endogenous variables) r and
Y.
 Was the honorable finance minister necessarily correct? • For different r there will be different Y.

 Movement vs shift in the investment schedule • We get a set of (r, Y) which satisfy above.

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The IS Curve Deriving the IS Curve

• Y = C(Y – T) + I(r) + G is the condition for goods r

market equilibrium (r2 , Y2)

• I(r) = Y – C(Y – T) – G
(r1, Y1)
• or, I(r) = S(Y) given T and G
(–) (+)

• Investment-saving equality  IS curve Y

Consider a combination of r and Y (r1,Y1) that solve the IS equation

• Can you draw a diagram to show the relation between
Then consider a higher r. At a higher r investment will be lower,
r and Y? aggregate demand will be lower than initial Y, and hence Y will fall to
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restore equilibrium. Follow the blue arrows.

Deriving the IS Curve: Alternative way The Sign of the Slope

• Y = C(Y – T) + I(r) + G

• dY = CY dY + Ir dr [or, ∆Y = (∆C/∆Y) ∆Y + (∆I/∆r) ∆r]

• dr/dY = (1 – CY)/ Ir < 0 [or, ∆r/∆Y = (1 – (∆C/∆Y))/ (∆I/∆r)]

• CY – MPC, Ir – interest sensitivity of investment

• High CY and Ir  low dr/dY  flat IS curve

• What is the economic reasoning?

• The adjustment rule :

• If AD >Y then Y increases

• If AD < Y then Y decreases

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The Money Market Determination of Interest Rate

• The demand for money (real balances)
r
• (M/P)d = L(r, Y)

• We will assume that the supply of real balances is

r*
given, fixed exogenously by the Central Bank : Real Money Demand

(M/P)s = (M/P)
• Money market equilibrium is given by MS/P Money Supply, Demand

L(r, Y) = (M/P)
(–,+)
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The LM Curve Deriving the LM Curve

• L(r, Y) = (M/P) r

(r2 ,Y2 )
(–, +)

• RHS is fixed, there are two variables on the LHS

(r1, Y1 )
• The combinations of r and Y that keep RHS fixed

(i.e. real money demand = real money supply) is Y

Consider an (r,Y) such that the money market is in equilibrium. Take a higher
the LM relation. income. Given financial wealth agents need to transact more and hence
require more real balances. To acquire this they sell bonds, bond prices fall
and interest rate rises. Agents are induced to hold the same real balances
• Can you draw a diagram to show the relation? even when they want more if and only if r increases. This will restore
15 16 equilibrium in the money (and hence bond) market.
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Deriving the LM Curve: Alternative way The Sign of the Slope

• (M/P) = L(r, Y)

• 0 = Lr dr + LY dY

• dr/dY = – LY / Lr > 0

• If LY is high and Lr is low, the LM curve is steep.

• The Adjustment Rule

• Demand for real balances > supply, interest rate
rises
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• Demand for real balances < supply, interest rate falls

The Macroeconomic System The Macroeconomic System

• Now we have two equations in the two unknowns • (M/P) = L(r, Y) : LM CURVE

r and Y
• Y = C(Y – T) + I(r) + G; T & G given : IS • The LM curve is the locus of all (r,Y)
CURVE combinations that make demand for real balances
• The IS curve is the locus of all (r,Y) combinations equal to the supply.
that make output (supply) equal to aggregate
demand.
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A Note on the LM Curve Does the Trap Exist?

• Did you notice how we drew a horizontal stretch on the • Trap implies that you cannot stimulate the economy by

LM curve? monetary expansion.

• It depicts the LIQUIDITY TRAP • Nominal rate cannot fall below zero.

• What does it mean? • Real rate can be negative if πe is positive and high

• Perfectly (interest) elastic demand for real balances.

leading to investment stimulus.

• Rise in money supply can cause currency to depreciate

• If bond prices are finite, then interest rate must be

strictly positive. leading to export stimulus (not possible in this model).

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The Exogenous Variables From IS-LM To Aggregate Demand at all Possible Prices

• We are now ready to play around with changes in the LM(P2)

P
r
levels of the exogenous variables G, T, M/P and LM(P1)

investigate the effects of fiscal and monetary policy on P2

the macro-economy, income, output, employment, P1

AD
interest rate and so on. IS
Y
Y Y2 Y1
• Fiscal Policy: Effects of higher/lower G & T on Y2 Y1
AD: All (P,Y) such that
equilibrium r & Y As P increases, M/P falls all goods and asset
Real balances fall, money markets are in equilibrium
• Monetary Policy: Effects of higher/lower M on demand > money supply, thus
r rises for all Y, LM shifts up Each point on AD is
23 equilibrium r & Y 24 P2>P1, so for higher P, Y is lower an IS-LM intersection
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Why is the Aggregate Demand Curve Downward-

Where Does the IS-LM Model Lead To?
Sloping? Same reason as Micro?

 Liquidity Effect: higher aggregate price level reduces the

KEYNESIAN IS CURVE
CROSS
real money supply, leading to a rise in interest rate and a fall IS-LM MODEL
THEORY OF
in investment spending (and consumer spending). LIQUIDITY LM CURVE
PREFERENCE
AGGREGATE
MODEL OF
DEMAND CURVE
AGGREGATE
DEMAND AND
 Wealth Effect: a higher aggregate price level reduces the AGGREGATE AGGREGATE
SUPPLY CURVE SUPPLY
purchasing power of households’ existing wealth (real value

of their asset) and reduces consumer spending. EXPLANATION OF SHORT RUN ECONOMIC FLUCTUATIONS
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