People’s Democratic Republic of Algeria

Ministry of higher education and scientific research

Ferhat Abbas University Setif 1

Faculty of Economic, Commercial and Management Sciences

LECTURE 2: INTRODUCTION TO THE
IS-LM MODEL AND ITS CHANGES IN
ACCORDANCE WITH FISCAL AND
MONETARY POLICIES
FIRST: INTRODUCTION
TO THE IS-LM MODEL
 1- THE MODEL ASSUMPTIONS
- Stability of the general price level;
- The aggregate demand consists of two markets:
• Goods and services market: It is expressed by the IS curve that describes the
equilibrium in the goods market when savings are equal to investment;
• Money market: It is expressed by the LM curve that describes the equilibrium
in the money market when the demand for money is equal to the money supply
. - The total equilibrium consisting of the equilibrium in the goods market and
the money market; graphically the total equilibrium represents by the
intersection of the IS/LM curve;
- Income inequality: where changes in monetary and fiscal policies lead to a
shift of both the IS and LM curves to the right or left.
2- Deriving the equation and curve of IS

We have an economic model consisting of two

sectors:
- C=C0+byd where yd=y,
- The investment function: i=i0+gi; where: i: interest
rate and g: interest rate coefficient, knowing that there
is an inverse relationship between investment I and
interest rate i.
 2-1- Deriving the IS Equation Mathematically
The IS equation can be derived as follows:

Y=C+I ⇒Y=C0+byd+I0+gi

⇒ y(1-b) =C0+ I0-gi

𝐶𝐶0+𝐼𝐼0 𝑔𝑔
Y𝐼𝐼𝐼𝐼 = − i ………1/ YI=f(i)
1−𝑏𝑏 1−𝑏𝑏

- It shows the relationship between income and the interest rate at

which equilibrium is achieved in the goods market. Accordingly,
each point on the IS curve reflects a specific equilibrium situation
and shows the interest rate through which the equilibrium income
level is determined
The IS curve can be represented graphically as in the following figure:

Through the curve, we notice that

i
there is an inverse relationship
between the interest rate and income,
i
1 where the lower the interest rate from i1
i to i2, the higher the income from y1 to
2
IS
y2, and the explanation for this is that
Y the lower the interest rate leads to an
Y Y
1 2 increase in investment and thus an
increase in income by a greater
amount due to the multiplier.
 2-2- IS Equation In A Three And Four Sector Model:
The IS Equation Can be derived In A Three And Four Sector Model
Taking Into Account The Tax Situation Independent Or Dependent On
Income, As Shown In The Following Table:
IS equation in a three-sector model IS equation in a four-sector model
Tax not 𝒚𝒚𝐈𝐈𝐈𝐈 𝒚𝒚𝐈𝐈𝐈𝐈
related to 𝐂𝐂𝟎𝟎 + 𝐈𝐈𝟎𝟎 − 𝐛𝐛𝐛𝐛𝐛𝐛𝐛𝐛 + 𝐛𝐛𝐛𝐛𝐛𝐛𝐛𝐛 + 𝐆𝐆𝐆𝐆 − 𝐠𝐠𝐠𝐠 𝐂𝐂𝟎𝟎 + 𝐈𝐈𝟎𝟎 − 𝐛𝐛𝐛𝐛𝐛𝐛𝐛𝐛 + 𝐛𝐛𝐛𝐛𝐛𝐛𝐛𝐛 + 𝐆𝐆𝐆𝐆 + 𝑿𝑿𝑿𝑿 − 𝒁𝒁𝒁𝒁 − 𝒈𝒈𝒈𝒈
= =
income 𝟏𝟏 − 𝐛𝐛 𝟏𝟏 − 𝐛𝐛 + 𝐳𝐳
TX=TX0
Tax related 𝒚𝒚𝐈𝐈𝐈𝐈 𝒚𝒚𝐈𝐈𝐈𝐈
to income 𝐂𝐂𝟎𝟎 + 𝐈𝐈𝟎𝟎 − 𝐛𝐛𝐛𝐛𝐛𝐛𝐛𝐛 + 𝐛𝐛𝐛𝐛𝐛𝐛𝐛𝐛 + 𝐆𝐆𝐆𝐆 − 𝐠𝐠𝐠𝐠 𝐂𝐂𝟎𝟎 + 𝐈𝐈𝟎𝟎 − 𝐛𝐛𝐛𝐛𝐛𝐛𝐛𝐛 + 𝐛𝐛𝐛𝐛𝐛𝐛𝐛𝐛 + 𝐆𝐆𝐆𝐆 + 𝐗𝐗𝐗𝐗 − 𝐙𝐙𝐙𝐙 − 𝐠𝐠𝐠𝐠
= =
TX=TX0+ty 𝟏𝟏 − 𝐛𝐛 + 𝒃𝒃𝒃𝒃 𝟏𝟏 − 𝐛𝐛 + 𝒃𝒃𝒃𝒃 + 𝒛𝒛
3- Deriving the equation and curve of LM
We saw previously that according to the liquidity theory of demand for
money, the demand for money is for the purpose of:
- Transactions and Reserves (Mt=f(y) /Mt=Ky)
- Speculation (Ma= f(i) /Ma= L0-mi)
SO Md=Ma+Mt
On the other hand, the money supply MS=M0 is an external variable
because the money supply is determined by the central bank according to
the monetary policy followed
Thus, equilibrium is achieved in the money market
when:
money supply=demand for money, i.e. Ms= Md or
Ms=M0=Ma+Mt.
3-1-Deriving the LM Equation Mathematically
We have MS=M0=MA+MT
𝑴𝑴₀ −𝑳𝑳𝑳𝑳+ 𝒎𝒎 𝒊𝒊
M0=MA+MT ⇒ M0=KY+L0-MI⇒ 𝒚𝒚𝑳𝑳𝑳𝑳 =
𝒌𝒌

* This Equation shows that there is a direct relationship between y and i

that achieves equilibrium in the money market, so any increase in interest
rate leads to an increase in income and vice versa. because the higher the
interest rate i, the lower the demand for money for speculation and the
higher the demand for money for transactions and reserves ,which leads
to an increase in income y.
*Accordingly, each value of interest rate i corresponds to a value of
income, which represents the sum of the combinations between income
and interest rate that ensure equilibrium in the money market.
The LM curve can be represented graphically as in the following figure:

LM

I2

I2

Y1 Y2
4- The general equilibrium (the current equilibrium in the two
markets)
The general equilibrium determines the interest rate and income level
that achieve equilibrium in both markets (IS=LM), as shown in the
following figure: The equilibrium
i LM interest rate i* and
E equilibrium income
i*
y* are determined at
the equilibrium point
IS
E.
Y*
SECOND: CHANGES OF THE
IS-LM MODEL ACCORDING
TO THE FISCAL AND
MONETARY POLICIES
 1- fiscal policy
it is the various measures taken by the government to maintain
the stability of economic activities, and their importance lies in
their close connection with the daily lives of individuals and
society through the imposition of taxes as well as the areas of
government spending on various sectors such as health,
construction and reconstruction.
2- types of fiscal policy:

- expansionary fiscal policy: it is used in the case of

recession or depression (increasing government spending g
or reducing taxes), increasing government spending by ∆g
leads to an increase in income due to the multiplier of
1
government spending by ∆y= ∆g which leads to the
1−𝑏𝑏

shift of the IS curve to the right.

- Contractionary fiscal policy : it is used in the case of inflation
(reducing government spending or increasing taxes) the case of
increasing taxes which leads to the shift of the is curve to the left
−𝑏𝑏
by the tax multiplier by ∆y= ∆tx
1−𝑏𝑏
-IS-LM model changes in accordance with fiscal policy
• shift IS to the right:
when following an expansionary fiscal policy by increasing
government spending or reducing taxes, this leads to the
transition of the is curve from is1 to is2 as shown in the following
figure:
 LM
i
∆yIS= KG∆G
i'

ie
∆yIS-LM
IS2

IS1

Ye Y’ Y
the rise in government spending ∆g led to a rise in
income, but slightly, i.e. by∆yis-lm instead of y∆IS= kG ∆
as a result of the impact of investment crowding (high
interest rate led to low investment), which led to a
decrease in income (low impact of change in
government spending on income due to the impact of
interest rate on investment (∆yIS-LM<∆yIS).
• shift IS to the left:
In the case of a Contractionary fiscal policy by reducing government
spending or raising taxes, the IS curve moves to the left from IS1 to IS2
as shown in the following figure:
 The increase in taxes leads to a decrease in income from Ye
to Y’ by:
∆yIS= KTX ∆TX, but as a result of the decrease in the interest
rate from ie to i', the impact of the increase in taxes decreased;
as investment increased, which led to a rise in income (income
decreased by ∆yIS-LM instead of ∆yIS= KTX ∆TX) This is due to
the impact of investment crowding out
 2- The monetary policy
It is the procedures and measures taken by the Central Bank in order to
achieve its objectives to maintain the stability of the price level, and to
solve various economic problems such as inflation, unemployment, and
economic recession.
 2. Types of monetary policy
- Expansionary monetary policy: It is used in case of recession
or depression, by an increase in the money supply.
This policy leads to a decrease in interest rates and thus an
increase in investment, production and income. And It results a
𝟏𝟏
shift of the LM curve to the right by ∆y= ∆MS
𝑲𝑲
1
the monetary multiplier .
𝐾𝐾
• The increase in the money supply leads to a decrease in the i (the
monetary impact of monetary policy), which leads to an increase
in I (the financial impact of monetary policy), including an
increase in the aggregate demand ; production and income due to
𝟏𝟏
the monetary multiplier (∆y=∆MS ), and the demand for money
𝑲𝑲

increases for the purpose of transactions and thus the total demand
for money increases.
- Contractionary monetary policy:

It is used in the case of inflation through reducing the money

supply, which results a rise in interest rates and thus a lack of

investment and a decrease in the level of income, including the

shift of the LM curve to the left.

 IS-LM model changes according to monetary policy
• shift LM to the right:
The LM curve moves to the right in the event of an increase in the money
supply MS (expansionary monetary policy) from LM1 to LM2 as shown in the
following figure:
i
LM1
LM2
ie 𝟏𝟏
∆Y= ∆MS
𝑲𝑲
i'
IS

Ye Y’ Y
The increase in the money supply led to an increase in income by

𝟏𝟏 𝟏𝟏
∆Y= ∆MS ; where is the cash multiplier and K is the
𝑲𝑲 𝑲𝑲

coefficient of association of income with the demand for money

for the purpose of transactions and reserves (Mt=KY).

On the other hand, the low interest rate from ie to i’ led to a rise in

investment and thus a rise in income.

• LM Shift Left
The LM curve moves to the right in the event of a decrease in the
money supply MS (Contractionary monetary policy) from LM1 to
LM2 as shown in the following figure:
i LM2
𝟏𝟏
LM1 ∆Y= ∆MS
𝑲𝑲
i'
ie

IS

Y’ Ye Y
We note that the shift of the LM curve from LM1 to LM2 due to the
reduction of the money supply led to a decrease in income, on the other
hand, the rise in the interest rate from ie to i’ resulted in a decrease in
investment and a decrease in income (the absence of the impact of
investment crowding out
Example C=100+0,8yd I=150-600i yd=y MS=200
Mt= 0.2y Ma=50-400i:
1.Determine each of the two IS/ LM equations and then determine
the general equilibrium.
2.Expansionary fiscal policy is represented in raising
government spending by ∆G=10:
- Determine the amount of shift in the IS curve.
- Determine the amount of change in equilibrium income resulting
from this increase in government spending.
3.The Contractionary fiscal policy applied is to raise taxes in the
amount of ∆TX=20:
- Determine the amount of shift in the IS curve.
- Determine the amount of change in equilibrium income resulting from
this increase
4. The expansionary monetary policy applied is to raise the money supply by the
value of ∆MS=20:

• Determine the amount of shift in the LM curve

• Determine the amount of change in equilibrium income due to this rise in the money
supply.

5. Contractionary monetary policy consists in reducing the money supply by

∆MS = -20:

• Determine the amount of transition in LM

• Determine the amount of change in equilibrium income due to this decrease in the
money supply.