Macroeconomic

THE IS-LM MODEL CHAPTER 2 DR/ AHMED SAID

ELBOKL

Dr/ Ahmed said Elbokl

 IN THIS CHAPTER, YOU WILL LEARN:

• the IS curve and its relation to:

• the Keynesian cross
• the loanable funds model
• the LM curve and its relation to:
• the theory of liquidity preference
• how the IS-LM model determines income and the
interest rate in the short run when P is fixed

Dr/ Ahmed said Elbokl 2

Context
• This chapter develops the IS-LM model,
the basis of the aggregate demand curve.
• We focus on the short run and assume the price level is fixed (so the
SRAS curve is horizontal).
• Chapters 11 and 12 focus on the closed-economy case. Chapter 13
presents the open-economy case.

Dr/ Ahmed said Elbokl

The Keynesian cross
• A simple closed-economy model in which income is
determined by expenditure.
(due to J. M. Keynes)
• Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
• Difference between actual & planned expenditure =
unplanned inventory investment

Dr/ Ahmed said Elbokl

Elements of the Keynesian cross
consumption function: C C (Y  T )
govt policy variables: G G , T T
for now, planned
investment is exogenous: I I

planned expenditure: PE C (Y  T )  I  G

equilibrium condition:
actual expenditure = planned expenditure
Y  PE
Dr/ Ahmed said Elbokl
Graphing planned expenditure
PE
planned
expenditure
PE =C +I
+G
MPC
1

income, output, Y

Dr/ Ahmed said Elbokl

Graphing the equilibrium condition
PE
planned PE
expenditure =Y

45º

income, output, Y

Dr/ Ahmed said Elbokl

The equilibrium value of income
PE
planned PE
expenditure =Y
PE =C +I
+G

income, output, Y
Equilibrium
income
Dr/ Ahmed said Elbokl
An increase in government purchases
PE

Y
=
E
At Y1,

P
PE =C +I
there is now an +G2
unplanned drop PE =C +I
in inventory… +G1

Δ
G
…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = ΔY PE2 =
Y1 Y2
Dr/ Ahmed said Elbokl
Solving for ΔY
Y C  I  G equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous

 MPC Y  G because ΔC = MPC

ΔY
Collect terms with ΔY Solve for ΔY :
on the left side of the
equals sign:  1 
Y   G
(1  MPC) Y G  1  MPC 

Dr/ Ahmed said Elbokl

The government purchases multiplier
Definition: the increase in income resulting from a $1
increase in G.
In this model, the govt
purchases multiplier equals Y 1

G 1  MPC

Example: If MPC = 0.8, then

Y 1 An increase in G
 5 causes income to
G 1  0.8
increase 5 times
as much!

Dr/ Ahmed said Elbokl

 Why the multiplier is greater than 1

• Initially, the increase in G causes an equal increase in Y: ΔY = ΔG.

• But #Y g #C
g further #Y
g further #C
g further #Y
• So the final impact on income is much bigger than the initial ΔG.

Dr/ Ahmed said Elbokl

An increase in taxes
PE
Initially, the tax

= E
P
PE =C1 +I

Y
increase reduces
consumption and +G
PE =C2 +I
therefore PE: +G

ΔC = At Y1, there is now

−MPC×ΔT an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new PE2 = ΔY PE1 =
equilibrium
Y2 Y1
Dr/ Ahmed said Elbokl
Solving for ΔY
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC Y  T 

Solving for ΔY : (1  MPC) Y   MPC T

Final result:
  MPC 
Y   T
 1  MPC 

Dr/ Ahmed said Elbokl

The tax multiplier
def: the change in income resulting from
a $1 increase in T :
Y  MPC

T 1  MPC

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2

Dr/ Ahmed said Elbokl

The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.

Dr/ Ahmed said Elbokl

NOW YOU TRY
Practice with the Keynesian cross
• Use a graph of the Keynesian cross
to show the effects of an increase in planned
investment on the equilibrium level of
income/output.

Dr/ Ahmed said Elbokl 17

ANSWERS
Practice with the Keynesian cross
PE

Y
=
E
P
At Y1, PE =C +I2
there is now an +G
PE =C +I1
unplanned drop
in inventory… +G

ΔI

…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = ΔY PE2 =
Y1 Y2
Dr/ Ahmed said Elbokl 18
The IS curve
def: a graph of all combinations of r and Y that result in
goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:

Y C (Y  T )  I (r )  G

Dr/ Ahmed said Elbokl

Deriving the IS curve
P PE =Y
PE =C +I (r2 )
E +G
ir g hI PE =C +I (r1 )
+G
g hPE ΔI

g hY Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

Dr/ Ahmed said Elbokl

Why the IS curve is negatively sloped

• A fall in the interest rate motivates firms to increase investment

spending, which drives up total planned spending (PE ).
• To restore equilibrium in the goods market, output (a.k.a. actual
expenditure, Y )
must increase.

Dr/ Ahmed said Elbokl

Fiscal Policy and the IS curve
• We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
• Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…

Dr/ Ahmed said Elbokl

Shifting the IS curve: ΔG
PE PE PE =C +I (r1 )
At any value of r, hG =Y
+G2=C +I (r )
PE
g hPE g hY 1

…so the IS curve shifts +G1

to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1
Y  G ΔY
1 MPC IS1 IS2
Y1 Y2 Y

Dr/ Ahmed said Elbokl

NOW YOU TRY
Shifting the IS curve: ΔT
• Use the diagram of the Keynesian cross or loanable
funds model to show how an increase in taxes shifts
the IS curve.
• If you can, determine the size of the shift.

Dr/ Ahmed said Elbokl 25

ANSWERS
Shifting the IS curve: ΔT
PE PE PE =C1 +I (r1 )
At any value of r, =Y
hT g iC g iPE +G =C +I (r )
PE 2 1

…so the IS curve shifts +G

to the left.

Y2 Y1 Y
The horizontal r
distance of the r1
IS shift equals
 MPC ΔY
Y  T
1 MPC IS2 IS1
Y2 Y1 Y
Dr/ Ahmed said Elbokl 26
The theory of liquidity preference

• Due to John Maynard Keynes.

• A simple theory in which the interest rate
is determined by money supply and
money demand.

Dr/ Ahmed said Elbokl

Money supply
r
M P 
s
The supply of interest
real money rate
balances
is fixed:

M P  M P
s

M/P
M P
real money
balances

Dr/ Ahmed said Elbokl

Money demand
r
M P 
s
Demand for interest
real money rate
balances:

M P
d
 L(r )

L (r )

M/P
M P
real money
balances

Dr/ Ahmed said Elbokl

Equilibrium
r
The interest interest M P 
s

rate adjusts rate

to equate the
supply and
demand for
money:
r1

M P  L(r ) L (r )

M/P
M P
real money
balances

Dr/ Ahmed said Elbokl

How the Fed raises the interest rate
r
interest
To increase r, Fed rate
reduces M
r2

r1
L (r )

M/P
M2 M1
real money
P P balances

Dr/ Ahmed said Elbokl

CASE STUDY:
Monetary Tightening & Interest Rates
• Late 1970s: π > 10%
• Oct 1979: Fed Chairman Paul Volcker announces
that monetary policy
would aim to reduce inflation
• Aug 1979–April 1980:
Fed reduces M/P 8.0%
• Jan 1983: π = 3.7%

How do you think this policy change

would affect nominal interest rates?
Dr/ Ahmed said Elbokl
Monetary Tightening & Interest Rates, cont.

The effects of a monetary tightening

on nominal interest rates

short run long run

Quantity theory, Fisher
liquidity preference
model effect
(Keynesian)
(Classical)

prices sticky flexible

prediction Δi > 0 Δi < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%

outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
Dr/ Ahmed said Elbokl
The LM curve
Now let’s put Y back into the money demand function:

M P 
d
 L(r ,Y )

The LM curve is a graph of all combinations of r and

Y that equate the supply and demand for real
money balances.
The equation for the LM curve is:
M P L(r ,Y )

Dr/ Ahmed said Elbokl

Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r
2
L (r ,
r1 Y2 ) r
L (r , 1

Y1 )
M1 M/P Y1 Y2 Y
P
Dr/ Ahmed said Elbokl
Why the LM curve is upward sloping

• An increase in income raises money demand.

• Since the supply of real balances is fixed, there is now excess demand
in the money market at the initial interest rate.
• The interest rate must rise to restore equilibrium in the money
market.

Dr/ Ahmed said Elbokl

How ΔM shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM
2
LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P
Dr/ Ahmed said Elbokl
NOW YOU TRY
Shifting the LM curve
• Suppose a wave of credit card fraud causes
consumers to use cash more frequently in
transactions.
• Use the liquidity preference model to show how
these events shift the LM curve.

Dr/ Ahmed said Elbokl 38

ANSWERS
Shifting the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM
2
LM1
r2 r2
L (r , Y1 )
r1 r1
L (r , Y1 )

M1 M/P Y1 Y
P
Dr/ Ahmed said Elbokl 39
The short-run equilibrium
The short-run equilibrium is the r
combination of r and Y that LM
simultaneously satisfies the
equilibrium conditions in the
goods & money markets:

Y C (Y  T )  I (r )  G IS
M P L(r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income
Dr/ Ahmed said Elbokl
 The Big Picture
Keynesian IS
cross curve
IS-LM
model Explanation
Theory of LM of short-run
liquidity curve fluctuations
preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve

Dr/ Ahmed said Elbokl

 C H A P T E R S U M M A RY
1. Keynesian cross
• basic model of income determination
• takes fiscal policy & investment as exogenous
• fiscal policy has a multiplier effect on income
2. IS curve
• comes from Keynesian cross when planned investment
depends negatively on interest rate
• shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services

Dr/ Ahmed said Elbokl 42

 C H A P T E R S U M M A RY
3. Theory of liquidity preference
• basic model of interest rate determination
• takes money supply & price level as exogenous
• an increase in the money supply lowers the interest rate
4. LM curve
• comes from liquidity preference theory when
money demand depends positively on income
• shows all combinations of r and Y that equate demand
for real money balances with supply

Dr/ Ahmed said Elbokl 43

 C H A P T E R S U M M A RY
5. IS-LM model
• Intersection of IS and LM curves shows the unique
point (Y, r ) that satisfies equilibrium in both the goods
and money markets.

Dr/ Ahmed said Elbokl 44