Money, Interest and Income

Prepared by:
Catherine Roween C. Almaden
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 The Structure of the IS-LM Model

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 Introduction
• The IS-curve is derived as a logical extension of the
Keynesian cross diagram.
• The IS curve or the goods market equilibrium, shows
combinations of interest rates and levels of output
such that planned spending equals income.
• In the Keynesian cross diagram, interest rates are
assumed to be constant; now they are allowed to
fluctuate.
• Investment and interest rate
– When interest rates decrease, it becomes more profitable to
increase the existing capital stock, so planned investment
spending increases.
– In other words, the AD curve shifts up.

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 The IS Function
• The investment function changes from
– I = Io to I = Io – bi
• The equation for the AD-line changes from
– AD = Ao + c1Y to AD = Ao + c1Y - bi
– with c1 = c(1 – t).
• from the equilibrium condition Y = AD, that is,
• Y = Ao + c1Y - bi
– ==> (1 - c1)Y = Ao – bi
– ==> Y = [1/(1 - c1)](Ao – bi) = t(Ao – bi).
• Solving this equation for i, we get
– i = (1/b)Ao – (b/)Y,
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 The Investment Schedule

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 Derivation of the IS Curve

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 The IS Function
• The slope of the IS-curve is determined by two
factors:
– the interest sensitivity of investment spending
– the size of the expenditure multiplier.
• The IS curve is negatively sloped because an
increase in the interest rate reduces planned
spending and therefore, reduces AD, thus
reducing the equilibrium Y.

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 The IS Curve
• As investment becomes more interest sensitive, any
change in the interest rate leads to a larger shift in the
AD-line, leading to a higher level of equilibrium output
and a flatter IS-curve.
• If the value of the expenditure multiplier becomes
larger, any shift in the AD-line caused by a specific
change in the interest rate will cause a larger increase
in equilibrium income.
– The IS-curve becomes flatter.
• As discussed in the previous chapter, any other factor
that may increase the slope of the AD-line, such as a
decrease in the income tax rate, will also increase the
size of the expenditure multiplier and therefore make
the IS-curve flatter.
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 Effect of the Multiplier on the Slope of the IS Curve

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 A Shift in the IS Curve
Caused by a Change
in Autonomous
Spending

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 Demand for Real Balances
• The demand for money (L) is a demand for real balances because people
hold money for what it will buy.
• Factors affecting demand for money:
– Price level (P)
• Positively related with L, the higher the price level, the more
nominal balances a person has to hold to be able to purchase a
given quantity of goods.
– Income (Y)
• Positively related to the level of Y. As income increases, people tend
to hold more money to finance the increased expenditures that
come with higher income.
– Interest rate (i), the opportunity cost of holding money
– Negatively related to the i. The higher the i, the more costly to hold
money, less cash will be held as people hold more assets that bear
interest.
• The equation for real money demand can therefore be written as
– L = kY – hi with k > 0 and h > 0.

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 Demand for Real Balances as a Function of the
Interest Rate and Real Income

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 The Supply of Money
• The supply of money is controlled by the Central Bank
• The nominal supply of money (Mo) is assumed fixed
• The price level is held constant, (Po)
• To make the supply of money in real terms,
– (Mo)/(Po), exogenous, i.e. independent of the i
• Therefore, there is equilibrium in the money market if
real money demand (L) is set equal to real money
supply (Mo)/(Po)
– L = (Mo)/(Po), ==> L = kY - hi = (M/P)

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 The LM Curve
• The LM curve or the money market equilibrium,
shows combinations of interest and levels of
output such that money demand equals money
supply.
• The equilibrium condition in the money sector,
that is, real money demand (L) has to equal real
money supply (M/P) as shown here:
– L(i,Y) = M/P ==> kY – hi = M/P
– ==> Y = (1/k)(M/P) + (h/k)i or
– i = (1/h)[kY - (M/P)]
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 Derivation of the LM Curve

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 An Increase in the Supply of Money
Shifts the LM Curve to the Right

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 Slope of the LM Curve
• The slope of the LM-curve is flatter if the value of h is
higher.
• The slope of the LM-curve is flatter if the value of k is
lower, i.e, if money demand is less sensitive to
changes in income.
• Any increase in income will increase the demand for
real money balances.
• Since money supply is assumed fixed, then equilibrium
in the money sector can only be restored if the money
balances demanded are reduced again through an
increase in interest rates.
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 Goods and Money Market Equilibrium

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 An Increase in Autonomous Spending Shifts the
IS Curve to the Right

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 Derivation of the
Aggregate Demand
Schedule

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 Reference:
Dornbusch, R., Fischer, S. and Startz
R. (2011). Macroeconomics. USA:
Mc Graw Hill.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights