IS-LM model

IS-LM model: what is the pair of r and Y so

that saving equals investment and the asset
market is in equilibrium at the same time?
IS: Y = m (a + G + I bT ) mhr.
LM: r = (1/L2)M/P + (L1/L2)Y

must be solved simultaneously for the two

variables, (r, Y).

Solving for the equilibrium r and Y in

the IS-LM model
Given
C = 200 + 0.75(Y T)
G = 100 T = 100

I = 200 25r

(M/P)d = Y 100r MS = 1000 P = 2

1000/2 = Y 100r
IS: Y = 200 + 0.75(Y 100) + 200 25r +
100
LM: r = Y/100 5

Solving for the equilibrium r and Y in

the IS-LM model
IS: Y = 200 + 0.75(Y 100) + 200 25r + 100
Y = 200 + 0.75Y -75 + 200 -25r + 100
Y = 425 + 0.75Y 25r
0.25Y = 425 25r
Y = 1700 100r
LM: r = Y/100 5
Substituting r from the LM curve into the IS curve,
Y = 1700 100(Y/100 5)
Y = 1700 Y + 500
2Y = 2200
Y = 1100
Substituting Y = 1100 into the LM curve
r = 1100/100 5
r=6

Fiscal Expansion
Suppose
that G is raised from 100 to 150. How

does the IS curve shift? What are the new
equilibrium r and Y?

IS: Y = 200 + 0.75(Y 100) + 200 25r + 150

LM: r = Y/100 5
r=7
Y = 1200
(r = 6
Y = 1100)
IS curve shifts right, equilibrium r and Y increase

Monetary Expansion
Suppose
the money supply is raised from 1000 to 1200.

How does the LM curve shift? What are the new
equilibrium r and Y?
(M/P)d = Y 100r MS = 1200 P = 2
1200/2 = Y 100r

IS: Y = 200 + 0.75(Y 100) + 200 25r + 100

LM: r = Y/100 6
r = 5.5 Y = 1150 (r = 6 Y = 1100)
LM curve shifts right, equilibrium r decreases and Y
increases

Change in Price
Suppose
the price level changes from 2 to 4. What

happens? What are the new equilibrium r and Y?
(M/P)d = Y 100r MS = 1000 P = 4
1000/4 = Y 100r

IS: Y = 200 + 0.75(Y 100) + 200 25r + 100

LM: r = Y/100 2.5
r = 7.25 Y = 975 (r = 6 Y = 1100)
Recall, an increase in prices is like a decrease in money
supply LM shifts left, equilibrium r increases and Y
decreases

Deriving the AD curve from the ISLM model

Using the given IS-LM model from the previous slide and
leaving the price level as endogenous (i.e. 1000/P = Y 100r)
IS: Y = 200 + 0.75(Y 100) + 200 25r + 100
LM:r = Y/100 10/P
Substituting r from the LM curve into the IS curve
Y = 200 + 0.75(Y 100) + 200 25(Y/100 10 /P) + 100
Y = 425 + 0.75Y 0.25Y + 250/P
Y = 850 + 500/P : AD Curve
Higher values of P reduce Y, hence AD curve is downward
sloping.
Expansionary monetary policy (increases in M) and
expansionary fiscal policies (increases in G or decreases in T)
shift the aggregate demand curve outwardthat is, they
increase Y for any given value of the price level.

Solving for the short run level of P

and Y in the AS-AD diagram
Recall, SRAS is horizontal i.e. short run prices are
fixed
P = P1
AD: Y = 850 + 500/P
AS: P = P1
Assume, the given short run price level P 1 = 1
Y = 850 + 500/1 = 1350
P1 = 2 Y = 850 + 500/2 = 1100
P1 = 4 Y = 850 + 500/4 = 975