The

OVERVIEW

This chapter combine~ the theory of income and

output and the theory of money and interest in a
two-market equilibrium model that shows how the
goods and money markets interact to determine
the level of output and the rate of interest. The
price level is not a variable in this model because
the model retains the assumptions of Part 2: The
aggregate supply curve is perfectly elastic up to
the full employment level of output and does not
shift; and the economy's level of output varies
along the range belOw the full employment level.
Therefore, changes in aggregate spending can
affeCt only the output level; the price level is fixed.
The first part of the chapter explains the derivation of the IS and LM functions on which the
model is built. At the particular combination of
income level and interest rate at which IS equals
LId. there is eqUilibrium in both the goods and the
money markets. The IS and LM functions have
long been the most basic tools of macroeconomics. The balance of the chapter uses them to
examine questions that could not be handled
adequately with the tools at hand in earlier chapters. Following the derivation of the IS and LM
functions is the derivation of the aggregate
demand function or curve. This is found from the
intersection formed by the IS and LM functions.
To simplify in this chapter, the assumptions are
such as to produce a perfectly inelastic aggregate
demand curve.

hte
Model: Fi e
Price Lev

The next part of the chapter analyzes the separate and combined effects of increases in investment and the money supply on the income level
and the interest rate. The conclusions reached
through the use of the I5-LM tool differ from
those reached when the goods and monetary
aspects of the analysis were considered separately. For example, the simple Keynesian multipliers developed for the two-sector economy In
Chapter 5 are now seen to apply only when
events in the monetary sector are such that the
interest rate remains constant as aggregate
spending for goods and services changes.
The same sort of general analysis is carried
out in the next part of the chapter for changes in
government spending and taxation. Here again
the simple government spending and tax multipliers presented in Chapter 6 are found to apply
only when the monetary authority acts to maintain
a constant interest rate.

234------~----...::...-----------

The last part of the chapter turns to the questic1nof the elasticities of the IS and LM functions,
and to the closely related Question of the effectiveness of monetary and fiscal policies. The elasticities of the two functions are analyzed to clarify
the difference between the extreme version of the
classical theory-which
argues that only monetary policy can be effective in raising the income
level-and the extreme version of the Keynesian

theory-which
argues that only fiscal policy can
be effective. On the basis of this analysis, the LM
function, if it is assumed to vary from perfect inelasticity at one extreme to perfect elasticity at the
other, can be divided into a segment consistent
with classical theory, a segment consistent with
Keynesian theory, and an intermediate segment
lying between the extreme versions of the two theories.

nprevious chapters, we developed separately the theories of income determination

and money and interest. Although this procedure provided an orderly introduction to the
relevant theory, it must now be recognized as
highly simplistic. The two parts are actually so
related that what happens in one depends on
what happens ioJhe other. In developing the simple Keynesian theory of income determination in
Chapters 4-7, we found that a rise in investment
spending would raise the equilibrium level of
income by an q.mount equal to the multiplier
times the rise in investment spending. However,
we implicitly assumed that the interest rate was
given. If we now admit the interest rate as a variable in the system, the rise in investment spending will, by raising the level of income, also force
up the interest rate. This in turn will discourage
investment, and the actual rise in the equilibrium
level of income will be less than it would otherwise be. Similarly, in developing the theory of
money and interest in Chapter 11, we saw that
an increase in the money supply would reduce
the interest rate, as shown by the movement
down the given demand curve for money. However, this curve assumed a given level of income.
If we nQw admit the income level as a variable in
the system, the increase in the money supply will,
by lowering the interest rate, stimulate investment
spending and raise the level of income. This will
~ncrease the transactions demand for money,
and the actual fall in the interest rate will be less
than it would otherwise be. Therefore, it appears

that the interest rate and the level at Income are

linked in a complicated manner. In this and the
following two chapters, we will construct and
employ an extended model that can accommodate this and other complications.1

The Goods Market

and the
Money Market

Our model consists of two parts: The first draws

together the determinants of equilibrium in the
market for goods, and the second draws together
the determinants of equilibrium-in the market for
money. For a two-sector economy, we found in
Chapter 4 that goods market equilibrium is found
at that level of Y at which the sum of C + I is just
equal to that level of Y.Goods market equilibrium
is also defined by an equality between saving

'The construction here will be almost entirely graphic.

For an algebraic formulation of the same elementary
model covered in this chapter, see the Appendix to Chapter 12 of E Shapiro, Macroeconomic Analysis-A Student
Workbook, 5th ed .. Harcourt Brace Jovanovich, 1982. A
concise algebraic treatment of a less elementary IS-LM
model is provided in WL. Smith and R.L. Teigen, Readings
in Money, National Income, and Stabilization Policy,
4th ed., Irwin, 1978, pp 1-22 The model, Including a variable price level, is developed in R.S. Holbrook, "The Interest Rate, Price Level, and Aggregate Output," in the same
.volume, pp. 38-54.

236
and investment. At the level of Y at which S = I,
the leakage from the income stream into S is
exactly offset by I. Money market equilibrium is
defined by an equality between the supply of and
the demand for money-m s = m d-the condition
that gave us the equilibrium interest rate. In other
words, at the interest rate at which ms = md there
is money market equilibrium.2
The particular level of income at which there
is goods market equilibrium depends in part on
conditions in the money market. The particular
interest rate at which there is money market equilibrium depends in part on conditions in the
goods market. For a preliminary look at what is
involved, let us briefly review the simplest possible Keynesian model as shown in Figure 12-1 .
Given the C + I, curve in Part A and the Sand
I, curves in Part B, the equilibrium level of Y is Y,.
If investment depends at all on the interest rate,
the C + I, curve in Part A and the I, curve in
Part B must have been drawn on the assumption
of some particular interest rate. Other things
being equal, a lower interest rate would indicate
a different position for the C + I curve-say
C
~
+ 12instead of C + I,-and a different position
for the I curve-say
/2 instead of I,. This, in turn,
would indicate a different equilibrium income
level, Y2 instead of Y,. Figure 12-1, however, does
not reveal what the interest rate may be-it
assumes some rate and proceeds from there.

A more complete general equilibrium model will also

include the market for factors of production. which,
because of the short-run assumption 01 a fixed capital
stock, becomes the marKet lor labor. Equilibrium in this
market requires equality between the supply of and the
demand for labor. From a Keynesian viewpoint. disequilibrium in this market in the form of an excess supply of
labor-that is. unemployment-can be corrected by policies designed to raise the level of output-that is, to shift
the equilibrium In the goods market to a higher level of
goods output whose production in turn calls for employment of more labor. From a classical viewpoint. the same
disequilibrium would be removed automatically by falling
wages and prices in a system characterized by such flexibility. Following the development '')1 the basic model,
which is limited to the goods and mo,1eymarkets, attention
will be given to these other questions in Chapter 13.
2

FIGURE 1~1
Equilibrium Levels of Income

Figure 12-2 shows the determination of the

equilibrium interest rate. Given the ms and md\
curves, the equilibrium rate is (" at which the
demand for and the supply of money are equal,
or mIl + msp, = md, = ms' However, the demand
for money is composed in part of the transactions
demand which depends on the level of income.
Therefore, the md1 curve must have been drawn
on the basis of some assumed income level that
defined mil' Other things being equal. a higher
income level would indicate a different position

EquDibrium
in the Goods
Market

mlZ

rz r----

r, '-"--m'l
Tn

FIGURE 1.1~

Equilibriwn Levels of the

Interest Rate
for the curve-say md2 instead of md . This would
indicate a different equilibrium rate ~f interest , r.2'
at which mt2 + m~ = md2 = m2. Figure 12-2,
however, does not reveal what the level of income
may be-it assumes some income level and proce~ds from there:'
It appears that we cannot determine the equilibrium income level without first knowing the
interest rate and that we cannot determine the
equilibrium interest rate without first knowing the
income level. Somehow Y and r must be determined simUltaneously. Although this cannot be
done through Figures 12-1 and 12-2, there are
nonetheless a particular income level and interE'st rate that simultaneously provide equilibrium
in the goods market behind Figure 12-1 and in
lhe money market behind Figure 12-2. The model
to be developed in this chapter provides this
simultaneous solution of the two equilibrium
values and clarifies some other important probI~s and policy questions. 3
,
J

Because equilibrium in the goods market requires

that Y = C + I and S = I, all the factors that
cause the consumption function and therefore
the saving function to shift and all the factors that
cause the investment function to shift influence
the determination of this equilibrium. Although
other factors may be introduced once the basic
model is developed, we assume here that investment is a function of the interest rate alone and
that consumption and therefore saving is a function of income alone. From the C + 1 approach,
we then have, in general terms, the following
three equations to cover the g00ds market:
Consumptfon function: C
Investment function: 1
Equilibrium condition: Y

C(Y)

I(r)

= C(Y) + I(r)

From the S, 1 approach, we have, in general

terms, the following three equations to cover the
goods market:
Saving function: S
Investment function: I
Equilibrium condition: S(Y)

S(Y)

=
=

I(r)
I(r)

One may develop the diagrammatic an~lysis that

follows on the basis of either or both of the
approaches. tlut attention here will be limited to
that based on the S, I approach.
The set of equations for that approach may
be shown graphically as in Figure 12-3. Part A
gives the investment spending schedule. showing that investment spending varies inversely with
the interest rate. The straight line in Part B is
drawn at a 45 angle from the origin. Whatever
the amount of planned investment measured

3This model was originally developed by J.R. Hicks in

hiI article MMr. Keynes and the 'Classics': A ~gest~
Interpretation, in Econometrica. April 1937, pp. 147-59.
reprinted in W. Fellner and B,F. Haley, eds., Readings'iJJ \
the Theory of Income Distribution, Irwin, 1946.pp:- 461-76.

See also F. Modigliani, "Liquidity Preference and the Theory of Interest and Morley," in FA. Lutz and L.w. Mints,
,005 . Reaoings in Monetary Theory, Irwin, 1951, partlculcirlypp. 190-206.

S
I
100 -

____

1_
40

Saving Function

S(Y)

Saving Inv8strnenl
5 c- I

Equality

I
I
I
I

IS

I
I

----------

IE

-1--------

----------:rF

'l

I
I
I

I
I
I

I
I

I
I

I
I
I

I
I
!

40

80

120

,I

--

160

200

Goods Market Equilibrium

S(Y)
I(r)

20

1 __

40

60

Investment Function
I
I(r)

FIGURE 12~
Goods Market ~quilibrium
5, ~

along the horizontal axis of Part B. equilibrium

requires that planned saving measured along the
vertical axis of Part B be the same. Therefore. all
points along the 45 line in Part B indicate equality of saving and investment. Part C brings in the
saving function. showing that saving varies directly
with income.
The 15 curve in Part 0 is derived from the
other parts of the figure. For example, assume
an interest rate of 6 percent in Part A, indicating
that investment is $20 per time periOd:4 In Part B
to satisfy the equality between 5 and I, saving
must also be $20, as shown on the vertical axis.
In Part C. saving will be $20 only at an income
level of $120.5 Finally. bringing together Yof $120
from Part C and r of 6 percent from Part A yields
one combination of Y and r at which 5 = I (and
Y = C + I). If we assume the lower interest rate
of 5 percent, Part A indicates that investment will
be $30, which yields an income level of $140 in
Part C. Therefore. Y of $140 and r of 5 percent is
another combinatidn of Y and r at which 5 = f.
Other combinations could be found in the same
way. Connecting th~se combinations gives us the
15 ctJrve in Part 0.6'
There is no longer a single level of income at
which 5 = t, but a different level for each different
interest rate. The higher the interest rate, the
lower will be the level of income at which 5 = I.
Viewed in one way. this follows from the fact that
a high r means a low f. A low I, through the multiplier.means a low Y. Viewed in another way, it
follows from the fact that a low Y means a low 5.
Because equilibrium requires that 5 = f, a low 5

4AII dollar amounts are in billions.

sThe saving function S = Sa
sY is here S = -$40
+ 'I2Y.
6 A!ternatively, the combinations of Y and , at which S
= 1could just as well be determined graphically by starting with assumed levels of Y.Assuming Y of $120, Part C
shows ~hat S will be $20. Moving from PartC through
P".,I B to, Part A. 1of $20 is consistent with" pf 6 Pf;rcent.
Therefore, in-Part D. Yof $120 and, of 6 percent identify
one combination at which S = ,.

means a low I. A low t is the resuJt of a high r.

Although the 15 function indicates that equilibrium in the goods market will be found 'at a lower
level of income for a higher interest rate, it alone
does not reveal what particular combination of Y
and r will be found in any specific time period. All
combinations on the 15 function are equally possible equilibrium combinations of Y and r in the
goods market.
Identifying all equilibrium combinations does
not. however, mean that the actual combination
in each time period will be one of them. There
may be disequilibrium in the goods market. Suppose that tile actual combination is the disequilibrium combination of Y = $140 and r =
6 percent indicated as point E in Part 0 of Figure
12-3. At the income level of $140. 5 will equal I
only if the interest rate is 5 percent. Therefore,
given this $140 income level and an interest rate
of 6 percent. 5 must exceed t because I will be
smaller at a rate higher than 5 perent, but 5 will
be unchanged. 5 depends only on the level of
income, which is here unchanged at $140. The
combination of Y = $140 and r = 6 percent is
also a disequilibrium from a second point of view.
At the interest rate of 6 percent, 5 will equalf only
if the income level is $120. Therefore. given the
combimition of this 6 percent interest rate and an
income level of $140 as at point~, 5 must exceed
I because 5 will be larger at an income level
above $120. but iwill be unchanged. t depends
only on the interes~ rate, which is here unchanged
at 6 percen.t. It follows that for any combination
of Y and r located anywhere in the space to the
right of the 15 curve. the same conclusion may
be drawn that was drawn for point E: There is a
disequilibrium
in which 5 exceeds I and Y
exceeds (C + I).
By the same line of reasoning, the combination of Y = $120 and r = 5 percent indicated as
point F is a disequilibrium of the opposite kind:
Here f must exceed 5. Generalizing as before,
f~r, any combination of Y and r anywhere in the
space to the left of the f5 curve, there is a disequi!ibrium in which I exceeds 5 and (C + I)

240----------------------rC~H~APTED:mR;-:lWE~iVCLVE
exceeds Y. In other words. the aggregate spending on goods exceeds the aggregate output of
goods.

Equilibrium
in the Money
Market
Equilibrium in the money market requires an
equa1ity between the supply of and the demand
for money. The Keynesian theory of the demand
for money makes the transactions demand (here
combined with the precautionary demand) a
direct function of the income level alone. orm,
= k(Y) . .It makes the speculative demand an
inverse function of the interest rate alone. or msp
= h(r). Total demand for money is md = mr +
ms = k(Y) + h(r). The supply of money ms is
determined outside the model--it is exogenous.
This may be written ms = mar in which m8 is simply the am0unt of money that exists, an amount
determined by the monetary authorities. (The
monetary authorities determine only the nominal
stock of money, Ms. but with P assumed to be
stable. determination of Ms also determines ms')
This .gives us three equations to cover the money
market:
Demand for money: md = k(Y)
Supply of money: ms = mil
Equilibrium condition: md = ms

h(r)

This set of equations is shown graphically in

Figure 12-4. Part A shows the speculative demand
for money as a function of r. Part B is drawn to
show a total money supply of $100. all of which
must be held in either transactions or speculative
balances. The points along the line indicate all
the possible ways in which the given money supply may be divided between m, and map' Part C
shows the amount of money required for transactions purposes at each level of income on the
assumption that k = 1/2. The LM curve of Part 0
is derived from the other parts as follows,
.

Assume in Part A an interest rate of 6 percent,

at which the public will want to hold $40 in speculative balances. In Part B, subtracting the $40
of speculative balances from a total money supply of $100 leaves $60 of transactions balances,
an amount consistent with an income level of
$120 as shown in Part C. Finally, in Part D, bringing together y of $120 from Part C and r of
6 percent from Part A yields one combination of
Yand r at which md
ms or at which there is
equilibrium in the money market. If we assume
the lower interest rate of 5 percent, Part A indicates that speculative balances will be $50,
Part B indicates that transactions balances will
be $50. and Part C indicates the income level of
$100 as that consistent with transactions balances of $50. This yields another combination of
Y and r~100 and 5 percent-at
which md =
ms' Other such combinations can be determi~ed
in the same way. In Part D, th~ function labeled
LM results when these combinations are connected.7
Although particular characteristics of the LM
function will call for attention later, in general the
function slopes upward to the right. With a given
stock of money. money market equilibrium is
found at combinations of high interest rates and
high income levels or low interest rates and low
income levels. Viewed in one way, this follows
from the fact that a high level of income calls for
relatively large transactions balances, which,
with a given money supply, can be drawn out of
speculative balances only by pushing up the
interest rate. Viewed in another way, it follows
from the fact that at a high interest rate speculative balances will be low; this releases more of

7 As with the IS curve. the combinations of Y and r at

which md = m. could just as well be determined graphically by starting with assumed levels of Y. Therefore,
assuming Yof $120, Part C ShONSthat m, will be $60.
Subtracting S60 from the total money supply of $100
leaves $40. As Part A shoNs. this is an amount the public
will be willing to hold in speculative balances, msp. at r of
6 percent. In Part D. Yof $120 and r of 6 percent therefore
identify one combination of Yand r at which md = m.,

m,
I

100

I
1

60

------

ms

= $100

---------1I

I
!

I
I

I
I

J..

_j

80

Transactions Demand
mt

;
10 ~-

Supply of Money

m.

k(Y)

mr +

msp

I
I
I
I
I
I
I

Fi

---------tI
I

I
-1-----------

I
I

I
I

I
I

I
I

I
I

Money Market Equilibrium

m, == k(Y) -;- h(r)

Speculative Demand
m.p

FIGURE 1;1..4
Money Market EquWbrium

h(r)

the money supply for transactions balances. This

money wil! be held in such balances only at a
correspondingly high level of income. Although
the LM function indicates why equilibrium in
the money market wil! occur at a higher interest
rate for a higher level of income, it alone cannot
reveal what particular combination of Y and (-"
will be f0und in any given time period. All combinations on the LM function are equally possible
equilibrium combinations in the money market.
As with the IS curve. identifying all combinations at which md = ms does not mean that the
actual combination in each time period will be
one of them. The actual combination may involve
a disequilibrium in the money market. For example. consider the disequilibrium combination
indicated by poin,t E in Part D of Fig!Jre 12-4. At
the income level of $120, md will equal ms only if
( is 6 percent. Therefore. if we combine this $120
income level with an interest rate of 5 percent.
md must exceed ms because md will be larger at
( = 5 percent. The quantity of money demanded
for speculative purposes rises with a lower interest rate. but the total supply of money is fixed.
Alternatively. if we start with the interes1 rate of
5 percent, md will equal ms only -if the income
level is $100. Therefore. if we combine this
5 percent interest rate with an income level of
$120 shown as point E, md must exceed ms
because md WIll. be larger at an income level
'&i>ove $100 than it will be at $100. The quantity
of money demanded for transactions rises with
a higher income. but the total money suppiy is.
as before. fixed. What has been concluded for
the combination indicated by point E holds true
for any combination located in the space to the
right of the LM curve; any combination of Y and
( in this space is necessarily a disequilibrium
combi[1ation in which md exceeds ms'
By the same reasoning. the combination of
Y = $100 and r = 6 percent indicated as point
F is a disequilibrium of the opposite kind: ms must
here exceed md. Generalizing as before. there is
a disequilibrium in which ms exceeds mCI for any
combination of Y and ( located in the space to
tr-18 ieTt of the L:'v1 curve.

Two ..Market

EquilibriUniThe Goods and Money

Markets
Equilibrium between Hie supply of and demand
for goods is possible at all combinations of Yand
r iridicated by the IS curve; similarly, equilibrium .
between the supply of and demand for money is
possible at ail combinations of Y and r indicated
by the LM curve. However, there is only one combination of Y and ( at which the supply of goods
equals the demand for goods and the supply.of
money equals the demand for money This combination is defined by the intersection of the IS
and LM curves derived in Figures 12-3 and 12-4
and brought together in Figure 12-5. in this dlustration, equilibrium in both markets occurs with
Y = $120 and ( =-= 6 percent.

"Ir

10

"-

81-

"IV

I
q-----------

I
III
I

) I-

__ I

1.
4L:

.1

80

._.

~c:

_-L-

1CJ

200

, __
v

;l4q

FIG1JP..J: 12 5
Equilibrium in 'the Goods and
Money Markets
9

From Disequilibrium to
Equilibrium
Every possible combination of Y and r in Figure
12-5 other than that given by the intersection of
the IS and LM curves is one at which there is
disequilibrium in the goods market, the money
market, or both. All those combinations that do
not lie on either the IS or the LM curve fall into
this last category. Because all such combinations
do not lie on a line, they necessarily jie in one of
the four areas identified by the Roman numerals
I through IV As we saw earlier, any combination
of Y andr that lies anywhere to the right of the IS
curve is a combination at which S > I and Y >
(C + I). The opposite is true for any combination
of Y and r anywhere to the left of the IS curve.
Similarly, any combination of Y and r anywhere
to the right of the LM curve is a combination at
which md > ms' The opposite is true for any combination to the left of the LM curve. Accordingly,
each of the four spa~s may be distinguished
from the other three in terms of the relationships
between the supply of and demand for goods
and betweenthe
supply of and demand for
money for any-'combination of Y and r that falls
within that space:

In Space
In Space
In Space
In Space

I:
II:
III:
IV:

Goods Market
f < S, (C + I) < Y
1< S, (C + I) < Y
I> S, (C + I) > Y
I> S, (C + I) > Y

for goods and the direction in which the interest

rate tends to move in response to an excess supply or excess demand for money, we can trace
out in a nonrigorous fashion a possible path that
the income level and the interest rate may follow
in response to any given disequilibrium situation.
if) Figure 12-6 we assume the economy is
located at the disequilibrium combination of Y
and r indicated by A, which is in Space IiI. Here
there is an excess demand for goods and an
excess demand for money. The excess demand
for goods tends to raise the income level. as
indicated by the horizontal arrow originating at A.
The excess demand for money tends to push up
the interest rate, as indicated by the vertical
arrow originating at A. With these forces at work,
it is not unreasonable to expect the economy to
move along the path designated by the arrow
from A~to B. Next, with the economy at B, the
supply of and demand for goods are equal,

Money
Market

md < ms
md> ms
md> ms
md < ms

From the analysis of the goods market considered in isolation, we know that a situation in
which' I > S or (C + I)
Y will lead to a rise in
income and vice versa. From the analysis of the
money market considered in isolation, we know
that a situation in which m d > m s will lead to a rise
in the interest rate and vice versa. What we now
have in the four spaces laid out in Figure 12-5
are various combinations of IS and LM disequi.Iibrium situations. Because we know the direction
in which the income .level tends to move in
. response to an excess supply or excess demand

:>

FIGURE 12-6
Possible Paths of Movement to
Equilibrium in the Goods an4
Money Markets

because we are on the IS curve. But we are still

at a point to the right of the LM curve, so the
demand for money exceeds the supply of money.
Therefore, a force is at work to push up the interest rate and the next movement may be along
the arrowfrom B to C. At C there is still an excess
demand for money, which again tends to push
up the inlerest rate as indicated by the vertical
arrow originating at C. However, at C there is an
excess supply of goods, "thich tends to reduc
the income level as shown by the horizontal arrow
originating at C. These forces may on balance
cause the economy to move along the path
described by the arrow running from C to D. At
0, the forces are the same as at C; the result is
a movelTocnt of the same kind. The combination
of income level and interest rate may change in
this way over time until finally the system reaches
that one combination of Y and r at which both
markets clear. Although the several discrete
steps traced out here help reveal the-underlying
process at work, the actual process would be a
continuous one in which Y and r might move
along a path like that indicated by the dashed
line running from A to 0 and then to the intersection of the two curves.
Instead of starting at A, we could start at any
other disequilibrium point in Figure 12-6 and
trace the movement of Y and r toward the single
pair of equilibrium values in the same way. No
matter what disequilibrium point one starts with,
all one need do is (1) identify whether I > S, 1<
S, or I = S, or in terms of aggregate spending
whether (C + !) > Y, (C + I) < Y, or (C + I) =
Y, which te!ls whether Y will tend to rise, fall, or
remain unchanged; (2) identify whether md > ms'
md < ms' or md = ms' which tells whether r will
tend to rise, tall, or remain unchanged; and (3)
establish the direction of movement at the Y, r
combination indicated by the forces found to be
at work in (1) and (2). For example, starting with
any point in Space I such as E, forces tend to
reduce both the income level and the interest
rate. The reader may trace the discrte steps
from E thrOi !gh H, which are different In direction
but exactly symmetrical with those from A through

..

D. As was shown for themovement-from-A.t6 the

intersection, the continuous;pa.th-th_at;t~~ ~
omy might follow fro~ E to H and then to the
intersection is indicated by a dashed line. Once
at the intersection. the combination of Y and ,
provides equilibrium in both markets; the income
level and the interest rate will remain unchanged
until the existing equilibrium is upset by a shift in
the IS or LM curve. or in both.8

E5-LM Equilibrium and the

Aggregate Demand Curve

In th~simple classical theory of Chapter 9, the
aggregate demand curve was derived from the
quantity of money and appeared graphically as
a downward sloping curve (rectangular hyperbola). Given the classical theory's conclusion
that the aggregate supply curve is a perfectly
inelastic line situated at the full employment level
of output, the intersection of the AD curve with
the AS curve did no more than determine the
price level of the full employment output.
The model being constructed in this chapter
includes the opposite extreme for the AS curvethat is. one that is perfectly elastic up to the full
employment level of output but perfectly inelastic
at that level. This kind of AS curve is shown in
Part B of Figure 12-7. The present model also
assumes that the economy operates below the
full employment level of output-that
is, along the
perfectly elastic portion of the AS curve. Some

8 Although it is quite illuminating to trace the path followed by Y and' as we have done here. the IS-LM model
, now before us does not in itself reveal that Y and , will
follow the path here described or any other particular path
from an initial disequilibrium position like A or E. As briefly
explained in Chapter 3. to trace the process of change in
the values of a model's variables from one period to
another can be done only with a dynamic model. The
IS-LM model isnot dynamic, but completely static. It identifies the values the variables must exhibit in order that
there be equilibrium. but it does not show the sequence
- of changes by which these values will be reached if we
start off with any values eltler than Ihese equilibrium

values.

i
12

r-

4,

2 ,-

IS
'-

...

-'

40

160

80

200

240

A
P
AS

AD

4
3

2
"'~

1
i.

40

80

.........

120

160

200

240

FIGURE 127
The IS-LM Curves and the
Aggregate Demand Curve

ular IS and LM curves, and it is from the intersection of this pair of curves that the AD curve is
derived in the present model. To derive the AD
curve, we make one final assumption-that
neither the IS nor the LM curve shifts with changes
in the price level. This assumption enables us to
postpone dealing with some major complications
until Chapter 13.
With this 3ssumption, whatever the price level
might be-1, 2, 3, 4, or any other level in Part B
of Figure 12-7-the IS and LM curves remain in
the position shown in Part A. Therefore, corresponding to each possible price level on the vertical axis of Part B, we have the same pair of IS
and LM curves and the same equilibrium figure
of 120 for the output level found in Part A. The
AD curve shows the toial amount of goods
demanded at various price levels, but on the
present assumption that amount is a constant
120. Therefore, the aggregate AD c.urve is perfectly inelastic at the output level of 120, as
shown in Part B. Throughout the balance of this
chapter we will assume that the IS andLM curves
do not shift with the price level; therefore all of
the AD curves will be perfectly inelastic. However, these AD curves can shift :to the right or the
left, and we next look at some of the factors that
will produce such shifts.

q,.;mges in Aggregate
Demand_ _'
,...---

.,-

//

:other assumptions finally yield the conclusion

that the level of output is determined entirely-p'
aggregate-demand. In this case, aggregate'sup1,~ly only determines the' price level at which that
'output will sell.
.:. ,:.J,n this model, the derivation of the AD curve
is more complicated than in the simple classical
model in which it only depends on the supply of
money Here it depends on all the factors that
determine the positions of the IS and LM curves.
The supply of money is only one of these factors.
At any time, these factors will determine partic~

The eqUilibrium combination of Yand r identified

by the intersection of the IS and LMfunct~ons will,
of course, change in response to any.$hift in
those functions, and the AD curve will s~ift to the
level of Y identified by the new infers~ctiof) ...Shifts
.in the IS function are caused by shifts in the
investment or the saving function (parts A"and .
of Figure 12-3); ,shifts in the LM, -function ar~
caused by shifts in the, money supply, transac-
tions demand, or speculative demand functions
(Parts B, C, and A, respectively, of Figure 12-4).
Finally, a shift in any of the functions on which the

.c

Is

and LM curves are based may result from a

change in the factors that determine the positions
of the-se functions. This givBs us a method of analyzing the effects of a change in any of these
underlying factors. We can trace a change in any
factor through the system to its final effect on the
income level and interest rate-assuming,
of
course, that all other factors remain unchanged.
Given the assumed shape of the aggregate supply curve, none of these changes will affect the
price .Ievel.

A Change in Investment
Among the various possibilities, a shift in the
investment curve is one of the most important.
Suppose a change in an underlying factor-for
-example, an improvement in business expectations-causes
this'curve to shift $20 to the right
at each rate~of interest. In Part A of Figure 12-8,
the original curve is labeled I, and the new one
12, In Figure 12-3, an IS curve was derived graphically from the investment and saving curves
given there. Similarly, in Figure 12-8, a separate
IS curve may be derived from each of the investment curves in combination with the given saving
curve. In Part D, the IS, and IS2 curves are based
on the I, and 12 curves, respectively. At each
interest rate, IS2 lies $40 to the right of IS,. In
other words, at each interest rate the level of
income at which S = I is now $40 greater than
it was before the shift in the investment schedule.
This follows from the fact that, with an increase
of $20 in investment, income must rise by $40 to
induce an increase of $20 in saving, given that
the MPS is 1/2. This is nothing more than the
simple multiplier in action, ~ Y(1 /MPS~/, which
gives us $40 = 2' $20.
, The original equilibrium was earlier -found at
Y pf $120 and r of 6 percent. Here it is shown
a@ain by the intersection of IS, and L,M in Part D
of Fig'Jre 12-8. As before, this gives us the AD,
curve positioned at Y of $120 in Part E. The LM
curve here is the sa\Tle as the one derived in Figure 12-4. The new equilibrium that results from
the shift in the investment curve is at Y of $140
and r of 7 percent (an 'increase of one percent-

age point) as shown by the intersection of IS2 and

LM in Part D. As the increase
in investment
,
.
spending starts an upward movement in income,
the rising income level increases the money balances needed for transactions purposes. This
leads to a rising interest rate, which in turn feeds
back to make the increase in investment spending less than the $20 and the increase in income
less than the $40 they would have been with no
rise in the interest rate. In the present illustration,
with the LM curve as given, the shift in the IS
curve caused by a rightward shift of $20 in the
investment curve raises Y by $20 and r by one
percentage point. The $20 rise in Y means an
increase of $10 in required transactions balances, given k = 0.5. The rise in r of one pe~centage point is just sufficient to reduce th~
amount of money the public wishes to hold in
speculative balances by $10, thereby supplying
the additional $10 needed for transactions bak
ances. Therefore, with ~ Y = $20 and ~r of one
percentage point, the supply of and demand for
money will again be in balance.
The same one percentage point rise in r will
decrease investment from $20 to $10. As may be seen in Part A of Figure 12-8, investment-which
would have risen from its original $20 at r -of
6 percent (point E) to $40 with no change in r
(Point F)-only rises from $20 to $30 (point G)
because one half of what would have been the
larger increase is choked off by the rise in r from
6 to 7 percent. The final increase in investment
of $10 turns out to be the same amount as the
increase in saving that occurs with a rise in
income of $20. From ~S = s(~Y), we here have
$1g- = 0.5($20). With ~ Y = $20 and ~r of one
percentage point, S will again equal I and Y will
again equal C + '- No other combination of
changes in Y and r will be consistent with equilibrium in both the goods and money rn'arkets,
assuming the indicated rightward shift in the
investment schedule with all else as given.
For a leftward shift in the investment schedule, the results will be the opposite. If the invest- ment schedule of Part A were to shift to the left
by $20 or from " to
the new equilibrium in
Part D wQuld show Yof $100 and r of 5 percent.

'3'

S
100

80

l-

S-

I
I

100

80 \-

6d-

::

40

t
!

I
20

I
I

r-

l~_l.-__

,---------..J _l.
I
I
--1..--_1 _...L __

..l...--.

120

200

160

--

---_

.....L..-..__...L
__
..._L..

60

80

__

100

2 ~.

I[
..__

~
.....L..-. _

20

.L_

40

..
_.L_ ..._L

60

80

.__
L.-..._.

100

_ ..

.l-

....1.- __ .....

160

200

FIGURE 128
A Change in Investment and the Change in Aggregate Demapd
'(

...
__.

Relative to the original equilibrium, t'1is would be

a decrease in Yof $20 and in r of one percentage
point.9 No other combination of changes in Yor
r would be consistent with equilibrium in both the
goods and money markets, assuming the indicated shift in the investment schedule with all
else as given.
Just as the intersection of IS1 and LM in
Part D established the AD1 curve in Part E, the
intersections of the IS2 and LM curves and of the
IS3 and LM curves establish the AD2 and AD3
curves, respectively, in Part E. Given the LM
curve in Part D, the shifts in the I curve of. Part A
which cause the indicated sh:fts in the IS curve
in Part D also produce the shifts here noted in
the AD curve in Part E.

A Change
in th'e Money Supply
As a second illustration of a shift in the AD curve,
assume a $20 increase in the money supply. This
shifts the ms curve in Part B of Figure 12-9 from
its original position of mS1 to the new position
ms2. With no change in the speculative demand
function or the transactions demand function, the
$20 increase in ms shifts the LM function rightward by $40 at each rate of interest, or from LM 1
to LM2. What lies behind this may be seen as
follows. Equilibrium between md and ms requires
a rise in Y sufficient to absorb the ms increase of
$20 in transactions balances, ml, if the interest
rate is assumed to be given. Because mt = k(Y),
we ' .J.veY = m,lk and ~ Y = tun,lk. Accordingly,
with k given as 0.5, a Y must be $40 to produce
a new equilibrium between md and ms at each
jntere~t rate.

9For simplicity, here we. assume that the LM curve is

linear over the range of interest rates (5 to 7 percent) relevant to our illustrations.
(This requires that we also
assume that the underlying speculative demand curve is
linear over this same range.) Specifically, the slope of LM
is taken to be 0.05 (r changes by 0.05 percentage point
for each $1 billion change in Yor by 1.00 percp-ntage point
for a $20 billion change in V). Any dE:;J~lrture from linearity
would give actual numerical resultsdifferent
from the symmetrical ones found in the illustrations.

The original eqUilibrium at Y of $120 and r of

6 percent is shown here again by the intersection
of IS and LM1 in Part 0 of Figure 12-9. The IS
curve here is the same as the one originally
derived in Figure 12-3. The new equilibrium that
results from the increase in the money supply is ..
at Y of $140 and r of 5 percent. Although the $20
increase in ms will shift the LM curve $40 to the
right at each interest rate. it will not raise the
equilibrium level of Y by $40, because, with-no
shift in the IS curve, a rise in the equilibrium level
of income cannot occur unless r falls. However,
a fall in r will increase the amount of money people choose to hold in speculative balances. In
the present illustration, $10 of the $20 increase
in M will be absorbed in speculative balances as
r falls from 6 to 5 percent (as may be seen from
Part A of Figure 12-9). This same fall in r is also
just sufficient to raise f by $10 (as may be seen
from Part A of Figure 12-8) and, through the multiplier, raise Y by $20. A rise in Yof $20 increase~
required transactions balances by $10, which
accounts for the balance of the $20 increase in
ms' Nu other possible combination of changes in
Y and r but this $20 increase and one percentage
point decrease will be consistent with equilibrium, assuming the indicated increase in the
money supply with all else as given.
If the change were in the opposite directiona $20 decrease in the money supply that shifts
the curve from ms 1 to ms 3-the new equilibrium
combination of Y and r would be at $100 and
7 percent, or a decrease in )l of $20 and a rise
in r of one percentage point. By the reasoning of
the preceding paragraph, no other combination
of changes in Y and r will provide a new equilibrium within the assumptions of the present illustration.
Because the LM 1 and IS curves in Figure
12-9 are identical with the LM and IS1 curves in
Figure 12-8, they intersect at Y = $120 and r =
6 percent. With the eqUilibrium interest rate set
at 6 percent, S = I and Y = C + I at Yof $120.
As in Figure 12-8, this establishes the AD; curve
in Part E at Y = $120. An increase from m.l to
ms2 shifts the LM curve from LM1 to LM21 lowers
the equilibrium interest rate, and makes S = J

249

.....J

-1- -+ - - - - - - - - - - -

__
40

10

I
I
I

I
I

-L __L.L__
L_--.L
80

,
40 t-

120

..L.._

160

..._._

200

8~

6~

I
I
I
I

.~

2 ~

I
,

I(

40

80

i -

l----l- L. __ l

120

......L.

160

200

.l-...,

.L

20

40

L
60

_ ... .c.

80

L.

100

L.
120 msp

"
-';

.'
_.,

"

FIGURE 12-9
A G p :Inthe Money Supply and the Change in Aggregate Demand

and Y = C + I at Y of $140. This establishes the

AD2 curve at Y of $140 in Part E. In the same way,
the LM3 curve based on mS3 yields the AD3 curve
at Y of $100 in Part E.
Although the present illustration involv~s
nothing more than a purely monetary change,
one result is still a change in the level of .real
income. In short, given the IS and LM curves as
in Figure 12-9, monetary policy can influence the
economy's level of output. As will be explained
later, the effect on the income level of an increase
in the mqney supply depends on (1) how great
the fall in the interest rate is, which in turn
depends on the elasticity of the speculative
demand function, and (2) how much investment
spending rises as a result of any given drop in
the interest rate, which in turn depends on the
interest elasticity of the investment function. If the
interest rate falls with a rise in the money supply
and if investment 'spending rises with a fall in the
interest rate, the income level will rise.

I
I
I
I
2

I'- __----.--L-_-----l-..._-L ,I

o.

40

80

120

--.L

IS,
----.--L-

160

200

240

AD2

AS

A
AD,

A Simultaneous Increase
in Investment and
the Money Supply
A

Now suppose that the two increases we have discussed separately occur simultaneously. The rise
in the investment function moves the IS curve
from IS, to IS2, and the rise in the money supply
moves the LM curve from LM, to LM2, as shown
in Part A of Figure 12-10. The result is a shift in
the equilibrium position from Y of $120 and r of
6 percent to Y of $160 and r of 6 percent. The AD
curve of Part B correspondingly shifts from its
position at Y of $120 to a position at Y of $160. A
rise in investment spending, with no change in
the money supply, produces a rise in income that
is dampened by a rise in the interest rate resulting from it. If the money supply increases by just
the amount necessary to prevent this rise in the
interest rate, the full i'ncome-expansionary effect
of the rise in investmeAt will be realized. The
increase in Y from $120 to $160, with an increase
in investment of $20 and an MPC of 1/2, is just
the result we found in the simple Keynesian

FIGURE 12-10
Effect on Aggregate Demand of a
Simultaneous Increase in
Investment and the Money
Supply
model in Chapter 5. Now we see that this result
will be realized only if an appropriately expansionary monetary policy-here
an increase in ms
of $20-is
pursued to prevent what otherwise
would be a rise in the interest rate and consequently a smaller rise in the income level.
The effects of shifts in other functions may be
traced in the same way. For example, an increase
in "thrift," which appears as an upward shift in the

saving function (Part C of Figure 12-3), will shift

the IS curv,eto the left and lower rand Y. An
increase in the demand for money to be held in
idle balances, which appears as a shift to the
right in the speculative demand function (Part A
\ of, Figure 12-4), will shift the LM curve to the left,
. ,,\raiser, and lower Y. A change in payments prac)ices that makes it possible for each dollar of
money to handle a larger volume of transaCtions
per time period reduces k,and appears as a less
steeply inclined, transactions demand function
(Part C of Figure 12-4), This will shift'the LM curve
to the right. lower r, and raise Y.

, Government Spending,
Taxation, and Aggregate
Demand,
_
Once government spending and taxation have
been added to the model, the equilibrium condition S = I in the goods market foi' a two-sector
economy becomes S + T = I + G for a threesector economy. This simply means that the
aggregate spending for goods and aggregate
output of goods will be equal when the sum of
the diversions, S + T, from the real income
stream is just matched by the sum of compensating injections, I + G, into the real..'income
stream. Alternatively, the equilibrium condition in
the goods market may be expressed as Y =
C + I + G. The equilibrium condition in the
money'market is md = ms' as before.
As in the first fiscal model of Chapter 6. both
government purchases of goods and services
and net tax receipts'are assumed to be independent of the level of income. Part A of Figure 12-11
shows $20 9f :government purchases added.
to the investment .schedule- of Figure 12-3.
'Bec.~use these Pwchases are also regarded
as independent of the interest rate, the I + G
curve lies $20 to the right of the I curve at all
interest rates. Whatever the interest rate, the sum
of I -+- G will be $20 greater than I alone. In termsof its'effecton Y,a dollar of G is no different from
, a dollar of I. Adding $20 of G therefore shifts the

IS curve $40 to the right. from IS1 to IS2, for the

,same reason that the increase in investment of
$20 shifted the IS curve to the right by $40 in
Figure 12_8.10 Part 0 of Figure 12-11 includes the
same LM function derived in Figure 12-4.
Other things being eElual, the introduction of
deficit-financed government purchases of $20
moves the Y, r equilibrium in' Part 0 from $120
and 6 percent to $140 and 7 percent and shifts
the AD curve in Part E from AD1 to AD2 Again
.the result shown is the same _as that in Figure
12-8 for a $20 shift in the investment demand
schedule. What otherwise would be an expansion in Yof $40, as indicat.ed by the simple multiplier of 2, becomes the lesser expansion of $20
due to the effect of the rise in r that accompanies
the rise in Y. However, there is a difference: G of
$20 is unaffected by the rise in r it causes, but
the rise in r reduces I by $10, which makes the
net change in I + G only $10 and the rise in
income~:only $20. The full income-expansionary
effect of G,is not realized, because tfie resulting
rise in r crowds out $10 of private investment
spending. Therefore, a fiscal policy designed to
raise the income level through a deficit-'financed
expansion of government spending may not produce the maximum possible rise of income unless
it is accompanied by an appropriately expansionary monetary policy. 1.1
Let us now suppo~e that there is a balanced
budget and that the government collects taxes
of $20 to match its spending of $20,thefeby

1lt would be more correct to designate the curve as

IG-ST instead of IS, but the simpler notation will be
retained. Note. however. that in Parts A-C the axes previou_slylabeled I are now I + G. and the axes previously
labeled S are now S + T.
11 Because government
spending in this example is
entirely deficit financed, we are concerned with the
method of deficit financing employed, If entirely financedby the sale oLgovernment securities to the public. there
will be no increase in the money supply; the results are as
described above. If financed by the appropriate "mix" of
sales to the public and the banking system, there will be
~n incrase in the money :;upply that permits the full $40 ;
potentiat expansion in Y.
.

S+T
100

I
!

:: f

60 ~

!
40

20

401-----~----

IrI1.__ .__

_1.

40

______
.Ll_L__~____----.L..
00

20!-- --

I
I

I I

..1...- .

r---

lW

100

200

I
,
,

I
I
I I I
I I

45.__'-_....L1_L
I I
I

20

40

' __
60

..l- ._
----L __..
80

100

r
I

10 \--

6,

i
4 ~-

i,
2

rI+~

IL

120
130

.....L.
__
20

i_.
40

..l-

..l_.

60

80

.1.__...
100

f ~ 160
'"

:\

140

Effect on Aggregate

fiGURE 12-1 i
D'emand of Changes in Government
and Taxation

Spending

avoiding deficit spending,. In the present model,

. taxes of $20 reduce disposable income by $20.
With,the" MPS of 1/2, the reduction in saving is
one-~alf of this amount. Consequently, at each
.'level of Y, T of $20 reduces 5 by $10 and C by
$10, which appears in Part C of Figure 12-11 as
a downward shift of $10 from 51 to 52 in the saving
function. To the leakage from income made up
of saving must now be added the leakage of $20
for taxes. This gives us the curve 52 + T, the sum
of saving and taxes, or that portion of the income
flow that does not appear as consumption
spending at each level of income.12
I of Part A and 51 of Part C gave us 151 of
Part 0; I + G of Part A with T of zero gave us 152
of Part 0; finally, I + G of Part A with 52 + T of
Part C gives us 153 of Part D. The new equilibrium
position indicated by the intersection of 153 and
LM in Part 0 is found at Y of $130 and r of 6.5
percent. Corresponding to this is AD3 positioned
at Y of $130 in Part E. In our illustration, adding
G of $20 and an equal amount of T raises the
equilibrium level of Y by one-half the increase in
the size of the b'udget.13
With G and T both independent of the level
of Y, we have a model similar to the one that gave
us the unit multiplier in Chapter 6. In that model,
the rise in Y was equal to the increase in the size
of the budget. However, because the interest rate
is now part of the model, we' firiOtha:t the adual
multiplier is less than the balanced-budget multiplier of 1 that appears in the simpler model. An
expansion in the size of the budget, with the
budget'balanced, will raise the income level, but
the rise in income-which
would otherwise be
(

12Forexample, with Y of $140 and T of zero, Yd' or Y

- T, would be $140; C would be $110, or $40 + 1/2($140

- 0); and $ would be $30, or - $40 + %($140 - 0), the
last figure as shown on the $, curve of Part C of Figure 1211 at.y of.$140. The imposition of T of $20 reduces Yd to
$120 when Y is $140. This reduces C to $100, or $4.0 +
%($140 - $20), and $ to $20; or -$40
+ %($140.$20), the latter figure as shown on the $2 curve at Y of
$140. Finally, adding T of $20 makes total diversions from
income $40 at Y'of $140, as shown on the $2 + T curve,
13Theoriginal budget was one in which both G and T
were zero.

equal to the expansion in the size of the budgetwill be dampened by the tendency for the interest
rate to rise with the rise in income. In other words,
a fiscal policy designed to produce a rise in
income while maintaining a balanced bUdget will
produ~e the maximum possible income increase
only if it is accompanied by an expansionary
monetary policy that prevents what otherwis~
might be a rise in the interest rate and a consequent reduction in private investment spending.
We have seen that a rise in the income level
m'ay be expected from an expansion in G with no
change in T and even from an expansion in G
that is matched by T. The third possibility, of
course, is a reduction in Twith no reduction in G,
a commonly cited example of which was the tax
cut of 1964. This major reduction cut federal tax
receipts about 10 percent below what they other~
wise would have been; in contrast. the more
recent anti-reCE:fssionary Tax Reduction Act' of
1975 reduced receipts about 5 percent below
what they otherwise would have been. Figure
12-11 may bE?used to illustrate an aspect of the
1964 tax cut much discussed at the Jime.-SUppose the original equilibrium is definedf/by)the
intersection of 153 and LM at Y otl$)3(j,~'nd
of
6.5' percent; this is the equilibriurl consistent with
1 + G of Part A and 52 + T ~f ParVJ. of Figure
12-11. With no change in G ~ ~Jax cut of $20,
the I + G curve remains ~
~crthe 52 + T
curve shifts downward to.8,. 't'fis'in turn causes
the 15 curve to shift from 153 'to 152, But the full
expansionary effect of the tax cut-a rise in Y
from $130 to $150-is not realized because the
interest rate rises. Therefore, in judging the prospective effectiveness of the 1964 tax cut, one
consideration was whether or not the expected'
increase in aggregate spending would be smaller
than otherwise obtainable due to adverse monetary effects, In President Johnson's words, ,''It
would be self-defeating to cancel the,stimulus,of
tax reduction by tightening money. Monetary and
debt policy should be directed toward maintainjng interest rates and credit conditions that
encourage private investment.,,14 The model In

1's.'

254
Figure 12-11 is far tOb simple.to come to grips
with the questions' involved, but it suggests. in
very general terms, that what is called-for is an
incre~~e in the money supply. This' Jncrease.
should be"sufficient to shift the LM cu~e to the
right 'by the amount necessary to s.ecure the
greater rise in income-from
$130 to $"1~~that
will follow f(om the increase in aggregate spending to be exp~cted at ,a stable interest rate.
~Itpough we will not go beyond the simple
model in which both G and T are assumed to be
independent of Y, the- IS-LM analysis of Figure
12-11 may be elaborated by introducing more
realistic fiscal assumptions. In Part C, for example. T may be treated as a function of Y, and the
effects of this more realistic fiscal assumption on
the..Y, r equilibrium combination may readily be
tr~ced. This . model will show how the potential
income-expansionary
effect of, say, a rise in
investment. spending may be restrainec.by both
a rise in the interest rate and a rise in tax receipts
as income expands. Although it adds something
to the simpler model of this section, like any other
model of this kind it will again bring out our principal conclusion: An increase in aggregate
spending-whether
it is the result of a shift in the
investment function. consumption function, or a
change in government spending or taxation-will
not produce the effect on income ~uggested by
the crude multipliers in earlier ch~ers.
When
,
we recognize the r<>leplayed by money and interest, we see how an otherwise greater expansion
of income suggested by crude multipliers may
be prevented by the rise in the interest rate that
may accompany a rise in income.

The :IS and LM

Elasticities
and MOftetaryiFiscaJ.
Policies
'
,
far, we have intentionally avoided specific reference to the elasticities of the IS and LM tunc:'
tions so that we might concentrate on the general
81)

characteristics at th~' present stab!e-ptice model

and the general conclusions it suggests. As we
allow for the elasticities of these functions. we will
find that some ofthese conclusions must be qualified and that some must even be abandoneq in
the extreme cases' of perfectly elastic or inelastic
functions. For example, an expansionary fiscal
.policy may rais,e only the interest rate and leave
the income level unchanged; conversely, it may
raise only the income level and leave the interest
rate unchanged. An expansionary monetary policy may lower only the interest rate and leave the
income level unchanged; or it may change neither the interest rate nor the level of income. The
reverse is possible for contractionary policies.

Elasticity of the IS and LM

Functions
With a fixed money supply, the LM function as
derived in Figure 12-4 slopes upward to the right.
However, at one extreme the function may become
perfectly elastic, and at the other extreme it may
become perfectly inelastic, with a range of varying elasticities in between. In general, the higher
the interest rate, the less elastic the corresponding point on the L~ function will be. These three
ranges are delineated in Part A of Figure 12-12,
in which the perfectly elastic section is the
"Keynesian range," the perfectly inelastic section
is the "classical range," and the section between
is the "intermediate range."
Why this particular shape with perfect elasticity at one extreme and perfect inelasticity at
the other? Remember that at sonie very low interest rate th~ speculative demand for money may
become perfectly elastic due to a consensus by
wealth-holders that the interest rate will fall no
lower and that security prices will rise no higher
Wealth-holders
accordingly
stand ready to
exchange seGurities for cash at existing security
prices. which produces the liquidity trap on the
speculative demand function. Here,' on the LM" ,
function: it produces what is known as the Keynesian range. At the other extreme, at some very
high int~rest rate, the speculative demand for
-~~-.---

!
L.

'I

t.L_L

FIGtJRE 1:112

Effects of Shifts m the is and

LM FWtctions with Various
Elasticities of the LM FwtCtiOfi
money may become zero and perfectly inelastic
at interest rates above this if wealth-holders
believe the interest rate will rise no higher and
that security prices will fall no lower. At this or any
higher rate, wealth-holders accordingly prefer to
hold only securities and no idle cash. This perfectly inelastic section of the speculative demand
function is known as the classical range on the
LM function.
Why are the three sections into which the LM
function has be-en diVIded labeled in this fash-

ion? In our simplified version of the classical theory, money is demanded only for transactions
purposes. Therefore, in Figure 12-4, classical
theory assumes that the speculative demand for
money is zero at each inter~st rate. In effect.
Part A of that figure vanishes. If the total money
supply given in Part B is $100. that $100 will be
held in transactions balances or msp = 0 and ms
=: tnr With k of 1/2 in Part C. the LM curve of
Part 0 becomes a perfectly vertical line at the
income level of $200. if the public holds, money
only for transactions purposes and if it holds
money balances equal to one-half of a period's
income, money market equiiibrium is found at an
. income level of $200 at all interest rates. 15
With the exception of the perfectly. inelastic
section-the
so-called classical range-it would
not be altogether incorrect to include the remainder of the LM function in the Keynesian range.
However, because of Keynes' emphasis on the
ineffectiveness of monetary policy, the Iiquiditytrap section alone has been identified. as the
Keynesian range. Within this range, monetary
policy is completely ineffective; therefore .. this
range most closely fits Keynes' emphasis.
The IS function as derived in Figure 12-3
slopes downward to the right. Its elasticity
depends on the responsiver:'ess of investment ./
spending to changes in the interest rate and on
the magnitude.of the mUltiplier. If the investment
spending schedule is perfectly inelastic (indipating that investment sRending is completely
tnsensitive to the interest rate). the IS curve
derived in Part 0 will' be perfectly inelastic.
regardless of the magnitude of the multiplier. If,
on the other hand, the investment demand
schedule shows some elasticity, as se~ms to be
the case, the IS curvewili be- more ela,stic, the
lower the MPS. The lower the MPS, the higher will
be the mutliplier and the greater will be _the
change in income for any increase in investment
resulting from a fall in the interest rate. Part A of .
Figure 12-13 shows three pairs of IS curves, each
''''The graphic derivation of a perlect!V inelastic
curve is shoM1 in Chsptei 13 on p. 268.

LM

output attained, Ys in Part A. Consequently, all of

the changes in AD shown in each figure from Y1
to Ys are accompanied by proportional changes
in y"6

Monetary and Fiscal Policy

.._, ..... '-

Y4

A
P
AD3
,

AD,

AD2

ADs
AD4

AS

I
PI

Monetary policy is the exercise of the central

bank's control over the money supply as an
instrument for achieving the objectives of general
economic policy. Fiscal policy is the exercise of
the government's control over public spending
and tax collections for the same purpose. We will
confine ourselves here to the single policy objective of raising the level of real income. The IS-LM
framework then provides a basis for comparing'
the effect of the two types of policy on the income
level and the interest rate and for comparing conditions under which each type of policy will oe
effective or ineffective in prodt.i'ciftg the; desired
change in income. For this purpose, tHe discussion is conveniently divided into three parts, each
corresponding to a range of the LM function in
Part A of Figure 12-12.

...

Consider first the Yl'

in the Keynesian range. An increase
in the money supply shifts the LM curve to the
right, from LM1 to LM2. This means that for each
possible level of income md = ms only at a lower
interest rate; the rate must fall by the amount necessary to make the public willing to hold larger
idle cash balances. But this is not true in the

The Keynesian Range

r, equilibrium

FIGURE 1213

Effects of Elastic and Inelastic IS

Functions in Different Ranges of
the LM Function
~ made up of one highly inelastic and one elastic
IS curve.
Parts B of both Figures 12-12 and 12-13
show AD curves corresponding to the various
levels of Y set off on the Y axis in Part A of each
of those figures. As in previous figures of this
chapter, the AS curve is assumed to be perfectly
elastic up to the full employment level of output.
Also as before, the full employment leve! is
assumed to be greater than the highest leve! of

16 Although
the present model contains a classical element in the form of the perfectly inelastic range of the LM
curve, the model is essentially Keynesian because it
shows that the equilibrium level of output may be below
it-Ie level consistent with full employment. Remember from
Chapter 9 that the simple classical model with its assumption of perfect wage and price flexibility yields a perfectly
inelastic AS curve, which is located at the full employment
ievel of output. This makes the full employment level of
output the only equilibrium level, a result altogether different from that found in Figures 12-12 and 12-13. Further
. comparisons between the classical and Keynesian models"
in terms of the IS-U.If framework will be presented in the
following chapter.

"liquidity trap." Here the interest rate is already

at an irreducible minimum for the time.being. As
the monetary authority purchases securities,
security-holders are willing to exchange them for
cash at the existing prices. Therefore, expansion
?f the money supply cannot cause the interest
rate to fall below the rate given by the trap. All
that happens is that the public holds more in
speculative balances and less in securities. Further increases in the money supply would shift
the LM curve still farther to the right, but the lower
end of the curve would remain anchored in the
same liquidity trap. If the economy is already in
the trap, monetary policy is powerless to raise
the income level. It cannot reduce the interest
rate any further to produce a movement down the
IS1 curve to a higher equilibrium income level.
The belief that the economy was in the trap during the early thirties led Keynes to his then unorthodox fiscal policy' prescriptions. Because government cannot raise the income level through
monetary policy, it can only try to do so through
fiscal policy. If a rise in income cannot be
acnieved by producing a movement down the IS 1
curve through monetary expansion, it can be
achieved
by producing a shift in the IS 1 curve
.
Itself, say from IS1 to IS'l' Fiscal measures such
as increased government spending or reduced
taxes .that could shift the IS curve become the
order of the day.
t~~ extent that monetary policy operates by
raising Investment spending through a reduction
in t.he cost of money, the impasse of monetary
policy for an economy caught in the trap means
that the elasticity or inelasticity of the IS function
is no longer relevant. In Part A of Figure 12-13, for

.:0

example, it does not matter Wh~eh r the IS function is th~ el.a~ticIS1 or the inelasti IS"1.17
The liqUidity trap is an extre e case that
could occur only during a dee depression, if
even then. A prosperous economy and a liquidity
trap do not go hand in hand. Because the pure
As we will see, the elasticity of the IS function does
::>ecomerelevaAt elsewhere, but not in the Keynesian
ange.
17

Keynesian range is the range of the liquidity trap,

one can",now appreciate what Professor Hicks
meant by his observation, made shortly after the
appearance of Keynes' book, that "the General
Theory of Employment is the Economics of
Depression.,,18

"

The Classical 'Range

Next let us examine the
Y4' r 4 equilibrium defined by the intersection of
IS3 and LM 1 in Part A of Figure 12-12. Some
increase
in the money supply will shift the LM 1
_
curVe to LM2. In contrast to the result in the
Keynesian range, the result is now an increase
in the inc.ome level from Y4 to Y5 and a fall in the
interest rate from r 4 to r 3' In the classical range
the i~terest rate is so high that speculative balances are zero; money is held for transactions
purposes only. Under these circumstances, if the
monetary authority enters the market to purchase
securities, security-holders can be induced to
exchange securitjes for cash only at higher
prices. As security prices are bid up and the
interest rate is pushed down, investment is stimulated (and, in classical theory, saving is discouraged). Because nobody chooses to hold
idle cash, expansion of the mo"ney supply will
produce a new equilibrium only by reducing the
interest rate by whatever amount is necessary to
increase the income level sufficiently to absorb
the full increase in the money supply in transactions balances. If in the present case we assume
that ilms = $20 and k = 1/2, equilibrium will be
restored only when Y has risen by $40, or, in general, when ilY = ilmjk. In the classical range,
the result follows the simple classical quantity
theory of money as a theory of aggregate
demand. Y rises proportionally with the increase
in ms' If V = 2 or k = 1/2, the rise in Y must be
twice the rise in ms in order to satisfy the equilibrium condition: msV = Y and ms = k(Y).
I

18 J.R. Hicks, "Mr. Keynes and the 'Classics': A Sug,

gested Interpretation," reprinted in W. Fellner and B.F.
Haley, eds., Readings in the Theory of Income Distribution
Irwin, 1946, p. 472.
.
'

In contrast to the Keynesian range, in which

monetary policy is completely ineffective, in the
classical range it appears to be completely effec
tive. No part of any increase in the money supply
disappears into idle cash balances. The increase
in the money supply leads to increased spending
that raises the income !evel to the point at which
the total increase in the money supply is absorbed
into transactions balances. Because all income
changes are real changes in the present model,
the increase in the money supply that i>hifts LM 1
to LM2 causes an increase horn Y4 to Y5 in output
as well as in income.
Again in contrast to the Keynesian range, in
which fiscal policy alone can be effective, fiscal
policy it') the classical range is completely ineffective. IAn upward shift in the IS function from IS3
to is' 3 in P?rt A of Figure 12-12 can raise only the
interest rate, from r4 to r5; the incdrne level stays
unchanged at Y4 Given the increase in spending
that lies behind the upward shift in the IS function,
the interest rate will rise sufficiently to crowd out
enough spending to leave aggregate spending
unchanged. Therefore, if the 'rise in spending
resulted from increased government spending,
the r.ise in the interest rate would crowd out an
amount of private spending equal to the rise in
government spending. The level of income is as
high as the given money supply can support. In
the classical range, an increase in income is
therefore impossible without an increase in the
money supply, and monetary policy becomes an
all-powerful method of controlling the income
'8"'e~
How does the elasticity of the IS functron affect
the equilibrium positions in the classical range?
Let us compare the elastic IS3 function and the
Inelastic IS" 3 function shown in Part A of Figure
12-13. Given the IS" 3 function, no increase in the
money supply and no reduction in the interest
rate is capable of raising the income level from
y 4 to Y 5' Monetary policy will raise Y, but not by
the multiple of ms given by 11k. Although this
seems to upset the result suggested by classical
theory, classical theorists woutd deny that the IS
curve could be so inelastic. Remember that in

-.

both classical and Keynesian theory investment

i.s a function of the interest rate, but that in classical theory saving also is function of the inter. est rate. Consequently, only if both saving and
investment are quite irisensitive to the interest
rate could there be an inelastic curve of the sort
described by /S" 3 in Part A of Figure 12-13.19 As
..long as one or the other is elastic, the reSUlting
IS function will also be elastic; with an elastic IS
function, the result of a change in the money sup- .
ply in the present model is d Y = dmslk.

The Intennediate Range Finally, let us examine the equilibrium of Y2, r2, as defined by !.he
intersection of /S2 and LM1 in Part A of Figu~e
12-12. Here again we see that some increase in the
money supply will shift the LM1 function to LM2.
In the Keynesian range, this increase in the
money supply left both Y and r unchanged
because that total increase was absorbed in
speculative balances at the existing interest rate. -.
In the classical range, this increase in the money ,
supply raised Y by the amount necessarY to
absorb the full increase in transactions balances.
This worked itself out through the interest rate
reduction that raised spending by the amount
needed to produce the required rise in income.
In the intermediate range, however, the increase
in the money supply is partially absorbed in both
speculative and transactions balances. The level
of income rises, but by an amount less than that
which would require the full increase in the
money supply for transactions purposes.
For example, suppose that the increase in the
money suppiy is $20 and k is 1/2. Although the
resultant shift in the LM function is $40, here the
rise in income (Y3 - Y2) is only ha~fthat amount.

191nterms of Part C of Figure 12-3, we may show saving

as a function of both Y and r by drawing in a similar fashion
successively higher saving functions to correspond witl1
successively higher interest rates. An inelastic investment
function in Part A combined with this income-elastic and
int8rest-elastic saving function in Part C will still produce
an elastic IS function in Part D.

In reducing the interest rate by the amount that

produce"s the increase in spending needed to
raise the income level by $20, $10 (one-half of
the increase in the money supply) is absorbed in
s"peGulative balances. The remaining $10 is
exactly the additional amount of money needed
for transactions purposes with the income level
up by $20.
In ~he intermediate range, monetary policy
has sume degree of effectiveness but not the
complete effectiveness it has in the classicnl
range. In general, the closer the equilibrium intersection is to the classical range, the more effective monetary policy becomes; the closer the
intersection is to the Keynesian range, the less
effective it becomes.
Within this range, fiscal policy is also effective
to some extent. Fiscal measures that shift the IS
function from IS2 to IS' 2' for example, will raise
the level of income and the interest rate to the
new equilibrium defined by the intersection of
IS'2 and LM1 If the shift in the IS function stems
from a deficH-financed increase in government
spending, the interest fate must rise. We are
assuming a fixed money supply described by
LM1, so the increased government spending is
being financed by borrowing from the public. Thp.
sale of additional securities by the government
depresses security prices, raises the interest
rate, and chokes off some amount of private
spending. The rise in the interest rate following
any given increase in government spending will

be greater or smaller depending on how high in

the intermediate range the equilibrium happens
to be Although fiscal policy is somewhat effective anywhere in the intermediat~ range, in general it will be more effective the closer equilibrium
is to the Keynesian range and less effective the
closer equilibrium is to the classical range.
Although both monetary and fiscal policies
have. varying degrees of effectiveness in the
intermediate range, the relative effectiveness of
each depends in large part on the elasticity of
the IS function. If the IS function is the inelastic
IS"2 in Part A of Figure 12-13, monetary poli~y
can do very littie to raise the level of income, even
in the intermediate range; fiscal policy alone is
.effective in such a situation. Furth~rrTlore, an
expansionary fiscal policy need not be concerned with adverse monetary effects in this
case. A shift in an inelastic IS function will raise
the interest rate, but this higher rate will have little
feedback on spending. Keynes maintained that
the investDlent schedule (as well as the saving
schedule) was interest inelastic. If this is the
case, the IS schedule must also be inelastic, and
fiscal policy, which is completely effective in the
Keynesian range, must be almost as effective in
the intermediate range. If the IS sch~dule is
indeed interest inelastic, tl1en the Keynesian
range becomes, in effect, the complete LM
curve, more applicable at the lower end than at
the upper end, but with some applicability
throughout.