MACROECONOMICS

SESSIONS 8 and 9
IS-LM Model
The Simultaneous Equilibrium in
the Goods and Financial Markets
 The World of IS-LM
• While studying simple multiplier model, we consider only
the goods market.
• However, there are other markets to be considered; money
market, labour market.
• In what follows we will bring in money market and see
how determination of income/GDP is influenced by the
presence of it.
• In Macroeconomics, one of the important information is the
interest rate; how it is determined and how it affects
planned expenditures of different agents.
 The World of IS-LM
• Assumptions

Short run
Fixed installed capacity of physical capital: Y = F(K, L).
Prices of goods and services do not change
Closed economy  no international capital mobility and
trade.
No explicit labour market.
The output is demand determined (the economy is demand
constrained).
Revisiting the Simple Model of Income Determination

• E = C(Y – T) + I + G; Y = E in equilibrium

• Given T, I and G we could determine Y.

• We did not consider money market explicitly.

• Interest rate was taken to be fixed.

Revisiting the Simple Model of Income Determination

• Now we have money and an earning asset (bond).

• How the presence of money and interest rate likely

to affect different expenditure components?

• The easiest way: I = I(r)

• The cost of resources for investing is r, and the

higher is r the lower is I.

Effect of Rising Interest Rate
Investment projects are ranked by their
expected internal rate of return. Only
those projects are taken up whose rates
of return exceed the interest rate
Effect of Falling Expected Rate of Return

Expected return to investment

reduces due to lower expected future
income
 The Investment Schedule
Interest rate, r
The schedule is
drawn for a
given state of
expectation

at a given A fall in
r
level of investors’
interest rate expectation

shifts the
schedule to
the left

I2 I1 Investment, I
reducing the
level of
investment
 Investment and Interest rate

 …. during the Lok Sabha debate on government action on

inflation, finance minister Pranab Mukherjee said, “If interest

rates are hiked abnormally, naturally there will no investment,
there will be no growth, there will be no job creation.” [Eco
Times (06/08/2010)]

 Was the honorable finance minister necessarily correct?

 The Market for Goods and Services
• Y = C(Y – T) + I(r) + G
• Output (income) is determined by the level of aggregate
demand.
• We continue to assume that T and G are given
• How many unknowns?
• We now have two unknowns (endogenous variables) r and
Y.
• For different r there will be different Y.
• We get a set of (r, Y) which satisfy above.
 The IS Curve

• Y = C(Y – T) + I(r) + G is the condition for goods

market equilibrium

• I(r) = Y – C(Y – T) – G
• or, I(r) = S(Y) given T and G
(–) (+)

• Investment-saving equality  IS curve

• Can you draw a diagram to show the relation between

r and Y?
 Deriving the IS Curve
r

(r2 , Y2)

(r1, Y1)

Consider a combination of r and Y (r1,Y1) that solve the IS equation

Then consider a higher r. At a higher r investment will be lower,

aggregate demand will be lower than initial Y, and hence Y will fall to
restore equilibrium. Follow the blue arrows.
Deriving the IS Curve: Alternative way
 The Sign of the Slope
• Y = C(Y – T) + I(r) + G

• dY = CY dY + Ir dr [or, ∆Y = (∆C/∆Y) ∆Y + (∆I/∆r) ∆r]

• dr/dY = (1 – CY)/ Ir < 0 [or, ∆r/∆Y = (1 – (∆C/∆Y))/ (∆I/∆r)]

• CY – MPC, Ir – interest sensitivity of investment

• High CY and Ir  low dr/dY  flat IS curve

• What is the economic reasoning?

• The adjustment rule :

• If AD >Y then Y increases

• If AD < Y then Y decreases

 The Money Market
• The demand for money (real balances)
• (M/P)d = L(r, Y)

• We will assume that the supply of real balances is

given, fixed exogenously by the Central Bank :
(M/P)s = (M/P)
• Money market equilibrium is given by
L(r, Y) = (M/P)
(–,+)
Determination of Interest Rate

r*
Real Money Demand

MS/P Money Supply, Demand

 The LM Curve

• L(r, Y) = (M/P)

(–, +)

• RHS is fixed, there are two variables on the LHS

• The combinations of r and Y that keep RHS fixed

(i.e. real money demand = real money supply) is
the LM relation.
• Can you draw a diagram to show the relation?
 Deriving the LM Curve

(r2 ,Y2 )

(r1, Y1 )

Y
Consider an (r,Y) such that the money market is in equilibrium. Take a higher
income. Given financial wealth agents need to transact more and hence
require more real balances. To acquire this they sell bonds, bond prices fall
and interest rate rises. Agents are induced to hold the same real balances
even when they want more if and only if r increases. This will restore
equilibrium in the money (and hence bond) market.
Deriving the LM Curve: Alternative way
 The Sign of the Slope

• (M/P) = L(r, Y)

• 0 = Lr dr + LY dY

• dr/dY = – LY / Lr > 0

• If LY is high and Lr is low, the LM curve is steep.

• The Adjustment Rule

• Demand for real balances > supply, interest rate
rises
• Demand for real balances < supply, interest rate falls
 The Macroeconomic System

• Now we have two equations in the two unknowns

r and Y
• Y = C(Y – T) + I(r) + G; T & G given : IS

CURVE
• The IS curve is the locus of all (r,Y) combinations

that make output (supply) equal to aggregate

demand.
 The Macroeconomic System

• (M/P) = L(r, Y) : LM CURVE

• The LM curve is the locus of all (r,Y)

combinations that make demand for real balances

equal to the supply.
 The arrows show
how r and Y will
adjust if the economy
r
is not on the IS or
the LM curve
LM

r*

IS

Y
Y*
The macro economic equilibrium in the goods and services
as well as the money and bond markets
Quadrant I: excess supply of goods, excess demand for money
Quadrant II: excess demand for goods, excess demand for money
Quadrant III: excess demand for goods, excess supply of money
Quadrant IV: excess supply of goods, excess supply of money
 Existence of a Stable Equilibrium
We make the assumption (plausible) that r adjusts faster than Y.
Suppose r adjusts instantaneously. This means that the asset
markets clear to keep the economy on the LM Curve.
B
r
LM

IS
A
Y
 Which Markets are cleared?
• IS – Goods market
• LM – Money or asset market
• IS-LM – Both markets simultaneously
• What about the Labour (factor) market?

r LM

Excess capacity and

Unemployment
IS

Y* YP Income
 A Note on the LM Curve

• Did you notice how we drew a horizontal stretch on the

LM curve?

• It depicts the LIQUIDITY TRAP

• What does it mean?

• Perfectly (interest) elastic demand for real balances.

• If bond prices are finite, then interest rate must be

strictly positive.
 Does the Trap Exist?

• Trap implies that you cannot stimulate the economy by

monetary expansion.

• Nominal rate cannot fall below zero.

• Real rate can be negative if πe is positive and high

leading to investment stimulus.

• Rise in money supply can cause currency to depreciate

leading to export stimulus (not possible in this model).

 The Exogenous Variables
• We are now ready to play around with changes in the
levels of the exogenous variables G, T, M/P and
investigate the effects of fiscal and monetary policy on
the macro-economy, income, output, employment,
interest rate and so on.
• Fiscal Policy: Effects of higher/lower G & T on
equilibrium r & Y
• Monetary Policy: Effects of higher/lower M on
equilibrium r & Y
 Where Does the IS-LM Model Lead To?

KEYNESIAN IS CURVE
CROSS
IS-LM MODEL
THEORY OF
LIQUIDITY LM CURVE
PREFERENCE
AGGREGATE
MODEL OF
DEMAND CURVE
AGGREGATE
DEMAND AND
AGGREGATE AGGREGATE
SUPPLY CURVE SUPPLY

EXPLANATION OF SHORT RUN ECONOMIC FLUCTUATIONS