IS-LM Framework

- Dr Vighneswara Swamy

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Coverage
1. Product and Money Market Equilibrium
2. Hicks-Hansen Model: IS-LM analysis.
3. The slope of the IS curve
4. Shift in the IS curve
5. Shift of the LM curve
6. Monetary Policy and its impacts on the LM curve
7. Fiscal Policy and its impact on the IS curve

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General Equilibrium of Product and
Money Market
▪IS - LM Framework – General Equilibrium of Product and Money
Market
▪IS-LM Framework is a macroeconomic tool that demonstrates the
relationship between interest rates and real output in the goods and
services market and the money market.
▪The intersection of the IS and LM curves is the "General Equilibrium"
where there is simultaneous equilibrium in both markets.
▪IS stands for Investment Saving & LM stands for Liquidity preference
Money supply .

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IS-LM Model
▪The IS-LM (Investment Saving – Liquidity Preference Money Supply)
model is a macroeconomic model that graphically represents two
intersecting curves.
▪The investment/saving (IS) curve is a variation of the income-
expenditure model incorporating market interest rates (demand).
▪The liquidity preference/money supply equilibrium (LM) curve
represents the amount of money available for investing (supply).
▪Hicks (1949) is credited with the invention of the IS-LM.
▪Hicks labeled SI-LL which later Alvin Hansen relabeled as showing IS and
LM curves in 1949
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IS-LM Model (Hicks-Hansen model)
▪IS-LM model is the core of short-run macroeconomics
▪The determination of output and interest rates in the short-run
▪The IS-LM model translates the General Theory of Keynes into neoclassical terms (often
called the neoclassic synthesis )
▪Developed by Keynes (1936)
▪Made famous by Hicks and Hansen
▪It was proposed by John Hicks in 1937 in a paper called “Mr Keynes and the "Classics":
A Suggested Interpretation” and enhanced by Alvin Hansen (hence it is also called the
Hicks-Hansen model).
▪Tool for macroeconomists during 1950s to 1970s
▪With rational expectations revolution, approach seemed to fall out of favour
▪Recent literature (McCallum, Rotemberg, Woodford, etc) has resurrected it

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IS-LM Model
The model examines the combined equilibrium of
two markets :
◦The goods market, which is at equilibrium when
investments equal savings, hence IS.
◦The money market, which is at equilibrium when the
demand for liquidity equals money supply, hence LM.
◦Examining the joint equilibrium in these two markets
allows us to determine two variables : output Y and the
interest rate i.
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IS-LM Model
IS-LM model is based on two fundamental assumptions:
1. All prices (including wages) are fixed.
2. There exists excess production capacity in the economy
This is a complete change in perspective compared to classical economics:
◦ The level of demand determines the level of output and employment.
◦ There can be an equilibrium level of involuntary unemployment.
Why can there be insufficient demand ?
◦ Criticism of Say’s law: Uncertainty can lead to precautionary saving rather
than consumption.
◦ Monetary criticism: the preference for liquidity can lead to under-
investment as savings are kept in the form of liquidity.
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IS-LM Model
The IS-LM model has become the “standard model” in macroeconomics.
Its essential contribution (linked to that of Keynes) is this potential equilibrium
unemployment:
◦ Such a situation is impossible in earlier neoclassic models, as the price of labour (like all
prices) is assumed to adjust naturally until supply and demand for labour are balanced.

This is why IS-LM (1937!!) remains central to modern macroeconomics, and has
been extended to explain more markets/ variables:
◦ The AS-AD model adds inflation into the problem
◦ The Mundell-Fleming model deals with international trade

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IS Curve and the Goods Market
The IS curve exhibits the combinations of interest rates Slopes downward
and levels of output such that planned spending equals r because
income
◦ It is derived in two steps: r→ I→ Y
1. Link between interest rates and investment
2. Link between investment demand and AD
Investment is no longer treated as exogenous, but
dependent upon interest rates (endogenous)
◦ Investment demand is lower the higher are interest
rates IS
1. Interest rates are the cost of borrowing money
2. Increased interest rates raise the price to firms Y
of borrowing for capital equipment → reduce
the quantity of investment demand 9
The IS Curve: Interest Rate and Aggregate Demand
Need to modify the AD function of the last chapter to reflect the new
planned investment spending schedule
AD = C + I + G + NX
= C + cT R + c(1 − t )Y  + ( I − bi) + G + NX
= A + c(1 − t )Y − bi

▪An increase in i reduces AD for a given level of income

▪At any given level of i, can determine the equilibrium level of income
and output
▪A change in i will change the equilibrium
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The IS curve
▪The IS curve shows all the combinations of interest rates i and outputs Y for which the goods market is in
equilibrium
▪It is based on the goods market equilibrium we have examined in the first two weeks
The Investment function The Savings function:
Is the sum of private investment (endogenous) Is obtained from the aggregate demand equation,
and public investment (exogenous) subtracting investment and consumption:
I g = I ( i )+ ( G − T ) S=Y-C-T
−
Here, the interest rate is the marginal S= -C0 +(1-c)(Y-T)
profitability of investment

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The Investment-Saving (IS) Curve
▪IS curve: equilibrium in the goods market.
– As interest rates rise, output falls.
▪ Demand:
▪ Z = C(Y-T) + I(Y,i) + G
▪ Equilibrium:
▪ Y = C(Y-T) + I(Y,i) + G
▪ Movements along the IS curve: As interest rates rise, output falls.
▪ Shifts in the IS curve: As government spending increases, output increases for
▪any given interest rate.
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 Keynesian Cross
A simple closed economy model in which income is
determined by expenditure. (due to J.M. Keynes). It
identifies equilibrium income.
Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & planned expenditure = unplanned
inventory investment
The two lines cross at A, meaning that here actual expenditure
equals planned expenditure/spending, and that planned
spending is perfectly compatible with income.
Keynesian cross:
◦ basic model of income determination
◦ takes fiscal policy & investment as exogenous
◦ fiscal policy has a multiplier effect on income.
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Deriving the IS Curve Keynesian Cross
from Keynesian Cross E
Actual expenditure
E =Y E =C +I (r1 )+G

A rise in
E =C +I (r2 )+G
Interest rate↑ leads to

Expenditure
interest rate
Planned expenditure
Investment↓ causes fall in
I
investment
Expenditure↓ expenditure

Output↓
Investment Function Y2 Y1 Y (output)

r r
IS curve
r2 r2
Interest rate

Interest rate↓ leads to

r1 r1
Investment↑
Expenditure↑ I IS
Investment I Y2 Y1 Y (output)
Output ↑
Fiscal Policy and its impact on IS curve
An increase in taxes T↑
shifts the IS curve to the left.
• Equilibrium in the goods market
implies that an increase in the
interest rate leads to a decrease
in output.
• Changes in factors that
decrease the demand for
goods, given the interest rate
shift the IS curve to the left.
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Autonomous
spending and IS curve
• Figure shows two different IS curves
→ differ by levels of autonomous
spending
– Initial AD with and i1 →
corresponding point E1 on IS curve in
Figure (b)
– If autonomous spending increases to ,
equilibrium level of income increases at
i1 → point E2 in panel (b), shifting out IS
• The change in income as a result
from a change in autonomous
spending is
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The Shift in the IS Curve
IS Curve: At lower interest rates, equilibrium IS Curves: An increase in government
output in the goods market is higher. spending shifts out the IS curve.

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The Slope of the IS Curve
The steepness of the IS curve depends on two things:
◦(i) Interest elasticity of investment
◦(ii) MPS, i.e., the slope of saving curve.
The slope of the curve is of significant interest to us because
it is a factor determining the relative effectiveness of
stabilisation policies, viz., monetary and fiscal policies

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The IS Curve: Why is it downward sloping?
r
Slopes downward because
r→ I→ Y
Recall that:
I+T=S+G
or
I(r) + T0 = S(Y) + G0
Differentiate implicitly with respect to Y and r:
IS ds
dr dY (+)
Y = = 0
dY dI ( −)
dr
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The Slope of the IS Curve
The steepness of the IS curve depends on two things:
◦(i) Interest elasticity of investment
◦(ii) MPS, i.e., the slope of saving curve.
The slope of the curve is of significant interest to us because
it is a factor determining the relative effectiveness of
stabilisation policies, viz., monetary and fiscal policies

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The LM Curve
▪The LM curve shows all the
combinations of interest rates i
and outputs Y for which the
money market is in equilibrium
▪Here, the interest rate i has a
monetary interpretation:
▪It is the opportunity cost of
money, in other words the
payment made for renouncing
liquidity (preference for liquidity)
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The LM Curve and the Money Market
The LM curve shows combinations of interest rates and levels of output
such that money demand equals money supply → equilibrium in the
money market
The LM curve is derived in two steps:
1.Explain why money demand depends on interest rates and income
◦ Theory of real money balances, rather than nominal
2.Equate money demand with money supply, and find combinations of
income and interest rates that maintain equilibrium in the money market
◦ (i, Y) pairs meeting this criteria are points on a given LM curve

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The Liquidity preference – Money supply
(LM) Curve
•LM curve: equilibrium in the money market.
– As output rises, interest rates rise.
• Demand for real balances: Md /P = Y L(i)
• Equilibrium in money market: Md=M
• LM Curve: M/P = Y L(i)
• Movements along the LM Curve: An increase in Y increases money demand, which
causes an increase in interest rates to maintain money market equilibrium.
• Shifts in the LM curve: An increase in money supply lowers interest rates at any given
level of output.

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The LM Curve
Liquidity preference:

With a level of output Y, the level of interest i adjusts so that the demand for
money (given by the liquidity function L) equals the exogenous supply:

M
P
= L Y,i
+ −
( )
M = Money supple (exogenous)

P = Level of prices (exogenous by assumption)

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The LM Curve
There are two motives for demanding real money balances:
1. The transaction and precautionary motive L1(Y) : The money demanded in order to be able to transact
in the future (function of the level of output)
2. The speculation motive L2(i) : The money demanded for purposes of speculation (opportunity cost of
the interest rate). When interest is high, people don’t want to hold money, whereas when the rates are
low, money demanded increases.

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

Why is the LM curve upward r r

Interest rate
Interest rate
sloping? LM
• An increase in income
raises money demand.
• Since the supply of real r2 r2
balances is fixed, there is
now excess demand in the L (r , Y2 )
money market at the initial r1 r1
interest rate. L (r , Y1 )
• The interest rate must rise
to restore equilibrium in
the money market. M1 M/P Y1 Y2 Y
Output
P Real money balance

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Monetary Policy and its impacts on LM curve
▪Monetary policy impact on the LM curve can be
understood in two dimensions:
1) Changes in the money supply
2) Autonomous changes in money demand

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The Shift in the LM Curve
The Effects of a Monetary
Expansion
An increase in money leads the LM curve
to shift down.
▪ Equilibrium in financial markets
implies that, for a given real money
supply, an increase in the level of
income, which increases the demand
for money, leads to an increase in the
interest rate.
▪ An increase in the money supply shifts
the LM curve down; a decrease in the
money supply shifts the LM curve up. 28
The Shift in the LM Curve
LM Curve: At higher levels of output, equilibrium An increase in money supply shifts the LM Curve. At
in the money market implies higher interest rates. the current level of output, the interest rate required
to maintain equilibrium in the money market is lower.

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The Shift in LM Curve: Increase in Money Supply

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The Shift in LM Curve: Increase in Money Demand

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The Supply of Money, Money Market
Equilibrium, and the LM Curve
Figure shows the
combinations of i and Y
such that demand for real
money balances exactly
matches available supply.
Assumption:
Real money supply is
M/P, where M and P are
assumed fixed
Point E1 is the equilibrium
point in the money
market
As Income increases to
Y2, interest rate moves to
i2. Then, the new
equilibrium moves to E2
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What shifts the LM curve?
Money: Increasing Money Supply increases M/P causing the LM curve
to the right.

Prices: Increasing Prices causes real Money Balances to fall shifting LM

curve to the left.

Expected Inflation π e: Increasing expected inflation causes returns

on bonds (assets other than money) to increase making it less
attractive to hold cash. Causes LM curve to shift right!

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The LM Curve: Hicks interpretation
r LM Curve (L=M): all
LM those combinations of
real interest rates and
income which bring the
money supply equal to
money demand.

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The LM Curve slopes upwards?
If Y increases, transactions and
precautionary demand increase.
r LM
There will be excess demand in the r
money markets Ms
Interest rates will be driven upward
So Y→ r, and the LM Curve slopes Md(Y2)
upward.
Liquidity Preference is: L = L(Y,r)
r1 Md(Y1)
Money Supply is: Ms = M0 = M
r0 Md(Y0)
Ms = Md implies M = L(Y,r) → LM Curve
− L
dr
= Y = − ( + )  0
dY L ( −) M Y0 Y1 Y2 Y
r
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The Slope of the LM Curve
The steeper the LM curve:
◦ The greater the responsiveness of the demand for money to income, as
measured by k
◦ The lower the responsiveness of the demand for money to the interest rate, h
→These points can be confirmed by examining equation:

1 M
i =  kY − 
h P 

→A given change in income has a larger effect on i, the larger is k and the smaller
is h

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Equilibrium in goods and money market
▪ The IS-LM model shows that monetary
policy influences income by changing
the interest rate.
▪ The IS-LM model shows that an
increase in the money supply lowers
the interest rate, which stimulates
investment and thereby expands the
demand for goods and services.
▪ Assumptions:
▪ Price level is constant
▪ Firms willing to supply whatever
amount of output is demanded
at that price level
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Changes in the Equilibrium Levels of
Income and the Interest Rate
The equilibrium levels of income
and the interest rate change when
either the IS or the LM curve shifts
Figure shows effects of an increase
in autonomous spending
▪ Shifts IS curve out by G ∆I if
autonomous investment is the source
of increased spending
▪ The resulting change in Y is smaller
than the change in autonomous
spending due to slope of LM curve

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IS-LM Framework
McCallum and Nelson (1997) observe 6 limitations:
◦ 1. IS-LM analysis presumes a fixed, rigid price level
◦ 2. No distinction between real and nominal rates
◦ 3. Only 2 assets; money and bonds
◦ 4. Only short-run, no steady states
◦ 5. Capital stock fixed
◦ 6. Not derived using microfoundations => Lucas Critique
Rational Expectations revolution: Move away from IS-LM
(although equivalent expressions were still used!)

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The IS-LM
◼The real and monetary sectors of the
r economy are resolved together.
LM
◼Money matters to real sector
outcomes.
◼There is no dichotomy (contrast).
r*
◼Assumptions:
◼Price level is constant
IS ◼Firms willing to supply whatever
Y* amount of output is demanded at that
Y
price level
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The IS-LM model
▪LM is a stock equilibrium (beginning of period).
▪IS is a flow equilibrium (end of period).
▪The model is an equilibrium of flows constrained by stocks. It is a
cash-flow equilibrium.
▪The time frame is long enough for full adjustment of real income and
interest, short enough so stocks do not change.
▪IS-LM equilibrium is not permanent. S>0 implies that wealth
(allocations) are increasing over time. Therefore LM is shifting due to
the stock of bonds. If net investment is positive, then the capital stock
grows.
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The IS-LM Model
▪Equilibrium in the goods market
implies that an increase in the interest
rate leads to a decrease in output.
▪Equilibrium in financial markets
implies that an increase in output leads
to an increase in the interest rate.
▪When the IS curve intersects the LM
curve, both goods and financial
markets are in equilibrium.

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Structure of the IS-LM Model
The IS-LM Model
Macroeconomic
equilibrium and policy

The intersection of IS and

LM represents the
simultaneous equilibrium
on the goods and the
money market for a given
value of government
spending G, taxes T, money
supply M and prices P

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IS-LM Model: The Effects of a Monetary Expansion
▪Monetary contraction, or monetary
tightening, refers to a decrease in the
money supply.
▪An increase in the money supply is
called monetary expansion.
▪Monetary policy does not affect the
IS curve, only the LM curve. For
example, an increase in the money
supply shifts the LM curve down.
▪Monetary expansion leads to higher
output and a lower interest rate.

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The IS-LM Model: Changes in the Equilibrium
Levels of Income and the Interest Rate
The equilibrium levels of income and
the interest rate change when either
the IS or the LM curve shifts
The Figure shows effects of an increase
in autonomous spending
Shifts IS curve out by 𝒂𝑮 ∆𝑰 if
autonomous investment is the source of
increased spending
The resulting change in Y is smaller than
the change in autonomous spending
due to slope of LM curve.

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The IS-LM Curve: Deriving
the AD Schedule
•The AD schedule maps out the IS-LM
equilibrium holding autonomous spending
and the nominal money supply constant
and allowing prices to vary
•Assume, prices increase from P1 to P2
–M/P decrease from M/P1 to M/P2 → LM
decreases from LM1 to LM2
–Interest rates increase from i1 to i2, and
output falls from Y1 to Y2
–Corresponds to lower AD

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The IS-LM Model: Macroeconomic equilibrium and policy

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The IS-LM Model: Explaining the Liquidity Trap

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IS-LM Model in the Long Run

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IS-LM Model: Using a Policy Mix
The combination of monetary The Effects of Fiscal and Monetary Policy.
and fiscal polices is known as the
monetary-fiscal policy mix, or Shift of Shift of Movement Movement in
simply, the policy mix. IS LM of Output Interest Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
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The IS-LM Model and the Facts
We can describe the basic mechanisms as below:
▪Consumers are likely to take some time to adjust their
consumption following a change in disposable income.
▪Firms are likely to take some time to adjust investment spending
following a change in their sales.
▪Firms are likely to take some time to adjust investment spending
following a change in the interest rate.
▪Firms are likely to take some time to adjust production following
a change in their sales.

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IS-LM Model: Merits and Demerits
Advantages Disadvantages
1. This model is widely used and seen as useful in gaining an 1. This model ignores uncertainty –
understanding of macroeconomic theory even though disputed and that liquidity preference only
in some circles and considered to be imperfect . makes sense in the presence of
2. It is used in most college macroeconomics textbooks. uncertainty.
3. Most modern macroeconomists see the IS-LM model as being 2. A shift in the IS or LM curve will
at best a first approximation for understanding the real world. cause change in expectations,
4. IS-LM can be used to assess the impact of exogenous shocks on causing the other curve to shift.
the endogenous variables of the model (interest rates and
output)
5. One can also evaluate the effectiveness of the policy mix, i.e.
the combination of:
▪ Fiscal policy: changes to government spending and taxes
▪ Monetary policy: changes to money supply
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Key words
Product Market
Money Market
Product and Money Market
Equilibrium
IS curve
LM curve
IS-LM Model

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