MARCO-ECONOMICS
ASSIGNMENT
TOPIC: IS-LM MODEL
Name: Vishwanath Sagar S
Course: B.com(Hons) 2nd Sem
Reg No: 18cbcom105
IS- LM MODEL
The IS–LM model, is a two-dimensional macroeconomic tool that shows
the relationship between interest rates and assets market (also known as
real output in goods and services market plus money market). The
intersection of the "investment–saving" (IS) and "liquidity preference–
money supply " (LM) curves models "general equilibrium" where
supposed simultaneous equilibria occur in both the goods and the asset
markets. Yet two equivalent interpretations are possible: first, the IS–
LM model explains changes in national income when the price level is
fixed in the short-run; second, the IS–LM model shows why
an aggregate demand curve can shift. Hence, this tool is sometimes used
not only to analyze economic fluctuations but also to suggest potential
levels for appropriate stabilization policies.
The model was developed by John Hicks in 1937, and later extended
by Alvin Hansen, as a mathematical representation of Keynesian
macroeconomic theory. Between the 1940s and mid-1970s, it was the
leading framework of macroeconomic analysis. While it has been
largely absent from macroeconomic research ever since, it is still a
backbone conceptual introductory tool in many macroeconomics
textbooks. By itself, the IS–LM model is used to study the short run
when prices are fixed or sticky and no inflation is taken into
consideration. But in practice the main role of the model is as a path to
explain the AD–AS model.
IS (investment–saving) curve:
The IS curve shows the causation from interest rates to planned
investment to national income and output.
For the investment–saving curve, the independent variable is the interest
rate and the dependent variable is the level of income. The IS curve is
drawn as downward-sloping with the interest rate r on the vertical axis
and GDP (gross domestic product: Y) on the horizontal axis. The IS
curve represents the locus where total spending (consumer spending +
planned private investment + government purchases + net exports)
equals total output (real income, Y, or GDP).
The IS curve also represents the equilibria where total private
investment equals total saving, with saving equal to consumer
saving plus government saving (the budget surplus) plus foreign saving
(the trade surplus). The level of real GDP (Y) is determined along this
line for each interest rate. Every level of the real interest rate will
generate a certain level of investment and spending: lower interest rates
encourage higher investment and more spending. The multiplier
effect of an increase in fixed investment resulting from a lower interest
rate raises real GDP. This explains the downward slope of the IS curve.
In summary, the IS curve shows the causation from interest rates to
planned fixed investment to rising national income and output.
The IS curve is defined by the equation
Y= C(Y-T(Y)) + I(r) + G+NX (Y),
where Y represents income, C(Y-T(Y)) represents consumer spending
increasing as a function of disposable income (income, Y, minus
taxes, T(Y), which themselves depend positively on
income), I(r) represents business investment decreasing as a function of
the real interest rate, G represents government spending, and NX(Y)
represents net exports (exports minus imports) decreasing as a function
of income (decreasing because imports are an increasing function of
income).
LM Curve
The money market equilibrium diagram.
The LM curve shows the combinations of interest
rates and levels of real income for which the money
market is in equilibrium. It shows where money
demand equals money supply. For the LM curve,
the independent variable is income and the
dependent variable is the interest rate.
In the money market equilibrium diagram, the
liquidity preference function is the willingness to hold cash. The
liquidity preference function is downward sloping (i.e. the willingness to
hold cash increases as the interest rate decreases).
Two basic elements determine the quantity of cash balances demanded:
1) Transactions demand for money: this includes both (a) the
willingness to hold cash for everyday transactions and (b) a
precautionary measure (money demand in case of emergencies).
Transactions demand is positively related to real GDP. As GDP is
considered exogenous to the liquidity preference function, changes
in GDP shift the curve.
2) Speculative demand for money: this is the willingness to hold
cash instead of securities as an asset for investment purposes.
Speculative demand is inversely related to the interest rate. As the
interest rate rises, the opportunity cost of holding money rather
than investing in securities increases. So, as interest rates rise,
speculative demand for money falls.
Money supply is determined by central bank decisions and
willingness of commercial banks to loan money. Money supply in
effect is perfectly inelastic with respect to nominal interest rates.
Thus the money supply function is represented as a vertical line –
money supply is a constant, independent of the interest rate,
GDP, and other factors.
Mathematically, the LM curve is defined by the equation M/P=
L(i,Y), where the supply of money is represented as
the real amount M/P (as opposed to the nominal amount M),
with P representing the price level, and L being the real demand
for money, which is some function of the interest rate and the
level of real income.
An increase in GDP shifts the liquidity preference function
rightward and hence increases the interest rate. Thus the LM
function is positively sloped.
Why the IS-LM Curve Is Flat at Zero?
Lower interest rates make it easier for households and businesses to
borrow money from banks. The loans that banks make inject more
money into the economy and allow it to recover from the recession.
When interest rates hit zero, however, increases in the money supply
have no effect. Households and businesses no longer have an increased
incentive to take out loans. The extra money sits in banks without being
spent. This is the reason the LM curve is flat at zero. Economists call the
inability of interest rates to go below zero the zero lower bound.
The Pros and Cons of the IS-LM Model
The IS-LM model is a controversial economic tool. It has a number of
detractors, including the creator Hicks himself, who said that the model
is best used “as a classroom tool” rather than in any practical
application. There are, however, pros to using the model.
Pros:
The model is commonly used to explain Keynesian
macroeconomics on a basic level.
It is a good introduction to and first approximation of policy-
making.
Cons:
Does not take into account a huge variety of factors the come to
play in the modern economy, such as international trade, demand,
and capital flows.
Takes a simplistic approach to fiscal policy, the money market, and
money supply. Central banks today in most advanced economies
prefer to control interest rates on the open market—Does not
reveal anything about inflation or international trade, and does not
provide insight or recommendations toward formulating tax rates
and government spending.
The IS-LM model is a great way to explain Keynes’s ideas about how
monetary systems, markets, and governmental actors can work together
to drive economic growth. However, as a practical model to advise on
fiscal or spending policy, it falls short.
