IS-LM Model

AS-AD Model
Policy Instruments
-- June 2021
IS-LM Model … “in the long run we are all dead model”
• Interpretation of John Maynard Keynes’ The General Theory of
Employment, Interest and Money (1936) → Great Depression
• Focused on the demand side of the model
• The market is not self-correcting, the gov’t should pursue stabilization policies
• Explains the causes of economic fluctuations in the short run
• Introduced the interest rate as an additional determinant of the
aggregate demand
• Discusses the shift factors of the aggregate demand
• Assumption: close economy, I is endogenous
IS-LM Model
• IS Curve
• Investment and Saving
• Keynesian Cross
• Market for Loanable Funds
• LM Curve
• Liquidity and Money
• Theory of Liquidity Preference
• IS-LM Model
• Determination of the equilibrium interest rate and income in the short run
IS Curve
Keynesian Cross
• Representation of Keynes’ General Theory (see: Simple Keynesian
Model (SKM): Assumptions, Conditions and Defects
(economicsdiscussion.net))
• Illustrates how the level of aggregate expenditure (E) varies with the
level of economic output (Y)
• Determines the equilibrium level of real GDP by the point where the
AE=Y
Keynesian Cross
• Actual Expenditure (Y)
• The amount hh, firms, and the gov’t spend on goods and services

• Planned Expenditure (E)

• The amount the hh, firms, and the gov’t would like to spend on goods and
services

Planned expenditure and actual expenditure differ because of unplanned inventory investment
Keynesian Cross
• Planned Expenditure
E
E = C+I+G E=C+I+G

• Consumption Function
C = C(Y-T)
mpc
• Investment Function
I= 𝐼 ҧ Assume that planned investment is fixed
• Policy Variables Income, output,Y

G = 𝐺ҧ and T = 𝑇ത

E = C (Y- 𝑇ത + 𝐼 ҧ + 𝐺)ҧ
 Keynesian Cross
• When the economy is at equilibrium,
Actual Expenditure = Planned Expenditure

E E Y=E
Y=E
E=C+I+G

Equilibrium

Y Y
 Keynesian Cross and Fiscal Policy

E Y=E
E=C+I+G

Equilibrium
Planned
Expenditure

Y
Equilibrium
Income
 IS Curve
• IS Curve shows the relationship of interest rate (r) and the level of
income (Y) when the goods market is at equilibrium
• New investment function: I= I(r) = 𝐼 ҧ − 𝑏𝑟 , b>0 Implications:
• The lower the interest rate, the higher is the planned
investment
• If the responsiveness of investment spending to the
interest rate (b) is large, then a relatively small
r increase in the r generates a large decrease in
investment spending

Position of the curve is determined by the b (slope) and 𝐼 ҧ

Implication:
I • decrease in the r increase the level of planned investment
spending (depending on b)
I • Changes in 𝐼 ҧ , shift the investment schedule
Deriving the IS Curve
Market for Loanable Funds and the IS Curve
IS Curve: The interest rate and the AD
• Recall: AD = C+I+G+NX
• New investment function: I= I(r) = 𝐼 ҧ − 𝑏𝑟 , b>0
• AD =[𝐶+ ҧ c 𝑇𝑅 + c(1 − t)Y] + ( 𝐼 ҧ − 𝑏𝑟 ) + 𝐺ҧ + 𝑁𝑋
• AD = 𝐴ҧ + c(1 − t)Y – br

Implication:
• An increase in the interest rate reduces AD for a given level of income
 LM Curve and the Money Market
• Shows the relationship of interest rate (r) and the
level of income (Y) when the money market is at
equilibrium

• Theory of Liquidity Preference

• Interest rate adjusts to balance the supply and demand
for real money balances
𝑀 𝑠 𝑀ഥ Money supply; determined by the

•( ) = central bank
𝑃 𝑃ത Prices are sticky in the SR
LM Curve and the Money Market
• Theory of Liquidity Preference
LM Curve
Deriving the LM Curve
IS-LM Model
• IS Curve shows the
relationship between
interest rate and the level
of income when the
goods market is at the
equilibrium
• Lm curve shows the
relationship between the
interest rate and the level
of income when the
money market is at the
equilibrium
IS-LM Model
Interaction between Monetary and Fiscal
Policy
• The shock brought about by a fiscal policy maybe counteracted or
enhanced by the monetary policy adapted (v.v.)

• For example:
• Suppose that the gov’t spending increase
• The central bank may:
• 1. hold money supply constant
• 2. hold real interest rate constant
• 3. Hold the level of income constant
AS-AD Model
• Used to explain
• Economic fluctuations
• Effects of monetary and fiscal policies to the economy
• The determination of price level and aggregate output
• The economy’s behavior in the short run and long run
Aggregate Demand

• Shows the relationship

of quantity of output
demanded and the
aggregate price level

Why is the AD Curve downward sloping?

1. Lower price – real income increases
2. Lower price – exports more competitive
3. lower price - lower interest rates
Aggregate Supply
• Shows the relationship of quantity of output supplied and aggregate
price level
Aggregate Supply
AS-AD Model
AS-AD Model
• Adverse Supply Shocks
• Natural disaster
• Environmental protection
law requiring firm to
reduce exhaust and
effluents
• Increase in union
aggressiveness

Adverse supply shocks causes the reduction of aggregate output

in the short run.
→ The gov’t can prevent the decrease in Y by employing
expansionary policies to increase aggregate demand
• Khan Academy, The expenditure-output, or Keynesian cross model.
The expenditure-output, or Keynesian cross, model (article) | Khan
Academy
• Dornbusch
• Mediodia, lecture note 2013