Ch. IS - LM

GOODS AND FINANCIAL
MARKETS: THE IS-LM

MODEL
Orusova O.V.
PhD in Economics,
Associate Professor
Economic Theory
Department
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
Contents
1. The Goods Market and the IS Relation

2. Financial Markets and the LM Relation
3. Putting the IS and the LM Relations
Together
4. Using a Policy Mix
5. IS-LM and AD-AS in SR and LR
6. Liquidity trap and IS-LM model
The Keynesian model can be viewed as showing what
causes the aggregate demand curve to shift.
In the short run, when the price level is fixed, shifts in
the aggregate demand curve lead to changes in
national income, Y.
The model of aggregate demand developed in this chapter called
the IS-LM is the leading interpretation of Keynes’ work. The IS-LM
model takes the price level as given and shows what causes income to
change. It shows what causes AD to shift.
Price level, P
SRAS
AD''
AD'
AD
Y* Y*' Y*'' Income, Output, Y
IS (investment and saving)
model of the LM (liquidity and money)
‘goods market’ model of the ‘money market
The IS curve (which stands for investment saving) plots the
relationship between the interest rate and the level of income that
arises in the market for goods and services.
The LM curve (which stands for liquidity and money) plots the relationship
between the interest rate and the level of income that arises in the money
market.
1 The Goods Market and the IS Relation
• In Income-Expenditure model, the interest rate

did not affect the demand for goods. The
equilibrium condition for closed economy was
given by:
Y = C(Y − T ) + I + G
Income-Expenditure model
AEpl=Y
AЕplanned
А
Positive Iunpl
e AEpl= C+Ipl + G
B
Negative Iunpl
0 Y2 Ye Y1 Y
7
The 45-degree line (Y=E) plots the points where this condition holds.
With the addition of the planned-expenditure function, this diagram
becomes the Keynesian cross.
How does the economy get to this equilibrium? Inventories play an

important role in the adjustment process. Whenever the economy is
not in equilibrium, firms experience unplanned changes in inventories,
and this induces them to change production levels. Changes in
production in turn influence total income and expenditure, moving the
economy toward equilibrium.
Expenditure, E Y=E
Planned expenditure,
E=C+I+G
Y2 Y* Y1 Income, output, Y
Investment, Sales and the Interest Rate
Investment depends primarily on two factors:

• The level of sales (+)
• The interest rate (-)
I = I (Y , i )
( + ,− )
Determining Output
Taking into account the investment relation, the equilibrium

condition in the goods market becomes:
Y = C(Y − T ) + I (Y , i ) + G
For a given value of the interest rate, i, demand is an increasing function of

output, for two reasons:
• An increase in output leads to an increase in income and also to an
increase in disposable income.
• An increase in output also leads to an increase in investment.
Closed economy equilibrium
•AD = AS
•AD = C (Y) + I (r) + G
•AS = C (Y) + S (Y) + T
•C (Y) + I (r) + G = C (Y) + S (Y) + T
•I(r) + G = S(Y) + T
•I = Sp + (T-G) = Sp + Sg
•I = S All points on IS curve
11
The IS curve summarizes this relationship between the interest rate
and the level of income. In essence, the IS curve combines the
interaction between I and Y demonstrated by the Keynesian cross.
Because an increase in the interest rate causes planned investment to
fall, which in turn causes income to fall, the IS curve slopes downward.
(b)
E
Y=E
Planned expenditure,
An increase in the interest rate (in
E=C+I+G
graph a), lowers planned
investment, which shifts planned
expenditure downward (in
graph b) and lowers income (in
graph c).
Income, output, Y
(a) (c)
r r
I(r) IS
Investment, I Income, output, Y
The Goods Market non-equilibrium
r Excess
supply of
goods
Excess YS > YD
demand for
goods IS
Y <Y
S D
Y
Shifts of the IS Curve
Changes in either Tx, Tr or G (fiscal policy) will shift the IS curve.
To summarize:
• Equilibrium in the goods market implies that an increase in the
interest rate leads to a decrease in output. This relation is
represented by the downward-sloping IS curve.
• Changes in factors that decrease the demand for goods, given
the interest rate, shift the IS curve to the left. Changes in
factors that increase the demand for goods, given the interest
rate, shift the IS curve to the right.
Shifts of the IS Curve
Shifts in the IS curve

Figure 5.3
An increase in taxes shifts the IS curve to the left
consider the demand for real money balances, L. The theory of
liquidity preference suggests that a higher interest rate lowers the
quantity of real balances demanded, because r is the opportunity
cost of holding money.
The supply and demand for real money
balances determine the interest rate. At the
r Supply equilibrium interest rate, the quantity of
money balances demanded equals the
quantity supplied.
Demand, L (r)
M/P M/P
L(r) = M/P
Money Demand equals Real Money Balances
(M/P)d = L (r,Y)
The quantity of real money balances demanded is negatively related

to the interest rate (because r is the opportunity cost of holding money)
and positively related to income (because of transactions demand).
r Supply r LM
r2
r1
L (r,Y)'
L (r,Y)
M/P M/P Y
An increase in income raises money demand, which increases the
interest rate; this is called an increase in transactions demand
for money. The LM curve summarizes these changes in the money
market equilibrium.
Financial Markets non-equilibrium
r
LM
M d < Ms
Md > Ms
Y
LM'
r Supply' Supply r LM
r2 r2
r1 r1
L (r,Y)
M´/P M/P M/P Y
A contraction in the money supply raises the interest rate that equilibrates
the money market. Why? Because a higher interest rate is needed to
convince people to hold a smaller quantity of real balances.
As a result of the decrease in the money supply, LM shifts upward.
r IS LM(P0)
r0
Y0 Y
The intersection of the IS curve/equation, Y= C (Y-T) + I(r) + G and the LM curve/equation
M/P = L(r, Y) determines the level of aggregate demand. The intersection of the IS and LM
curves represents simultaneous equilibrium in the market for goods and services and in the
market for real money balances for given values of government spending, taxes, the money
supply, and the price level.
The Goods Market non-equilibrium
YD < YS
Y >
D YS
IS
Y
Financial markets non-equilibrium
r
LM
M d < Ms
Md > Ms
Y
Putting the IS and the LM Relations
Together
r Md < Ms
1 LM
YD < YS
Md < Ms YD < YS
E 4 Md > Ms
r0
YD >YS 2
Md > Ms IS
3 YD >YS
Y0 Y
Equilibrium adjustment process
Area on Goods market Money market
the
graph Non- Output Non- Interest rate
equilibrium adjustment equilibrium adjustment
(slow) (fast)
1 YD < YS Decreases Md < Ms Decreases

2 YD >YS Increases Md < Ms Decreases
3 YD >YS Increases Md > Ms Increases
4 YD < YS Decreases Md > Ms Increases
IS-LM Model: equilibrium adjustment process
4. Fiscal Policy, Activity and the Interest Rate
• Fiscal contraction, or fiscal consolidation, refers to

fiscal policy that reduces the budget deficit.
• An increase in the deficit is called a fiscal expansion.
• Taxes affect the IS curve, not the LM curve.
Y = C(Y − T ) + I (Y , i ) + G
+G Consider an increase in government purchases.
This will raise the level of income by G/(1- MPC).
r IS IS´ LM
B
A
The IS curve shifts to the right by G/(1- MPC) which raises income
and the interest rate.
-T Consider a decrease in taxes of T.
This will raise the level of income by
T × - MPC/(1- MPC).
r IS IS´ LM
B
A
The IS curve shifts to the right by T × - MPC/(1- MPC) which raises

income and the interest rate.
Monetary Policy, Activity and the Interest Rate
• 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.
(M/P)d = L (r,Y)
+M Consider an increase in the money supply.
r IS LM
LM
A
B
Y
The LM curve shifts downward and lowers the interest rate which raises
income. The lower interest rate, in turn, stimulates planned investment,
which increases planned expenditure, production, and income Y.
The IS-LM model shows that monetary policy influences income by
changing the interest rate. In the short run, when prices are sticky, an
expansion in the money supply raises income. We have discussed
how a monetary expansion induces greater spending on goods and
services—a process called the monetary transmission mechanism.
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.
Using a Policy Mix
Table 5.1 The Effects of Fiscal and Monetary Policy
Shift of Movement Movement in

Shift of IS LM in Output Interest Rate
Increase in taxes Left None Down Down

Decrease in taxes Right None Up Up
Increase in Right None Up Up
spending
Decrease in Left None Down Down

spending
Increase in money None Down Up Down

Decrease in None Up Down Up
money
Using a Policy Mix (Continued)
• The combination of monetary and fiscal polices is known

as the monetary-fiscal policy mix, or simply, the policy
mix.
• Sometimes, the right mix is to use fiscal and monetary
policy in the same direction.
• Sometimes, the right mix is to use the two policies in
opposite directions—for example, combining a fiscal
contraction with a monetary expansion.
An increase in P lowers the value of real money
balances, and Y, shifting LM leftward to point B.
Notice that r increased. Since r increased, we
r IS LM(P2) know that investment will decrease, as it just
LM(P1) got more costly to take on various investment
B projects.
As Investment is part of AD, AD decreases –
A downward sloping AD curve.
P Y
P2 B
P1 A
AD
Y
Monetary policy and AD
41
Fiscal Policy and AD
42
Short-Run Versus Long-Run Effects of a Positive Demand
Shock
3. …until an eventual rise in nominal
Aggregate wages in the long run reduces short-
price level run aggregate supply and moves the
1.An initial positive economy back to potential output.
demand shock… LRAS
SRAS
2
SRAS
1
E
3
P
3
P E 2. …increases the
2 E1 2
aggregate price level
P and aggregate output
1
AD
2 and reduces
AD unemployment
1 in the short run…
Potential Y Y Real GDP
1 2
output
Inflationary gap
+G Y = C (Y-T) + I(r) + G
Suppose there is a +G.
This translates into a rightward shift of the IS and AD curves.

LM '(P2)
r IS IS´
In the short run, we move along SRAS from C LM(P0)
point A to point B.
B
But as the output market clears, in the long-run, A
the price level will increase from P0 to P2.
This +P decreases the value of real money LRAS Y
balances, which translates into a leftward shift P
of the LM curve. P2 C SRAS'
B SRAS
P0 A
M/ P = L (r, Y) AD´
AD
Chapter Eleven 44Y
Finally, this leaves us at point C in both diagrams.
Remember that SR is the movement
from A to B.
Now it’s time to determine the effects on the variables in the economy.
For the variables Y, P, and r, you can read the effects right off the diagrams.
LM(P2)
r IS IS´ LM(P0)
Y +, because Y moved from Y* to Y´ C
P 0, because prices are sticky in the SR. A B
r +, because a +Y leads to a rise in r
as IS slides along the LM curve.
C +, because a +Y increases the level of Y
LRAS
consumption (C=C(Y-T)). P
I – , since r increased, the level of C
Investment can decrease or +, since Y P2 SRAS'
B
increased, Investment can increase. P0 SRAS
A
AD´
AD
Chapter Eleven Y* Y´ Y 45
Remember that LR is the movement from A to C.

LM(P2)
r IS IS´ LM(P0)
Y 0, because rising P shifts LM to left, returning C
Y to Y* as required by LRAS. A B
P +, in order to eliminate the excess demand at P .
0
r +, reflecting the leftward shift in LM due
to +P
C 0, since both Y and T are back to their initial LRAS Y
P
levels (C=C(Y-T))
I – – , since r has risen even more due to the P2 C SRAS'
B
+P and Y returned to Y*. P0 SRAS
A
A AD´
D
Y* Y´ Y
Chapter Eleven 46
Suppose there is a +M. M/ P = L (r, Y)
Look at the appropriate equation
that captures the M term:
Notice that M/ was increased, thus increasing the value of the real money
supply which translates into a rightward shift of the LM and AD curves.
In the short run, we move along SRAS from r IS LM(P0)
point A to point B. LM
A= C
But as the output market clears, in the long run,
the price level will increase from P0 to P2. B
This +P decreases the value of the Y
LRAS
real money supply which translates into a P
leftward shift of the LM curve. P2 C SRAS'
P B SRAS
A AD´
M/ P = L (r, Y) 0 AD
Chapter Eleven 47
Finally, this leaves us at point C in both diagrams. Y
Remember that SR is the
movement from A to B.
Now it’s time to determine the effects on the variables in the economy.
Y +, because Y moved from Y* to Y´.

r IS (P2)
LM (P0)
P 0, because prices are sticky in the SR.
LM 
r –, because a +Y leads to a decrease in r A= C
as LM slides along the IS curve.
C +, because a +Y increases the level of B
consumption (C=C(Y-T)).
I + , since r decreased, and Y increased LRAS Y
the level of investment increased. P
P2 C SRAS'
Monetary expansion is more investment P0 B SRAS
friendly than a fiscal expansion. A AD´
AD
Chapter Eleven Y* Y´ 48
Y
Remember that LR is the movement from A to C.
Y 0, because rising P shifts LM to left, returning
r IS LM (P0)
Y to Y* as required by LRAS.
P +, in order to eliminate the excess demand at P .
0
LM 
r 0, reflecting the leftward shift in LM due
A= C
to +P, restoring r to its original level. B
C 0, since both Y and T are back to their initial
levels (C=C(Y-T)).
I 0, since Y or r has not changed. LRAS Y
P
P2 C SRAS'
Notice that the only LR impact of an P0 B SRAS
increase in the money supply was an A AD´
increase in the price level. AD
Chapter Eleven
Y* Y´ Y 49
Chapter Eleven 50
IS' LM(P2) 1) +C causes the IS curve to shift
r IS LM(P0) right to IS‘.
C
•
B• Y = C (Y-T) + I(r) + G
A•
2) This leads to a rightward shift in AD
to AD’.
Short Run:
Move from A to B.
LRAS Y Long Run:
P
Market clears at P0 to P2
P2 C SRAS'
• from B to C.
3) +P causes LM(P0) to shift leftward
A
P0 • B • SRAS to LM(P2) due to the lowering of the
real value of the money supply.
AD AD' M/ P = L (r, Y)
Chapter Eleven Y 51
IS' LM(P2)
r IS LM(P0)
C •
Short Long
B• Run: Run:
A•
Y + 0
Y
P 0 +
P LRAS r + ++
P2 C • SRAS' C + +
I -,+? --
P0 A• B• SRAS
AD AD'
Chapter Eleven Y 52
6. Liquidity trap and LM curve
Chapter Eleven 53
Liquidity trap and monetary policy
Chapter Eleven 54
Liquidity trap and monetary policy
Chapter Eleven 55
55
Liquidity trap and fiscal policy
i IS1
IS
I min
LM
Y0 Y1 Y
Chapter Eleven 56
56

Ch. IS - LM

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Ch. IS - LM

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GOODS AND FINANCIAL

MARKETS: THE IS-LM

1. The Goods Market and the IS Relation

• In Income-Expenditure model, the interest rate

How does the economy get to this equilibrium? Inventories play an

Investment depends primarily on two factors:

Taking into account the investment relation, the equilibrium

For a given value of the interest rate, i, demand is an increasing function of

Shifts in the IS curve

Money Demand equals Real Money Balances

The quantity of real money balances demanded is negatively related

1 YD < YS Decreases Md < Ms Decreases

• Fiscal contraction, or fiscal consolidation, refers to

• An increase in the deficit is called a fiscal expansion.

• Taxes affect the IS curve, not the LM curve.

The IS curve shifts to the right by T × - MPC/(1- MPC) which raises

• An increase in the money supply is called monetary

• Monetary policy does not affect the IS curve, only the

Shift of Movement Movement in

Increase in taxes Left None Down Down

Decrease in Left None Down Down

Increase in money None Down Up Down

• The combination of monetary and fiscal polices is known

This translates into a rightward shift of the IS and AD curves.

Remember that LR is the movement from A to C.

Y +, because Y moved from Y* to Y´.

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