Prof.

Fei DING
The Hong Kong University of Science and Technology

ECON 2123: Macroeconomics

THE IS–LM MODEL

PREVIOUSLY …

Ch4: Financial Markets

LEARNING OBJECTIVES
❖Explain factors that determine the demand for money and write down the
money demand function.
❖ Define and derive equilibrium interest rate in the financial markets.
❖ Describe roles of banks and understand how the supply and demand of money
change with and without the presence of banks.

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 SO FAR, INTEREST RATE PLAYS NO ROLE IN
THE GOODS MARKET !

❖ How does lower interest rate work to fight recession?

➢ Connecting money market with real-side of economy

❖ How are output and interest rate determined

simultaneously?
➢ interest rate affecting output
➢ output affecting the interest rate

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 Ch5: Goods and Financial Markets:
The IS-LM Model

LEARNING OBJECTIVES
❖ Explain and derive the IS relation and the LM relation.
❖ Define and derive the “grand” equilibrium using the IS-LM Model.
❖ Apply the IS-LM model to predict and explain effects of fiscal and monetary
policy, both separately and together.

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WHAT IS THE IS-LM MODEL?
❖ People trade both goods and financial assets.
❖ The equilibrium of an economy → both goods and
financial markets should be at their equilibria.
❖ IS-LM: a framework to analyze both markets at the
same time to define the “grand equilibrium”.
➢ Goods market → Y; Financial market → i
➢ Focus on the equilibrium in the short run.
➢ Start from the financial market (LM) first.

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LM: LIQUIDITY – MONEY
❖ Recall money market equilibrium: M = $YL(i )

= YL(i )
M
❖ Convert to real Ms = real Md :
P
➢ Price level P: GDP deflator or CPI
➢ Income: $Y = YP, or Y = $Y/P
➢ Nominal money stock M is exogenous → short run real
money stock M/P is also exogenous. Why?
➢ Endogenous: Y and i → not every pair will make LHS = RHS.

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LM: LIQUIDITY – MONEY
a) At a given interest rate, an increase in b) Equilibrium in the financial markets implies
income leads to an increase in the that an increase in income leads to an
equilibrium interest rate. increase in the interest rate. The LM curve
is therefore upward sloping.

= YL(i )
M
P

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THE LM CURVE
❖ Each point on the LM curve → an equilibrium
in the money market
➢ Change output (income) → new equilibrium
interest rate, given by the intersection of real
money supply and real money demand.
❖ “Higher economic activities puts pressure on
interest rates.” (moving along the curve)
❖ How would a change in monetary policy affect
the LM curve?
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RECALL: EXPANSIONARY MONEY POLICY

Figure 4 - 4 Ms'
The Effects of an Increase
in the Money Supply on the
Interest Rate

An increase in the supply of

money leads to a decrease
in the interest rate.

This statement holds for

any level of income Y.

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AN EXPANSIONARY MONEY POLICY

Figure 5 - 5
Shifts of the LM curve
An increase in money
causes the LM curve to
shift down.

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A CONTRACTIONARY MONEY POLICY

LM'
i Supply' Supply i LM

i2 i2

i1 i1

Md

M´/P M/P M/P Y

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THE LM CURVE

❖ How would the arrival of Octopus cards affect

the LM curve of Hong Kong?

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SHIFTS OF THE LM CURVE
❖ Changes in factors that decrease the supply (or
increase the demand) for money, given Y, shift the LM
curve up (shift in).
➢ Example: monetary contraction

❖ Changes in factors that increase the supply (or

decrease the demand) for money, given Y, shift the LM
curve down (shift out).
➢ Example: monetary expansion

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REFRESH

For each interest rate, the LM curve illustrates

the level of output where
1) the goods market is in equilibrium.

2) inventory investment equals zero.

3) money supply equals money demand.

4) all of the above

5) none of the above

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REFRESH

The LM curve shifts down when which of the

following occurs?
1) an increase in taxes

2) an increase in output

3) an open market sale of bonds by the central

bank
4) an increase in consumer confidence

5) none of the above

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QUOTE OF THE DAY

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IS: INVESTMENT – SAVING
❖ Recall: goods market equilibrium is defined as
Y = Z = C(Y – T) + I + G.
➢ Investment was assumed to be exogenous,
➢ so interest rate would not affect the demand for goods.
❖ But investment depends on
➢ Business volume (level of sales): output ↑ leads to
investment ↑
➢ Interest rate: i ↑ leads to investment ↓
I = I (Y , i )
( + ,− )
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IS: INVESTMENT – SAVING
Determining Output Y = C(Y − T ) + I (Y , i ) + G
Figure 5 - 1
Equilibrium in the
Goods Market
The demand for goods is
an increasing function of
output, but less than
one-for-one. Equilibrium
requires that the demand
for goods be equal to
output.

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IS: INVESTMENT – SAVING
❖ Goods market equilibrium now becomes
Y = C(Y − T ) + I (Y , i ) + G
❖ Endogenous variables: Y and i → equilibrium values
are such that LHS = RHS.
❖ All the equilibrium (Y, i) pairs form the IS curve.
❖ Suppose (Y1, i1) constitutes an equilibrium. Would
(Y1, i2 > i1) also constitute an equilibrium?
➢ i2 > i1 → I goes down → LHS > RHS
➢ What should happen to Y to make LHS = RHS again?
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THE IS CURVE
Figure 5 - 2
The Derivation of the IS Curve

(a) An increase in the interest rate

decreases the demand for goods
at any level of output, leading to a
decrease in the equilibrium level
of output. (through investment)

(b) Equilibrium in the goods market

implies that an increase in the
interest rate leads to a
decrease in output. The IS
curve is therefore downward
sloping.

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SHIFTS OF THE IS CURVE

❖ How would changes in exogenous variables (C,

T, G) affect the IS curve?
❖ Example: Increasing taxation leads to …
Figure 5 - 3
Shifts of the IS Curve

An increase in taxes reduces

demand, and thus reducing
equilibrium output at any
given interest rate. The IS
curve shifts to the left.

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SHIFTS OF THE IS CURVE
❖ Changes in factors that decrease the demand for
goods, given the interest rate, shift the IS curve to
the left (shift in).
➢ Shifting down ZZ → Y ↓ → IS curve to the left
➢ Example: fiscal contraction
❖ Changes in factors that increase the demand for
goods, given the interest rate, shift the IS curve to
the right (shift out).
➢ Shifting up ZZ → Y ↑ → IS curve to the right
➢ Example: fiscal expansion
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THE IS CURVE VS. THE LM CURVE
❖ Each point on the IS curve → an equilibrium in the
goods market
➢ Change interest rate → new equilibrium output Y, given by
the intersection of (new) demand ZZ and the 45-degree line
in goods market.
❖ Each point on the LM curve → an equilibrium in the
money market
➢ Change output (income) Y → new equilibrium interest rate,
given by the intersection of real money supply and real
money demand.

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REFRESH
Q1: In the goods market, when we change output level
and derive the corresponding equilibrium level of
interest rate, we can derive the IS curve.
Q2: In the financial market, when we change the
interest rate to derive the corresponding equilibrium
level of output, we can derive the LM curve.
1) True
2) False
3) Uncertain
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IS–LM: THE “GRAND” EQUILIBRIUM
IS relation: Y = C(Y − T ) + I (Y , i ) + G
M
LM relation: = YL(i )
Figure 5 - 6 P
The IS–LM Model

Equilibrium in the goods market implies

that an increase in the interest rate leads
to a decrease in output. This is
represented by the IS curve. Equilibrium
in financial markets implies that an
increase in output leads to an increase in
the interest rate. This is represented by
the LM curve. Only at point A, which is
on both curves, are both goods and
financial markets in equilibrium.

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QUOTE OF THE DAY

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POLICY APPLICATIONS

❖ Fiscal policy: Government chooses G–T (<=> 0)

➢ G and T affect IS or LM or both?
➢ Fiscal expansion → IS to the right (Y ↑ at same i)
➢ Fiscal contraction → IS to the left (Y ↓ at same i)
❖ Monetary policy: Central bank chooses Ms
➢ Ms affects IS or LM or both?
➢ Expansion → LM down (i ↓ at same Y)
➢ Contraction → LM up (i ↑ at same Y)
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FISCAL CONTRACTION: (G–T) ↓
Figure 5 - 7
The Effects of an Increase in Taxes
An increase in taxes shifts the IS curve to the left and …

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FISCAL CONTRACTION: (G–T) ↓
Figure 5 - 7
The Effects of an Increase in Taxes
An increase in taxes shifts the IS curve to the left and leads to a decrease in the
equilibrium level of output and the equilibrium interest rate.

T ↑ → IS shifts left
→ Y ↓ and i ↓ → I ?

In the short run, a

reduction of the
budget deficit may
decrease investment.

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FISCAL CONTRACTION: AN INCREASE IN T
❖ Goods market channel: Higher taxes → lower disposal
income → lower consumption → lower demand → lower Y
➢ Lower Y → further reducing C and I → further reducing Y @ same i
➢ Point D is an EQ in the goods market.
➢ But NOT in the money market → above the LM.
➢ At point D, money demand < > money supply ???
❖ Money market channel: lower Y (income) → lower money
demand → lower i
➢ Lower i → higher I → higher demand → offsetting some decline in Y
❖ IS shifts to the left, new EQ moves along the LM curve to A’.
➢ C ↓ for sure, investment I ambiguous (Y ↓ and i ↓ → I ?)
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Deficit Reduction: Good or Bad for Investment?

A deficit reduction may decrease rather than increase investment.

Investment = Private saving + Public saving

I = S + (T – G)
Given private saving, if T-G goes up – investment must go up:
Given S, T-G going up implies that I goes up.

However, S is affected by a fiscal contraction because Y ↓.

Recall: S = –c0 + (1 – c1) (Y – T).
If S ↓ by more than (T-G) ↑ → I ↓

To sum up: A fiscal contraction may decrease investment. Or,

looking at the reverse policy, a fiscal expansion—a decrease in taxes
or an increase in spending—may actually increase investment.

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Fiscal Contraction: Good or Bad for Greece and for the Euro?

Problem → the public debt of Greece is unsustainable.

❖ Austerity → fiscal contraction, cutting spending and increasing
taxes, so budget deficit (G-T) ↓.
❖ But the IS-LM model shows
➢ Fiscal contraction leads to lower output (Y ↓), which means a smaller
pie and less tax revenues.
➢ “So what a government does to reduce what it needs to pay at the
same time decreases what it is able to pay.”

❖ So, is austerity the wrong prescription for Greece?

➢ YES, in the short run.
➢ We will see the good side of austerity (saving) in longer time frames.

❖ Note: a fiscal contraction in combination with a monetary

expansion can reduce budget deficit without sacrificing output.
➢ But Greece does not have its own currency… 
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MONETARY EXPANSION: MS ↑
Figure 5 - 8
The Effects of a
Monetary Expansion
A monetary expansion leads to
higher output and a lower
interest rate.

M ↑ → Y ↑, i ↓ → I ↑
A monetary expansion
is more investment C
friendly, i.e.,
increasing investment.

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MONETARY EXPANSION: MS ↑
❖ Money market channel: higher money supply → lower i @
the same Y
➢ Point C is an EQ in the money market.
➢ But NOT in the goods market → below the IS.
➢ At point C, demand for goods < > supply for goods ???
❖ Goods market channel: lower i → higher investment I →
higher demand → higher Y
➢ Higher Y (income) → higher money demand → offsetting some
decline in i
❖ LM shifts down, new EQ moves along the IS curve to A’.
➢ C and I increase for sure (Y ↑ and i ↓ → I ↑)
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POLICY SHOCKS
Table 5-1 The Effects of Fiscal and Monetary Policy
Movement Movement in
Shift of IS Shift of LM in 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

❖ Fiscal expansion → IS shifts out (right)

❖ Fiscal contraction → IS shifts in (left)
❖ Monetary expansion → LM shifts out (down)
❖ Monetary contraction → LM shifts in (up)
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REFRESH
An increase in the money supply must cause which of
the following?
1) a leftward shift in the IS curve
2) a reduction in the interest rate and ambiguous effects on
investment
3) an increase in investment and a rightward shift in the IS
curve
4) no change in the interest rate if investment is independent
of the interest rate
5) no change in output if investment is independent of the
interest rate
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NO LINKAGE TO THE GOODS MARKET
When interest rate is independent of Investment.
i
IS LM

LM’

A’

Y
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FISCAL EXPANSION: (G–T) ↑
Compared to Ch3 model,
i fiscal policy less effective due to i changes.
IS IS’
LM

A’

A D

Y
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MIXING FISCAL AND MONETARY POLICY
Fiscal and monetary policy can be used in the
same direction.
❖ Fiscal expansion can be used to stimulate Y.
➢ But the increase in i would partially offset the
effect (as I decreases).
❖ Monetary expansion can be used to cancel
the increase in i,
➢ At the same time enhancing the impact on Y.
❖ Focus box: The US recession of 2001
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The U.S. Recession of 2001

Figure 1 The U.S. Growth Rate, 1999:1 to 2002:4

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 41 of 33

The U.S. Recession of 2001

Expansionary monetary policy

The Fed increased

money supply to
fight recession.

Figure 2 The Federal Funds Rate, 1999:1 to 2002:4

The U.S. Recession of 2001

Expansionary fiscal policy

T ↓, G ↑, (G-T) ↑

Figure 3 U.S. Federal Government Revenues and

Spending (as Ratios to GDP), 1999:1 to 2002:4
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The U.S. Recession of 2001

Figure 4 The U.S. Recession of 2001

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MIXING FISCAL AND MONETARY POLICY

Fiscal and monetary policy can also be used in

the opposite direction.
True or false or uncertain?
 Monetary contraction and fiscal expansion
increase equilibrium output and interest rate
simultaneously.

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STEP 1: MONETARY CONTRACTION

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STEP 2: FISCAL EXPANSION

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STEP 3: POLICY MIX POSSIBLE OUTCOMES
Outcome 1 Outcome 2

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STEP 3: POLICY MIX POSSIBLE OUTCOMES

Outcome 3

So the answer should be–

It depends.
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MIXING FISCAL AND MONETARY POLICY
Fiscal and monetary policy can also be used in the
opposite direction.
Example: When the economy has a large budget deficit
(like in Greece),
❖ Cutting G and increasing T improve the budget deficit,
but the downside is?
❖ Expansionary monetary policy can offset the negative
impact on Y.
➢ Greece cannot do it! 
➢ But US did it during the Clinton–Greenspan era.
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 The IS curve (which stands for investment
saving) plots the relationship between the
interest rate and the level of income that
arises in the equilibrium of the goods and
services market.

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 equilibrium of the money market.

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IS–LM: THE “GRAND” EQUILIBRIUM
❖ The IS relation follows from the condition that the supply of
goods must be equal to the demand for goods.
❖ Tell us how the interest rate affects output: through
investment.
❖ The LM relation follows from the condition that the supply of
money must be equal to the demand for money.
❖ Tell us how output affects the interest rate: through money
demand.
❖ Because the interest rate influences both investment and
money demand, it is the variable that links the two parts of
the IS-LM model.
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IS–LM: THE “GRAND” EQUILIBRIUM
❖ The IS curve is drawn for a given fiscal policy.
➢ Changes in fiscal policy that raise the demand for goods
and services shift the IS curve to the right (shift out).
➢ Changes in fiscal policy that reduce the demand for goods
and services shift the IS curve to the left (shift in).

❖ The LM curve is drawn for a given monetary policy.

➢ Changes in monetary policy that raise the money supply
shift the LM curve down (shift out).
➢ Changes in monetary policy that reduce the money supply
shift the LM curve up (shift in).
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IS–LM: THE “GRAND” EQUILIBRIUM

Interest rate changes do not shift the IS or LM curve!

❖ (Y, i) are endogenous variables in the IS-LM model.

➢ Changes move along the curve.

❖ Only changes to variables exogenous to the IS-LM

model can shift the IS or LM curve.
➢ For example, the changes in G or T (fiscal policy), or the
changes in the money supply (monetary policy).

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ANYTHING ELSE CAN SHIFT THE CURVES?
Other exogenous changes can also shift the IS or LM
curve.
❖ IS: increase or decrease in consumer/investor
confidence will raise or reduce total demand and thus
shift the IS curve.
❖ LM: exogenous changes in money demand can shift
the LM curve, how?
➢ Credit cards and ATMs, doubts about the health of
the banking system, etc.
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DOES THE IS-LM MODEL FIT THE FACTS?
❖ Short answer: Yes! ☺
❖ But the model ignored “dynamics”.
➢ Take time for consumers to adjust their consumption
following a change in income.
➢ Take time for firms to adjust investment spending following
a change in sales.
➢ Take time for firms to adjust investment spending following
a change in the interest rate.
➢ Take the for firms to adjust production following a change in
their sales.
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SEE YOU NEXT TIME ☺

❖ Assigned reading:
➢ Chap. 5 from 6th ed. textbook

➢ 6th ed. Chap. 18 (for next time)

❖ To do: Problem set 2 and quiz 2

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