2022 Introduction To Economics Notes 18

BRITISH UNIVERSITY VIETNAM
18
THE IS/LM: An Introduction
Over the last few weeks we have analysed the goods market and the assets markets separately.
The goods market: The Keynesian 45° National Income model of Aggregate Expenditure
The assets market: Money markets, Bond markets.
But while we examined them, we ignored the impact that one might have upon the other. Now we'll begin
to put them together and analyse them simultaneously − in something known as the IS - LM model, the
basics of which were put together by John Hicks in 1937.
The Goods Market & Money (Assets) Market: The Missing Link
Last week we saw that the demand for money was a function of income: L = L(Y)
The rate M0
Therefore, the higher the level of of interest [The Supply of Money]
income, the higher will be the
demand for money.
Given a fixed supply of money, the

market rate of interest is
determined by the interaction of i0
that fixed supply and the demand
for money:
L0 [The Demand for Money]
MS0 Money
Stock
If incomes rise, and – as a result – there is an increase in the demand for money, this means that there
will be a rise in the rate of interest:
The rate M0
of interest [The Supply of Money]
i1
i0
L1

MS0 Money
Stock
Introduction to Economics 439

But we know from our examination of Investment Expenditure (a couple of weeks ago) that a higher
interest rate discourages investment spending (and consumption spending too, actually) − and thus
causes income/output to fall. In terms of the 45° model:
Aggregate AE0
Expenditure
[C,I,G]
AE1
−
A – di0
−
A – di1
45°
Y1 Y0 National
Income
Such a decline in income will have a negative impact upon the demand for money.
The rate M0
of interest [The Supply of Money]
i1
i0
L1

MS0 Money
Stock
This decrease in the demand for money leads to a lower interest rate. This in turn will lead to an increase
in consumption and investment spending which will lead to a multiplied increase in the level of national
income. Such an increase in income will lead to an increase in the demand for money . . . . . . . . which will
lead to a higher interest rate, hence less investment, hence less income…………..and so on and so forth.
Therefore, the level of spending in the economy − and consequently the level of output and income −
as well as the rate of interest, must be jointly determined by equilibrium in both the goods market and
the assets market.
The IS - LM model is all about that joint equilibrium.
440 Introduction to Economics

INCOME
THE ASSETS THE GOODS

MARKETS MARKETS
Money, Bonds Aggregate Demand,

Output
INTEREST RATES
Monetary Fiscal
Policy Policy
The Goods Market Equilibrium is shown by the IS Curve. The Assets Markets Equilibrium is shown by the
LM Curve.
I = Investment
S = Savings
L = The demand for Money (or liquid assets)

M = The supply of Money
Formulated by John Hicks in 1937, the "IS - LM" model describes equilibrium in the goods market:
Investment = Savings
I=S − or the IS for short
and simultaneous equilibrium in the money markets:
Demand for Money = Supply of Money
L=M − or the LM for short

18.1 DERIVATION OF THE IS SCHEDULE
The IS curve shows combinations of interest rates and levels of output such that planned investment
equals planned savings, and thus planned spending equals income.
The basic model (closed economy):
Y=C+I+G
where: C = a + bYd; Yd = Y – T and I = I – di

−

−
Y = a + b[Y – T] + I – di + G

−
Y = a + bY – bT + I – di + G
 Y – bY = a – bT + I – di + G
−
 Y[1 – b] = a – bT + I – di + G
−
−
a – bT + I – di + G
 Y =
(1 – b)
You will recall from a couple of weeks ago that an increase in the rate of interest will have a negative
impact upon the equilibrium level of national income, and a decrease in the rate of interest will have a
positive impact. More precisely, we could write:
Y −d
=
i 1−b
Geometrically, changes in the rate of interest affect the national income model as the following sequence
of diagrams show. First of all, assume a fairly high rate of interest, i 0.
Aggregate
Expenditure
C + I0 + G
−
a – bT + I − di0 + G
45°
Y0 National
Income
The resultant level of national income will be Y0, as shown above.

Then the interest rate falls to i1:
Aggregate
Expenditure
C + I1 + G
C + I0 + G
−
a – bT + I − di1 + G
−
a – bT + I − di0 + G
45°
Y0 Y1 National
Income
This results in a higher level of national income – Y1.
Then the interest rate falls again, this time to i2:
Aggregate
Expenditure C + I2 + G
C + I1 + G
a – bT + −
I − di2 + G C + I0 + G
a – bT + −
I − di1 + G
a – bT + −
I − di0 + G
45°
Y0 Y1 Y2 National
Income
The resultant level of national income is an even higher Y 2.
From these schedules, which show the different levels of national income at different rates of interest,
we can derive the IS curve.

1. At the initial (high) rate of interest i0:
Aggregate
Expenditure
C + I0 + G
−
a – bT + I − di0 + G
45°
Y0 National
Income
The rate
of interest
i0 •
Y0 National
Income
… we can derive one point on a diagram which plots the market rate of interest (vertical axis) against the
level of national income. This point represents a position where the 45° model is in equilibrium - i.e. it
shows a combination of interest rate and national income/output where the economy is in equilibrium.

2. If the interest rate falls from i0 to i1, this generates a higher level of investment spending, and
the Aggregate Expenditure function shifts upwards. The economy achieves equilibrium at a
higher level of income/output: Y1.
Aggregate
Expenditure
C + I1 + G
C + I0 + G
−
a – bT + I − di1 + G
−
a – bT + I − di0 + G
45°
Y0 Y1 National
Income
The rate
of interest
i0 •
i1 •
Y0 Y1 National
Income
On the lower diagram, which plots the rate of interest against the level of income, we can derive a second
point which represents equilibrium in the top diagram; i.e. a different combination of interest rate and
level of income/output where the goods market (the 45° model) is in equilibrium.

3. If the interest rate falls yet again, this time from i1 to i2, this generates an even higher level of
investment spending, and the Aggregate Expenditure function shifts upwards yet again. The
economy achieves equilibrium at the even higher level of income/output: Y 2.
Aggregate
Expenditure
C + I2 + G
C + I1 + G
−
a – bT + I − di2 + G C + I0 + G
−
a – bT + I − di1 + G
−
a – bT + I − di0 + G
45°
Y0 Y1 Y2 National
Income
The rate
of interest
i0 •
i1 •
i2 •
Y0 Y1 Y2 National
Income
On the lower diagram − which shows the rate of interest plotted against the level of income − we can
derive a third point which represents equilibrium in the top diagram; i.e. another different combination
of interest rate and level of income/output where the goods market (the 45° model) is in equilibrium.

Join the dots …
Aggregate
Expenditure
C + I2 + G
C + I1 + G
−
a – bT + I − di2 + G C + I0 + G
−
a – bT + I − di1 + G
−
a – bT + I − di0 + G
45°
Y0 Y1 Y2 National
Income
The rate
of interest
i0
i1
i2
IS
Y0 Y1 Y2 National
Income
… and you have the IS schedule.
Every point on the IS curve has something important in common with all other points.
Each point represents a combination of interest rate and level of output (income) at which
the goods market clears (i.e. where the 45° model is in equilibrium).
Hence the IS curve is known as the goods market equilibrium schedule. It shows all combinations of
interest rates and levels of output where we have equilibrium in the goods market (i.e. supply = demand
for all goods and services).

18.2 THE SLOPE OF THE IS CURVE
The gradient of the IS curve is determined by two factors:
The interest response of investment (d)
The magnitude of the multiplier (M)

 which in turn is dependent upon the size of the marginal propensity to consume
(b), the marginal propensity to invest (n), the government’s marginal propensity to
consume (g), the marginal propensity to import (m) and any other variable which affects
the gradient of the Aggregate Expenditure function.
If investment spending is extremely sensitive to the rate of interest (i.e. d is large) .......
Aggregate
Expenditure
C + I1 + G
−
a – bT + I − di1 + G C + I0 + G
−
a – bT + I − di0 + G
45°
Y0 Y1 National
Income
The rate
of interest
d
big
i0
i1
IS
Y0 Y1 National
Income
… then the IS curve is relatively flat.
This is because a small change in the interest rate causes a relatively large change in aggregate
demand, and hence a large change in income.
However, if investment spending is not very sensitive to the rate of interest (i.e. d is small) - showing an
identical decrease in the rate of interest .....
Aggregate
Expenditure
C + I1 + G
C + I0 + G
−
a – bT + I − di1 + G
−
a – bT + I − di0 + G
45°
Y0 Y1 National
Income
The rate
of interest
small
d
i0
i1
IS
Y0 Y1 National
Income
then the IS curve is relatively steep. This is because (the same) change in the interest rate causes a
relatively small change in aggregate demand, and hence a small change in income.

The bigger the multiplier, the flatter will be the IS schedule.
The smaller the multiplier, the steeper will be the IS schedule.
If the multiplier is large - i.e. the AE is relatively steep ....
Aggregate
Expenditure
C + I1 + G
C + I0 + G
a – bT + −
I − di1 + G
a – bT + −
I − di0 + G
45°
Y0 Y1 National
Income
The rate
of interest
M
big
i0
i1
IS
Y0 Y1 National
Income
… and thus the IS curve is relatively flat.

If the multiplier is small, resultant AE is relatively flat ......
Aggregate
Expenditure
C + I1 + G
C + I0 + G
a – bT + −
I − di1 + G
a – bT + −
I − di0 + G
45°
Y0 Y1 National
Income
The rate
of interest
small
M
i0
i1
IS
Y0 Y1 National
Income
… and thus the IS is relatively steep.

18.3 THE POSITION OF THE IS CURVE
The position of the IS curve is determined by the level of autonomous aggregate expenditure.
An autonomous increase in the level of aggregate demand - i.e. no change in the rate of interest, but
merely, say, an increase in government spending - causes the IS curve to shift to the right.
The extent of this horizontal shift is precisely equal to the full multiplier effect on national income.
Aggregate
Expenditure
C + I + G1
C + I + G0
−
a – bT + I − di + G1
−
a – bT + I − di + G0
45°
Y0 Y1 National
Income
The rate
of interest
i0
IS0
IS1
Y0 Y1 National
Income

Alternatively, a decrease in autonomous expenditure in the economy (interest rates unchanged) has the
reverse effect - the IS shifts horizontally to the left.
Aggregate
Expenditure
C + I + G0
C + I + G1
−
a – bT + I − di + G0
−
a – bT + I − di + G1
45°
Y1 Y0 National
Income
The rate
of interest
i0
IS0
IS1
Y1 Y0 National
Income
18.4 POSITIONS OFF THE IS CURVE
Having now derived the IS curve, and looked at the factors determining its position and its slope; the real
power behind the analysis is looking at points which are not on the IS curve.
Bearing in mind that the IS curve shows the goods market equilibrium - i.e. all combinations of interest
rates and levels of output at which the goods market clears - points which are not on the IS curve
therefore represent disequilibrium in the goods market - i.e. combinations of interest rates and levels of
output at which the goods market does not clear.

i
At , the same level of income
(Y0) exists as at  - but the rate
of interest is lower. i0 • 
At such a low rate of interest,
the demand for investment at
 obviously exceeds the demand
for investment at . i1 •  • 
If demand exceeds the level of
output, there is disequilibrium
in the goods market: excess IS
demand for goods. Y0 Y1 Y
i0 •  • 
At , the interest rate is higher
than at : thus the demand for
goods is lower than at 
– disequilibrium once again,
i1 •  this time an excess supply of
goods.
IS
Y0 Y1 Y
All points below and to the left

of the IS curve show that the
interest rate is too low and thus
aggregate demand is too high
Excess
relative to output Demand
– an excess demand for goods. for
goods
IS
Y
Excess All points above and to the right

Supply of the IS curve show that the
of
goods
interest All
ratepoints above
is too highand
andto thus
the right
aggregate demand is too low the
of the IS curve show that
interest
relative to output rate is too high and thus
aggregate demand is too low
– an excess supply
relative of goods.
to output
a– an excess supply of goods.
IS
Y

IS Summary
 The IS curve shows combinations of interest rates and levels of income/output
which generate equilibrium in the goods market.
 It is negatively sloped because a decrease in the rate of interest increases

planned investment spending, thereby increasing aggregate demand, and hence
increasing the equilibrium level of income/output.
 The more sensitive the interest response is, the more income/output changes if
there's a change in the rate of interest, and hence the flatter is the IS.
 The smaller the multiplier - the less sensitive spending is to changes in the rate of
interest, and obviously the less income/output expands given a change in the rate
of interest - and thus the steeper is the IS.
 The position of the IS curve is determined by the level of autonomous spending in

the economy (that is: spending not linked to the rate of interest or income).
An increase in spending
shifts it to the right….
whereas a decrease in spending

shifts it to the left.
 At points At points to the right

to the left of of the curves there
the curve, there is excess supply
is excess demand for of goods and
goods and services in services in
the economy. the economy
IS

18.5 THE LM SCHEDULE

Leaving the goods market, and turning to the assets market - money, bonds, etc. - you will recall from a
couple of weeks ago that the amount of money individuals demand as cash balances is a function of their
incomes and the rate of interest.
L = f(Y, i)
More specifically, we can now say that:
L = kY − hi
where: L is the demand for money

k is that fraction of income demanded as cash
Y is income
h is the interest response
i is the rate of interest
The higher the rate of interest, the less is the quantity of money demanded as a cash balance; the lower
the rate of interest, the greater is the amount demanded.
The rate
of interest
[%]
L = kY − hi
Cash Balances (M1)
[$]
The greater the interest response, (which is, effectively, the elasticity of demand for money) the flatter
the demand schedule:
i
small
h
i
big
h
L
L
Cash Balances (M1) Cash Balances (M1)
[$] [$]

An increase in income will increase the demand for money. The distance of the horizontal shift will be
kY.
L1 = kY1 − hi
L0 = kY0 − hi
Cash Balances (M1)
kY [$]
Of course, if Keynes was right about the Liquidity Trap (because of the speculative demand for money),
the demand function becomes perfectly elastic at some critical, low rate of interest.
Cash Balances (M1)

[$]
The supply of money is controlled by the central bank − in the UK that's the Bank of England, in the USA
the Federal Reserve Bank, in Singapore it’s the Monetary Authority of Singapore (MAS). Assuming they
have perfect control, the supply curve is perfectly inelastic.
i
M
Cash Balances (M1)

[$]

i
M0 M1
An increase in the money supply.
Cash Balances (M1)

[$]
i
M1 M0
A decrease in the money supply.
Cash Balances (M1)

[$]
It is important to note at this point that the IS − LM model assumes a zero inflation equilibrium.
That is to say, the supply of money − M above − is not measured simply in dollars, but in dollars
divided by the current price level. So, it shows rather than nominal money supply.
But if inflation is non-existent, real money supply = nominal money supply.

18.6 DERIVATION OF THE LM CURVE
At a level of income, say Y0, which generates the demand for money L 0, an equilibrium is achieved in the
money market at interest rate i0.
i M i
i0 i0 •
L0
MS0 Cash Balances (M1) Y0 National Income
[$]
At a level of income, say Y1, which generates the demand for money L 1, an equilibrium is achieved in the
money market at interest rate i1.
i M i
i1 i1 •
i0 i0 •
L1
L0
MS0 Cash Balances (M1) Y0 Y1 National Income
[$]
Join the dots (!) and you have the LM curve.
i i
M
LM
i1 i1 •
i0 i0 •
L1
L0
MS0 Cash Balances (M1) Y0 Y1National Income
[$]

The LM curve shows all combinations of interest rates and levels of income such that equilibrium
exists in the money market.
At all points along the LM curve, the supply of money equals the demand for money; and hence the
demand for assets must equal the supply of assets.
18.7 THE SLOPE OF THE LM CURVE
The more that the demand for money alters given a change in income, the steeper the LM curve will be.
If k is small:
i i
M small
k
LM
i1 i1
i0 i0
L1
L0
MS0 Cash Balances (M1) Y0 Y1 National Income
[$]
…. then the LM is relatively flat.
If k is large:
i i LM
M
i1 i1
k
big
L1
i0 i0
L0
Cash Balances (M1) Y0 Y1 National Income
[$]
…. then the LM is relatively steep.
The more that the quantity of money demanded alters given a change in the rate of interest, the flatter
the LM curve will be.
If h is small:
i i LM
i1 small
h
i0
L0
Cash Balances (M1) National Income
[$]
…. the LM is relatively steep.
If h is large:
i i
h
big
LM
i1
i0
L0
Cash Balances (M1) National Income
[$]
…. then the LM is relatively flat.
[Note: I haven’t proved this here. That’s for you to do in a tutorial!]

18.8 THE POSITION OF THE LM CURVE
You will recall that earlier we suggested that real money supply was held constant along the LM curve.
It should therefore be intuitively obvious that if there is a change in the real money supply, there will be a
shift in the position of the LM curve.
An increase in the real money supply causes the LM curve to shift down; and conversely a decrease in
the real money supply causes the LM curve to shift up.
An increase in the real money supply:
i i
LM0
M0 M1
LM1
i0 i0
i1 i1
L0
Cash Balances (M1) Y0 National Income
[$]
To restore money market equilibrium at income level Y0, the interest rate has to fall to i1. At each level
of income, the interest rate has to be lower in order to induce people to hold the larger amount of money.
A decrease in the real money supply:
i i
M1 M0 LM1
LM1
i1 i1
i0 i0
L0
Cash Balances (M1) Y0 National Income
[$]
To restore money market equilibrium at income level Y 0, the interest rate must to rise to i1. At each
level of income, the interest rate has got to be higher in order to induce people to hold the smaller
amount of money.

18.9 POSITIONS OFF THE LM CURVE
At all points along the LM curve, the money market is in equilibrium. It follows, therefore, that at all points
not on the LM curve, the money market is in disequilibrium.
Given different demands for money, L 0 and L1 following an increase in income, Y0 to Y1, equilibrium in
the money market is at  and  respectively below, corresponding to  and  on the LM.
i M i
LM
i1 • • i1 • •
i0 • i0 •
L1
L0
[$]
If income remained at Y0, but the interest rate rose to i1, the economy would be in disequilibrium at point
 There is an excess supply of money.
Alternatively, if there was an increase in income from Y 0 to Y1, and a corresponding increase in the
demand for money from L 0 to L1, but interest rates did not adjust, the economy would be in disequilibrium
at point .
i M i
LM
i1 • i1 •
i0 • • i0 • •
L1
L0
[$]
Here we have excess demand for money.
Hence, at any point i LM

which is above and to the
left of the LM curve, Excess
there is an excess supply Supply
of
of money money
And at any point which is
Excess below and to the right of
Demand the LM curve, there is an
for excess demand for
money money
National Income

LM Summary
 The LM curve shows combinations of interest rates and levels of income/output
which generate equilibrium in the money market.
 If the money market is in equilibrium, the assets markets must be in equilibrium

too - thus the LM curve shows all combination of interest rates and
income/output at which the assets markets are in equilibrium.
 Changes in the real money supply cause the LM to shift.
An increase in money
supply shifts it downwards….
whereas a decrease in money

supply shifts it upwards.
LM
 At points to the left (and
above) the curve,
there is an At points to the right
excess supply (and below) the curve, there
of money. is an excess demand for money.

18.10 JOINT EQUILIBRIUM
The IS schedule shows all combinations of interest rates and levels of income such that the goods
market is in equilibrium.
The LM schedule shows all combinations of interest rates and levels of income such that the assets
markets are in equilibrium.
For there to be simultaneous equilibrium − that is: equilibrium in the goods and assets markets
simultaneously − the rate of interest and the level of income must satisfy both the IS and the LM
schedules.
The rate
of interest LM
i%
i* • E
IS
Y* National Income
[$]
At the rate of interest i* and level of income Y*, the goods market clears and the assets markets clear.
Putting that another way: the market rate of interest and the equilibrium level of national income are
determined by the interaction of the goods market (IS) and the assets markets (LM).
It's worthwhile pausing to review the meaning of point E , the point of joint equilibrium in the IS-LM
diagram. Given the assumption of zero inflation, at income level Y*, firms in the economy are supplying
the required output which just meets the level of aggregate demand in the economy. The demand for
money is equal to the supply of money, which means that the demand for bonds and other financial
assets are just equal to the supply of those assets.
This means that in the goods market, companies are producing their planned amount of output: there
is no unintended building up of inventory, nor is the demand for their products outstripping their ability
to supply them.
In the assets market, individuals are happy with their portfolio of money and assets. There is no "income
pressure" to raise their demand for cash balances (and hence depress their demand for assets), nor is
there any "interest pressure" doing the opposite.

18.11 CHANGES IN THE JOINT EQUILIBRIUM
The equilibrium level of income and rate of interest will alter if either the IS or the LM curve shifts.
If the IS shifts to the right:
The rate
of interest LM0
i%
i1 • E1
i0 • E0
IS1
IS0
Y0 Y1 National Income
[$]
… the economy ends up in equilibrium at a higher level of income at a higher rate of interest.
If the IS shifts to the left:
The rate
of interest LM0
i%
i0 • E0
i1 • E1
IS1 IS0
[$]
… the economy ends up in equilibrium at a lower level of income at a lower rate of interest.

If the LM shifts down:
The rate
of interest LM0
i% LM1
i0 • E0
i1 • E1
IS0
[$]
… the economy ends up in equilibrium at a higher level of income at a lower rate of interest.
If the LM shifts up:
The rate
of interest
LM1 LM0
i%
i1 • E1
i0 • E0
IS0
[$]
… the economy ends up in equilibrium at a lower level of income at a higher rate of interest.

18.12 CROWDING OUT
Imagine there was an increase in autonomous spending in the economy, with no monetary expansion to
accommodate it. From the simple 45° model, we know this would cause aggregate demand to rise, and
hence lead to a higher level of income.
The way we would have looked at it previously, the total change in the level of income would simply have
been:
the initial increase in spending x the multiplier.
Aggregate AE1
Expenditure
AE0
1
− Y =  AE ×
A1 1−b
AE
−
A 0
45°
resultant Y
Recall that we demonstrated that such a change in autonomous expenditure will cause the IS function
to shift to the right, with the horizontal extent of that shift being precisely equal to the change in income
in the 45° model:
The rate
of
interest
i0
IS1
IS0

But this means, if we look to the new equilibrium on the IS-LM, that the rise is the equilibrium level of
income is actually less than predicted by the simple 45° model.
The rate
of
interest LM0
i1
i0
IS1
IS0
Y0 Y2 Y1 National Income
Part of the predicted increase in National Income is crowded out by a higher rate of interest.
Graphically, this is quite clear. But what does it means in terms of economics?
At first glance it appears contradictory to the 45° model.
In fact, it is more sophisticated. Basically, the 45° model, from which we derived the IS, is too naïve in
the way that it shows a change in aggregate demand leading to a change in income while completely
ignoring the money side of the economy.
The increase in spending does tend to increase income. But such an increase in income will lead to an
increase in the demand for money. With money supply fixed, the increased demand for money will push
up the market rate of interest.
When the rate of interest rises, the level of investment spending in the economy will decline, as
investment is inversely related to the rate of interest.
As a result, the final change in income will be less than the full multiplier effect in the 45° model would
suggest. Part of it is crowded out by the rise in the rate of interest.
The IS Schedule shifts to the right and the extent of this horizontal shift is precisely equal to the full
multiplied effect on income as per the 45° model, but actual income (output) eventually rises by less
because there is then an interest rate induced decline in aggregate demand.
This can be seen as two effects within the 45° model – see overleaf……….

This can be seen as two effects within the 45° model:
1. An increase in autonomous spending pushes up aggregate demand, increasing output and

causing the IS to shift to the right.
Aggregate AE1
Expenditure
AE0
−
A1 − di0
−
A0 − di0
45°
The rate
of
interest
i0
IS0 IS1

2. But as output begins to rise, so too does income. An increase in income leads to an increase in
the demand for money. With real money supply fixed, monetary equilibrium can only be
maintained at a higher rate of interest.
As the interest rises, this induces the level of (non-autonomous) investment to decline.
Aggregate AE1
Expenditure
AE2
AE0
−
A1 − di0
−
A1 − di1
−
A0 − di0
45°
The rate
of
interest
LM0
i1
i0
IS0 IS1
Thus output and income do not rise by as much as the simple 45° model suggests. Part of it is crowded
out by a rise in the rate of interest.

Obviously, the flatter that the LM curve is, the closer is the actual change in income to the one predicted
by the 45° model - only partial crowding out occurs.
The rate
of
interest
Y predicted by
the 45° model
LM0
i1
i0
IS1
IS0
Y0 actual Y Y1 National Income
And the steeper the LM is, the closer the change in income is to zero - almost total crowding out.
The rate
of LM0
interest
i1
i0
Y predicted by
the 45° model
IS1
IS0
actual Y

18.13 ADJUSTMENT TOWARDS EQUILIBRIUM
We've just shown an adjustment to a new equilibrium, given an autonomous change in spending. It
involved changes in income and the rate of interest through time.
But how is the new equilibrium actually reached? The IS - LM model makes two main assumptions:
1. Output Adjusts
Output increases whenever there is excess demand for goods, and declines when there is an excess
supply of goods.
Although an assumption, this reflects reality. Think about it on a Micro level: firms do adjust their output
to avoid undesired accumulation or rundown of inventory.
2. Interest Rates Adjust
The market rate of interest rises if there is excessive demand for money, and declines if there is an
excess supply of money.
Once again, although an assumption, it is not unrealistic. The adjustment occurs because an excess
demand for money implies there is an excess supply of other financial assets - gold, bonds, etc. In an
effort to acquire more money, people sell off assets, thereby causing the prices to fall, or their yields to
rise. The interest rate is merely the yield of money.
The rate LM
of Excess Supply of Money
interest
Excess Supply of Goods
Excess Supply Excess Demand

of Money for Money
i*
Excess Demand Excess Supply
for Goods of Goods
Excess Demand for Money

Excess Demand for Goods
IS
Y* National Income
The rate LM
of 1
interest ESG
ESM
4
EDG
ESM EDM
i*
ESG
2
EDM
EDG
3
IS
Y* National Income

The Goods Market The Money Market

Region Disequilibrium Adjustment: Disequilibrium Adjustment:
Output [Y] Interest Rate [i]
1 ESG ESM
Excess Supply of Goods Y falls Excess Supply of Money i falls
2 ESG EDM
Excess Supply of Goods Y falls Excess Demand for Money i rises
3 EDG EDM
Excess Demand for Goods Y rises Excess Demand for Money i rises
4 EDG ESM
Excess Demand for Goods Y rises Excess Supply of Money i falls
RAPID ASSET MARKET ADJUSTMENT
It is a reasonable - and useful - assumption to make that money markets adjust quickly.
Since the money market can adjust simply through the buying and selling of bonds, the interest rate will
adjust rapidly and hence we can assume the money market will very soon be in equilibrium again.
If this is so, we can say that the economy will always be in monetary equilibrium.
If the economy is always in monetary equilibrium, the implication is that the economy is always on the
LM curve.
Any departure from equilibrium in the money market will be almost instantaneously eliminated through
an interest rate adjustment.
In disequilibrium, therefore, we simply move along the LM curve.
The rate
of interest LM
i%
i* • E
IS
Y* National Income
[$]

18.14 MONETARY AND FISCAL POLICY
Governments attempt to control the macroeconomy by means of monetary policies and fiscal policies.
Monetary Policy: The tool of monetary policy is manipulation of the money supply - and hence the
market rate of interest.
The initial impact is felt in the assets market, with knock-on effects in the goods
market.
Fiscal Policy: The tools of fiscal policy are the manipulation of the level of government spending
and the rate of income tax.
The initial impact is felt in the goods market, with knock-on effects in the assets
market.
Monetary Policy
An increase in the real money stock shifts the LM curve to the right The assets market adjusts rapidly.
The interest rate drops, which stimulates investment. The increased investment has a multiplied impact
upon income - through time.
Once all adjustments have taken place, a rise in real money stock leads to lower interest rates (quick fall,
then slow rise) and higher equilibrium income (slow rise).
The rate LM0

of interest LM1
i0
i2
i1 IS0
The Transmission Mechanism
The process by which changes in monetary policy affects the level of output (income) is known as the
Transmission Mechanism.
[1] [2] [3] [4]
A change Portfolio adjustments Spending adjusts Output adjusts

in the lead to a change to the to the
real in asset prices change in change in
money supply. and interest rates. aggregate demand.
interest rates.

The Liquidity Trap……. revisited
If Keynes was right about the Liquidity Trap − which, you will recall, is where the interest rate is so low
that everybody in a society holds cash and no bonds − how can this be viewed in terms of IS-LM analysis?
If the demand for money becomes infinitely elastic below a certain, critical rate of interest, you will recall,
manipulating the money supply has no effect on the market rate of interest.
The rate M0 M1
of
interest
[%]
i* L
MS0 MS1 Money Stock

[$]
What does this imply for the LM schedule? The LM curve is horizontal, and changes in the money supply
have no effect on it whatsoever.
The rate The rate

of of
interest interest
[%] [%]
i* L LM
Money Stock National Income

[$]
The Liquidity Trap and No Crowding Out
If the economy is in a Liquidity Trap, the LM is horizontal which implies there is no crowding out. If the
government increases spending, the rate of interest is not altered, and income rises by the full multiplied
effect.
[See next page.]

The rate
of
interest
i0 LM0
IS1
IS0
No crowding out.
∆Y = ∆G x Multiplier
The extent to which crowding out does or does not take place is one of the greatest
controversies in Macroeconomics.
Fiscal Policy
Pure Keynesians believe that the LM curve is flat, and thus there will be no crowding out - as we saw
with the Liquidity Trap - and therefore Monetary Policy is pointless. They believe a government should
concentrate on fiscal policy alone, stimulating aggregate demand through a mixture of taxation and
spending.
Pure Monetarists are at the other extreme. They believe that the LM curve is vertical, and therefore
fiscal policy is pointless: its effects will be entirely crowded out. They believe fiscal stimulation will lead
to higher rates of interest, but no change in income (output). They believe a government should
concentrate on monetary policy alone, controlling the money supply.
Their argument is based on a complete rejection of the link between the demand for money (cash) and
the rate of interest.
L  L(i) or L = kY − hi where h = 0.
If h = 0, then when the money market is in equilibrium, given a real money supply of M, then:
M = L = kY
The amount of money you demand is purely a function of your income.
Note: M is the real money supply (i.e. nominal money supply discounted by the general price level), thus:
M
= kY
P
Multiplying both sides by P:
M = PkY
which, of course, brings us back to the Cambridge Cash Balance approach.

The Monetarist View of the Demand for Money:
L0
The rate
of
interest
CB0 Cash Balances
… thus: The Monetarist View of the LM:
The rate LM0

of
interest
National Income
and hence: the Monetarist view of any fiscal expansion:
LM0
The rate
of
interest
i1
i0
IS1
IS0
Y0 National Income
…..is that it will always be totally crowded out.

18.15 The Paradox of Thrift …… re-visited
Back on pages God knows what we examined the Keynesian concept of the Paradox of Thrift through
the eyes of the simple 45 degree model. Now that we have introduced the IS/LM, we can have a look
at the Paradox of thrift in a more sophisticated manner. [Even though the result here may be ambiguous,
it is this kind of IS/LM analysis we will invoke next term when playing with the IS/LM in an open economy
framework, where the results will be much more precise than what follows.]
You will recall that the concept of the Paradox of Thrift is that an increase in savings will actually lead to
a decrease in savings in an economy.
If there is an increase in savings, there will be less spending. The IS schedule will shift to the left.
Moreover, if we increase the level of savings, this means that the Marginal Propensity to Save must have
risen - thus the MPC has declined, leading to a smaller multiplier effect and hence a steeper IS schedule.
i LM0
i0
i1
IS1 IS0
Y1 Y0 Y
This leads to a lower level of National Income and a lower rate of interest.
So…..is there a Paradox of Thrift?
We have to check to see what has happened to the level of savings in the economy. If they have gone
up, then no: there is no paradox (an increase in savings has led to an increase in savings). If they have
dropped, then there is a paradox (an increase in savings has caused a decline in savings!]
At first glance at the diagram, it may seem impossible to determine what has happened to savings. But
what we have to do is to see if we can work out what has happened to investment spending. We can
then infer what has happened to savings because, ceteris paribus, Investment will be equal to Savings
[see page 321 the very first page about the 45° model!]
From chapter 14, we know that investment is positively linked in national income (the bigger an economy,
the more investment there will be) but is negatively linked to the rate of interest (the higher the rate of
interest will be).
In the above diagram, income has declined from Y 0 to Y1. Therefore investment MUST HAVE declined
too (and hence savings).
[But this is as unsophisticated as the 45° model, because we are ignoring the rate of interest like we did
earlier.]

In the diagram on the previous page, the rate of interest has dropped from i0 to i1. Therefore investment
MUST HAVE increased (and hence savings must have increased too).
So: Is there a Paradox of Thrift?
WE CAN”T SAY!!!!! It depends upon whether the interest-induced increase in investment outweighs the
income-induced decline in investment.
[Don’t worry: within the next three weeks there will be instances where we can say FOR SURE that there
is a Paradox of Thrift; and other instances where we can say FOR SURE that there is not a Paradox of
Thrift. It all depends on whether there is perfect capital mobility, or not; and whether the exchange rate
is flexible or fixed . . . . and what we can deduce about the level of national income and the final rate of
interest . . . . . . but all that is yet to come.]
At last . . . . . we have all of the foundations of Macroeconomics in place.
We are now ready to begin proper Macro analysis, and enjoy all the fun that it entails . . . . .
The jigsaw will hopefully soon start to make sense.
See you next week.

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2022 Introduction To Economics Notes 18

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BRITISH UNIVERSITY VIETNAM

The assets market: Money markets, Bond markets.

Given a fixed supply of money, the

L0 [The Demand for Money]

Introduction to Economics 439

L0 [The Demand for Money]

The IS - LM model is all about that joint equilibrium.

440 Introduction to Economics

THE ASSETS THE GOODS

Money, Bonds Aggregate Demand,

L = The demand for Money (or liquid assets)

I=S − or the IS for short

and simultaneous equilibrium in the money markets:

Demand for Money = Supply of Money

L=M − or the LM for short

Introduction to Economics 441

18.1 DERIVATION OF THE IS SCHEDULE

The basic model (closed economy):

where: C = a + bYd; Yd = Y – T and I = I – di

The resultant level of national income will be Y0, as shown above.

442 Introduction to Economics

Then the interest rate falls to i1:

This results in a higher level of national income – Y1.

Then the interest rate falls again, this time to i2:

The resultant level of national income is an even higher Y 2.

Introduction to Economics 443

1. At the initial (high) rate of interest i0:

444 Introduction to Economics

Introduction to Economics 445

446 Introduction to Economics

Join the dots …

… and you have the IS schedule.

Introduction to Economics 447

18.2 THE SLOPE OF THE IS CURVE

The gradient of the IS curve is determined by two factors:

The interest response of investment (d)

The magnitude of the multiplier (M)

… then the IS curve is relatively flat.

Introduction to Economics 449

The bigger the multiplier, the flatter will be the IS schedule.

The smaller the multiplier, the steeper will be the IS schedule.

If the multiplier is large - i.e. the AE is relatively steep ....

… and thus the IS curve is relatively flat.

450 Introduction to Economics

Introduction to Economics 451

18.3 THE POSITION OF THE IS CURVE

452 Introduction to Economics

18.4 POSITIONS OFF THE IS CURVE

Introduction to Economics 453

All points below and to the left

Excess All points above and to the right

454 Introduction to Economics

 It is negatively sloped because a decrease in the rate of interest increases

 The position of the IS curve is determined by the level of autonomous spending in

whereas a decrease in spending

 At points At points to the right

Introduction to Economics 455

18.5 THE LM SCHEDULE

More specifically, we can now say that:

where: L is the demand for money

456 Introduction to Economics

Cash Balances (M1)

Cash Balances (M1)