The Goods and Financial Markets: The I S-L M Model

Product Market
 Goods and Financial Markets: The IS-LM Model
Q1. How output and the interest rate are determined in the short run?

➢ IS-LM developed by J R Hicks and Alvin Hansen (1937) in their classic article
"Keynes and the Classics” .
➢ analysis allows us to solve for income(Y) and the interest rate(i) J R Hicks
simultaneously.
➢ analyse the impacts of Monetary and Fiscal Policy changes on the
economy and provide appropriate solution to business cycle issues.
➢ Simultaneous equilibrium between Goods Market and Financial Markets

Fundamental inflexibility assumptions:

Alvin Hansen
W : Fixed
P : Fixed
i : Flexible
In all these cases W and P are assumed to be constant
 Goods and Financial Markets: The IS-LM Model

Simple(Classical) Model Keynesian IS-LM

Income Fixed Variable Variable

Interest Rates Fixed Fixed Variable

Price Fixed Fixed Fixed

Consumption Autonomous Functions of Income Functions of Income

Product
Market

Investment Autonomous Autonomous Functions of Interest Rate

Financial

Money Supply Not Included Not Included Autonomous.

Market

Functions of Income and Functions of Income and

Money Demand Not Included Interest Rate Interest Rates
1. The Goods Market and the IS Relation:
• Product Market Equilibrium when Y=Z.
• In the simple model the interest rate did not affect the demand for goods.

A. Two Sector Model

❖ Product Market Eqm.(Keynes) :
Y= C+ I
or ҧ
Y= C (Y) + 𝐼………(1) The Top Companies in
𝐼 ҧ i.e. autonomous Investment India Under expansion

• In Keynesian Model Investment was assumed to be constant for simplicity (𝐼).ҧ •Jindal Steel & Power
•Adani Ports
• In fact, Investment depends on production Y (or level of sales (+)) and the interest rate i (-). •Opto Circuits
•Ola Cabs
• Accenture

❖ Product Market Eqm.(Hicks ): 𝐼 = 𝐼(𝑌, 𝑖)

(+, −)
Y=C(Y)+ I(i)…………….(2)
1. The Goods Market and the IS Relation
Determining Output

• IS Curve: The IS curve shows the relationship between the rate of interest(i) and national
income (output, Y), with the product market equilibrium.

❖ Product Market Eqm:

Taking into account the investment relation above,
Y=C(Y)+ I(i)…………….(2) Or S=I the equilibrium condition in the goods market becomes:
Where C = Co+c1Y 0<c1<1
I = I0-h i , h>0 we know Y=C0+c1Y+I0-hi
=> Y=C0+c1Y+I0-hi
1
=> Y-C0-c1Y = I0-hi……..(3) => 𝑌 = C0 + I0 − ℎi …..(4)
1 − 𝑐1
=> S(Y) = I(i)…………..(3a)
=> Y=f(i)……(5) IS Curve
1. The Goods Market and the IS Relation
Example:
Let C(Y)=10+0.5Y
I(i)=200-2000i
So Y= C+I
=>Y=10+0.5Y+200-2000i
=>Y=420-4000i

If i=6%, then Y= 180

The IS curve is the locus of point showing equilibrium

point of the product market at different levels of
interest rate, savings and income.
1. The Goods Market and the IS Relation
Equilibrium in the Goods Market
➢ The demand for goods is an increasing function of
output.
➢ Equilibrium requires that the demand for goods be
equal to output.
➢ ZZ the aggregate demand curve is upward-sloping
because, for a given value of the interest rate, an
increase in output leads to an increase in the demand C0+c1Y+I0-hi
for goods through its effects on consumption and
investment.
➢ Z Z is a curve rather than a line because we have not
assumed that the consumption and investment relations
are linear.
➢ Z Z is flatter than the 45-degree line because we have
assumed that an increase in output leads to a less than
one-for-one increase in demand.
➢ The intersection of ZZ and the 45-degree line (point A)
is the equilibrium level of output.
1. The Goods Market and the IS Relation
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.
b. Equilibrium in the goods market implies 180
that an increase in the interest rate leads
to a decrease in output.

Y = 420 – 4000 i
The IS curve is therefore downward sloping.
6%
180
1. The Goods Market and the IS Relation
Shift in IS Curve ( due to Demand shocks, I )

• Downward-sloping IS curve: Equilibrium in the

goods market implies that an increase in the
interest rate leads to a decrease in output.

• Shifting the IS curve: Changes in factors that

decrease (increase) the demand for goods given
the interest rate shift the IS curve to the left (right).
• A decrease in I shifts the IS curve to the left.
• Due to increase in Tax
• Factors that shift IS Curve are C, I, G,T, or
NX
2. The Financial Market and the LM Relation
• Financial (Money) Market Equilibrium: when Demand for Money(Md) is equal to Supply of Money (Ms).
The interest rate is determined by the equality of the supply of and the demand for money:

• Keynes:
• Supply of Money is fixed : ሜ
𝑀𝑆 = 𝑀𝑠
• Demand for Money : 𝑀𝑑 = 𝑀𝑇 𝑑 + 𝑀𝑆𝑃 𝑑
𝑊ℎ𝑒𝑟𝑒, 𝑀𝑇 𝑑 = 𝑘𝑌, 𝑎𝑛𝑑, 𝑀𝑆𝑃 𝑑 = 𝐿(𝑖)

• MTd= Transaction and Precautionary Demand for Money

• MdSp= Speculative Demand for Money
• Ms = nominal money stock
• Y = nominal income
• i = nominal interest rate
2. The Financial Market and the LM Relation
• Money Market Equilibrium: when demand for money is equal to supply of money
ሜ . . . . . . . . (6)
Md= 𝑀𝑠.

• The LM relation: In equilibrium, the real money supply is equal to the real money demand,
which depends on real income, Y, and the interest rate, i:
ሜ
𝑀𝑠 𝑘𝑌+𝐿(𝑖)
= ………(7)
𝑃 𝑃

Recall: before, we had the same equation nominal terms (nominal income and nominal money supply).
Dividing both sides by P (the price level) gives us the above equation in real terms.
2. The Financial Market and the LM Relation
• LM curve shows the relationship between interest rate(i) and national income(Y) with
Money Market Equilibrium.

ሜ = 𝑀𝑑
𝐸𝑞𝑢𝑙𝑖𝑏𝑟𝑖𝑢𝑚: 𝑀𝑠
𝑀𝑑 = 𝑀𝑇 𝑑 + 𝑀𝑆𝑃 𝑑
ሜ = 𝑘𝑌 + 𝐿(𝑖)
=> 𝑀𝑠
𝑊ℎ𝑒𝑟𝑒, 𝑀𝑇 𝑑 = 𝑘𝑌, 𝑎𝑛𝑑, 𝑀𝑆𝑃 𝑑 = 𝐿(𝑖)
ሜ = 𝑘𝑌 + 𝐿ሜ − 𝑙𝑖
=> 𝑀𝑠
𝐿𝑒𝑡, 𝑀𝑆𝑃 𝑑 = 𝐿ሜ − 𝑙𝑖
1
ሜ − 𝐿ሜ + 𝑙𝑖)
=> 𝑌 = (𝑀𝑠 l >0
𝑘

𝑆𝑜, 𝒀 = 𝒇(𝒊). . . . . . . . . (𝟖)

2. The Financial Market and the LM Relation
Example:
ሜ = 150
𝐿𝑒𝑡: 𝑀𝑠

𝑀𝑡 = 𝑘𝑌 = 0.5𝑌

𝑀𝑠𝑝 = 𝐿ሜ − 𝑙𝑖 = 150 − 1500𝑖

𝑀𝑑 = 𝑘𝑦 + 𝐿ሜ − 𝑙𝑖 = 0.5𝑌 + 150 − 1500𝑖

1
=> 𝑌 = (150 − 150 + 1500𝑖)
0.5
=> 𝑌 = 3000𝑖

𝑰𝒇 𝒊 = 𝟔%, 𝒀 = 𝟏𝟖𝟎
• LM curve is the locus of point showing equilibrium parts of the
money market at different levels of interest rate, income and
demand for money.

With fixed interest rate or low interest rate LM curve will be flat
2. The Financial Market and the LM Relation
Deriving the LM Curve
b) Equilibrium in the financial markets
a. The Effects of an Increase in Income on the Interest Rate
implies that an increase in income
leads to an increase in the interest
rate. The LM curve is therefore
upward sloping.
2. The Financial Market and the LM Relation
Shifts of the LM Curve

An increase in Money Supply

causes the LM curve to shift
down, as interest rate goes
down.
3. Putting the IS and the LM Relations Together
1
• Product Market: Y=f(i) 𝐼𝑆 Re 𝑙 𝑎𝑡𝑖𝑜𝑛: 𝑌 = 𝐶 + 𝐼0 − ℎ𝑖
1 − 𝑐1 0
1
• Money Market : Y=f(i) 𝐿𝑀 Re 𝑙 𝑎𝑡𝑖𝑜𝑛: 𝑌 = (𝑀𝑠 ሜ − 𝐿ሜ + 𝑙𝑖)
𝑘

When the IS curve intersects

the LM curve, both goods and
• Ms>Md financial markets are in equilibrium.
S>I
Equilibrium in Money market
Equilibrium in Goods market
• Md>Ms
I>S
4. Putting the IS and the LM Relations Together
B. Three Sector Model

❖ Product Market Eqm.(Hicks ): Y=C+I+G ❖ Financial Market Eqm.(Hicks ):

Where, No change in Financial market equilibrium
C= C0+c1(Y-T); I=I0-hi, h>0; G=G0; T=T0+tY, 0<t<1 condition:
𝐸𝑞𝑢𝑙𝑖𝑏𝑟𝑖𝑢𝑚: 𝑀𝑠 ሜ = 𝑀𝑑
Substituting Y= C0+c1(Y-T0-tY)+I0-hi+G0
=>Y=1−c1+c t (C0-cT0+I0+G0-h i)….(1)
1 1 Where Md= MdT+MdSp
=> Y=f(i) ….(2)

Let’s define, C0-c1T0+I0+G0=A0 and 1−c1+c t =Gm

1 1
Then, Y=Gm (A0-hi)
4. Putting the IS and the LM Relations Together
Derivation of the IS Curve: Derivation of the LM Curve:
• Example: Y=C+I+G • Example:
Let C= 100+0.75(Y-T) ሜ = 200 billion
Let MS= 𝑀𝑠
I=200-2000i; G0=100 MdT=ky=0.5Y
T=80+0.20Y MdSp=L0-li=100-2500i
Now Y= Co+c1(Y-T0-tY)+I0-hi+G0
=>Y=(1/1-0.75 (1-0.20))*(100-0.75*80+200-2000i+100) ሜ = 𝑀𝑑
Then Money Market Equilibrium: 𝑀𝑠
=>Y=850-5000i
=>200=0.5Y+100-2500i
Alternatively: I+G=S+T
S=-100+0.25(Y-T) =>Y=200+5000i------------LM Curve
Now, I+G=S+T
=>200-2000i+100=-100+0.25(Y-(80+0.20Y))+80+0.20Y For i=6%, Y=500
=>Y=850-5000i……IS Curve
If i=6%, Then Y=550
4. Putting the IS and the LM Relations Together
IS relation: Y = C(Y − T ) + I (Y , i) + G
M
LM relation: = YL(i )
P

Simultaneous Equilibrium: IS=LM

Y=850-5000i ….from IS Equation
Y=200+5000i …from LM Equation
So,
If i=6.5%, then equilibrium, Y=650
5. Fiscal Policy and Monetary Policy Changes: IS-LM Model
A. Fiscal Policy: Refers to the discretionary changes made in the Government Spending and Taxes intended
to achieve certain economic goals.

Fiscal Policy (Spending and Taxes)

• Shifts IS curve
• increase in Spending or cut in Taxes shifts IS curve to the right and vice versa

B. Monetary Policy: Refers to the discretionary use of the powers of the Monetary Authority to change the
demand for and supply of money in accordance with the need of the economy.

Monetary Policy (money supply)

• Shifts LM curve
• increase in money supply shifts LM curve to the right and vice versa
5. Fiscal Policy and Monetary Policy Changes: IS-LM Model
• Fiscal Policy: • Monetary Policy:
− − −
o Decrease in G–T−
֞ fiscal o Decrease in i ֞ increase in M ֞
contraction ֞ fiscal monetary expansion
consolidation
− − −
o Increase in G–T ֞ fiscal o Increase in i ֞ decrease− in M ֞
expansion monetary contraction ֞ monetary
tightening
o Taxes affect the IS curve, not the
LM curve. o Monetary Policy affects LM curve not IS
curve
5. Fiscal Policy and Monetary Policy Changes: IS-LM Model
The Effects of an Increase in Taxes
5. Fiscal Policy and Monetary Policy Changes: IS-LM Model
The Effects of a Monetary Expansion by A monetary expansion leads to higher
decreasing Interest rate output and a lower interest rate.
6. Using Policy Mix: IS-LM Model

The Effects of Fiscal and Monetary Policy.

Shift of LM Movement of Output Movement in

Shift of IS 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
6. Using Policy Mix: IS-LM Model
German re-unification(Oct 3 1990) and the German Monetary-Fiscal Policy Mix

Selected Macro Variables for Germany, 1991-1994

1991 1992 1993 1994

GDP growth (%) 3.7 3.8 4.5 3.1

Investment growth (%) 5.9 8.5 10.5 6.7

Budget surplus (% of GDP) −2.1 0.2 −1.8 −2.9

(minus sign = deficit)

Interest rate (%) 4.3 7.1 8.5 9.2

6. Using Policy Mix: IS-LM Model
German re-unification(Oct 3 1990) and the German Monetary-Fiscal Policy Mix
6. Using Policy Mix: IS-LM Model
The Clinton-Greenspan Policy Mix

Selected Macro Variables for the United States, 1991-1998

1991 1992 1993 1994 1995 1996 1997 1998
Budget surplus (% of −3.3 − 4.5 − 3.8 − 2.7 − 2.4 − 1.4 − 0.3 0.8
GDP)
(minus sign = deficit)
GDP growth (%) −0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7
Interest rate (%) 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8

Bill Clinton : US President 20 January 1993 – 20 January 2001

Alan Greenspan : FED Chairmen 1987 to 2006
6. Using Policy Mix: IS-LM Model
The Clinton-Greenspan Policy Mix
Deficit Reduction and Monetary Expansion

The appropriate combination of deficit

reduction and monetary expansion can achieve
a reduction in the deficit without adverse
effects on output.
The U.S. Recession of 2001

The Fed cut the federal funds rate from 6.5%

The U.S. Growth Rate, 1999:1 to 2002:4
in January to 2% at the end of 2001.
The U.S. Recession of 2001

President George Bush also cut

taxes in 2001 and 2002 budgets.
The events of September 11, 2001
also lead to an increase in spending
on defense and homeland security.

U.S. Federal Government Revenues and Spending (as

Ratios to GDP), 1999:1 to 2002:4
The U.S. Recession of 2001
What happened in 2001 was the
following:

▪ The decrease in investment

demand led to a sharp shift of
the IS curve to the left, from IS
to IS”.

▪ The increase in the money

supply led to a downward shift
of the LM curve, from LM to
LM’.

▪ The decrease in tax rates and

the increase in spending both
led to a shift of the IS curve to
the right, from IS’’ to IS’.

The U.S. Recession of 2001

Deficit Reduction: Good or Bad for Investment?

• Equilibrium in the goods market implies

I = S + (T − G)

• Given private saving (S), a lower government deficit (higher T − G) means

higher I.

• However, a fiscal contraction lowers output and so S goes down by more

than T − G increases, so I decreases.
Deficit Reduction: Good or Bad for Investment?
The Effects of a Combined Fiscal Consolidation and a Monetary Expansion

The fiscal consolidation shifts the IS

curve to the left.
A monetary expansion shifts the LM
curve down.
This allows for the reduction in the
deficit without a recession.
References
• Ch 5 Macroeconomics by Oliver Blanchard, 7 E
• Ch 12 and 13 Macroeconomies by N G Mankiw,11 E, McMillian Learning

Additional Readings/ references ( optional) more understanding.

• Dimand, Robert, Edward Nelson, Robert Lucas, Mauro Boianovsky, David Colander, Warren Young, et al. The IS-LM
Model: Its Rise, Fall, and Strange Persistence. Raleigh, NC: Duke University Press, 2005.
• Young, Warren, and Ben-Zion Zilbefarb. IS-LM and Modern Macroeconomics. New York: Springer, 2001.
Thank You