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BBA 4 Semester
Macroeconomics
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2 Unit Notes
What Is the IS-LM Model?

The IS-LM model appears as a graph that shows the intersection of goods and the
money market. The IS stands for Investment and Savings. The LM stands for
Liquidity and Money. On the vertical axis of the graph, ‘r’ represents the interest
rate on government bonds. The IS-LM model attempts to explain a way to keep the
economy in balance through an equilibrium of money supply versus The IS-LM is
also sometimes called the Hicks-Hansen model.

Breaking Down IS-LM

In order to gain a full understanding of how the four components work together, it
is important to first understand what each component means on its own.

Investment

In macroeconomics, an investment is defined as a quantity of goods purchased in a

period of time that are not consumed or used in that time. Investment increases as
interest rates decrease.

Savings

Savings, sometimes known as deferred consumption, is income that is not spent.

As interest rates fall, savings also fall, as most households take advantage of lower
interest rates to make purchases.

Liquidity

Liquidity refers to the demand for and amount of real money, in all of its forms, in
an economy. Those who part with liquidity, in the form of saving or investing, are
rewarded through interest payments or dividends.

Money

Money is a any verifiable record or item that can be used as a means of paying for
goods and services.

Putting IS-LM Together

The IS curve describes the goods market. The IS curve slopes down and to the
right, representing the fact that as interest rates fall, people and businesses try to
invest more in long-lasting goods like houses, cars, and equipment. When interest
rates fall, families also tend to put less away for savings and spend more on
consumer goods. Thus the effect of a falling interest rate is an increase in GDP
through greater investment and less personal savings.

The LM curve describes the money market. The LM curve slopes up and to the
right. It represents what economists call the money market. As the economy
expands, banks and other financial institutions need funds to support the extra
investment. To get those funds, they encourage consumers to deposit more of their
cash into longer term deposits like certificates of deposit or bonds.

The IS relationship and LM relationship create opposing forces. On the one hand, a
falling interest rate tends to cause the economy to expand. On the other hand, an
expanding economy causes interest rates to rise. Where the two curves meet, the
forces are balanced and the economy is in equilibrium.

The Pros and Cons of the IS-LM Model

The IS-LM model is a controversial economic tool. It has a number of detractors,

including the creator Hicks himself, who said that the model is best used “as a
classroom tool” rather than in any practical application. There are, however, pros
to using the model.

Learn more about the benefits and drawbacks, below.

Pros:

 The model is commonly used to explain Keynesian macroeconomics on a

basic level.
 It is a good introduction to and first approximation of policy-making.

Cons:

 Does not take into account a huge variety of factors the come to play in the
modern economy, such as international trade, demand, and capital flows.
 Takes a simplistic approach to fiscal policy, the money market, and money
supply. Central banks today in most advanced economies prefer to control
 interest rates on the open market—for example, through sales of securities
and bonds. This model cannot account for that should not be used as the sole
tool in determining monetary policy.
 Does not reveal anything about inflation or international trade, and does not
provide insight or recommendations toward formulating tax rates and
government spending.

The IS-LM model is a great way to explain Keynes’s ideas about how monetary
systems, markets, and governmental actors can work together to drive economic
growth. However, as a practical model to advise on fiscal or spending policy, it
falls short.

Why does IS Curve Slope Downward?

What accounts for the downward-sloping nature of the IS curve. As seen above,
the decline in the rate of interest brings about an increase in the planned investment
expenditure. The increase in investment spending causes the aggregate demand
curve to shift upward and therefore leads to the increase in the equilibrium level of
national income. Thus, a lower rate of interest is associated with a higher level of
national income and vice-versa. This makes the IS curve, which relates the level of
income with the rate of interest, to slope downward.

Steepness of the IS curve depends on (1) the elasticity of the investment demand
curve, and (2) the size of the multiplier. The elasticity of investment demand
signifies the degree of responsiveness of investment spending to the changes in the
rate of interest.

Shifts in the LM Curve:

Another important thing to know about the IS-LM curve model is that what brings
about shifts in the LM curve or, in other words, what determines the position of the
LM curve. As seen above, a LM curve is drawn by keeping the stock or money
supply fixed.

Therefore, when the money supply increases, given the money demand function, it
will lower the rate of interest at the given level of income. This is because with
income fixed, the rate of interest must fall so that demands for money for
speculative and transactions motive rises to become equal to the greater money
supply. This will cause the LM curve to shift outward to the right.
The other factor which causes a shift in the LM curve is the change in liquidity
preference (money demand function) for a given level of income. If the liquidity
preference function for a given level of income shifts upward, this, given the stock
of money, will lead to the rise in the rate of interest for a given level of income.
This will bring about a shift in the LM curve to the left.

It therefore follows from above that increase in the money demand function causes
the LM curve to shift to the left. Similarly, on the contrary, if the money demand
function for a given level of income declines, it will lower the rate of interest for a
given level of income and will therefore shift the LM curve to the right.

The LM Curve: The Essential Features:

From our analysis of the LM curve, we arrive at its following essential

features:

1. The LM curve is a schedule that describes the combinations of rate of interest

and level of income at which money market is in equilibrium.

2. The LM curve slopes upward to the right.

3. The LM curve is flatter if the interest elasticity of demand for money is high. On
the contrary, the LM curve is steep if the interest elasticity demand for money is
low.

4. The LM curve shifts to the right when the stock of money supply is increased
and it shifts to the left if the stock of money supply is reduced.

5. The LM curve shifts to the left if there is an increase in the money demand
function which raises the quantity of money demanded at the given interest rate
and income level. On the other hand, the LM curve shifts to the right if there is a
decrease in the money demand function which lowers the amount of money
demanded at given levels of interest rate and income.

Critique of the IS-LM Curve Model:

The IS-LM curve model makes a significant advance in explaining the

simultaneous determination of the rate of interest and the level of national income.
It represents a more general, inclusive and realistic approach to the determination
of interest rate and level of income.
Further, the IS-LM model succeeds in integrating and synthesising fiscal with
monetary policies, and theory of income determination with the theory of money.
But the IS-LM curve model is not without limitations.

Firstly, it is based on the assumption that the rate of interest is quite flexible, that
is, free to vary and not rigidly fixed by the Central Bank of a country. If the rate of
interest is quite inflexible, then the appropriate adjustment explained above will
not take place.

Secondly, the model is also based upon the assumption that investment is interest-
elastic, that is, investment varies with the rate of interest. If investment is interest-
inelastic, then the IS-LM curve model breaks down since the required adjustments
do not occur.

Characteristics of the IS-LM Graph

The IS-LM graph consists of two curves, IS and LM. Gross domestic product
(GDP), or (Y), is placed on the horizontal axis, increasing to the right. The interest
rate, or (i or R), makes up the vertical axis.

The IS curve depicts the set of all levels of interest rates and output (GDP) at
which total investment (I) equals total saving (S). At lower interest rates,
investment is higher, which translates into more total output (GDP), so the IS curve
slopes downward and to the right.

The LM curve depicts the set of all levels of income (GDP) and interest rates at
which money supply equals money (liquidity) demand. The LM curve slopes
upward because higher levels of income (GDP) induce increased demand to hold
money balances for transactions, which requires a higher interest rate to keep
money supply and liquidity demand in equilibrium.

The intersection of the IS and LM curves shows the equilibrium point of interest
rates and output when money markets and the real economy are in balance.
Multiple scenarios or points in time may be represented by adding additional IS
and LM curves.

In some versions of the graph, curves display limited convexity or concavity.

Shifts in the position and shape of the IS and LM curves, representing changing
preferences for liquidity, investment, and consumption, alter the equilibrium levels
of income and interest rates.
Limitations of the IS-LM Model

Many economists, including many Keynesians, object to the IS-LM model for its
simplistic and unrealistic assumptions about the macroeconomy. In fact, Hicks
later admitted that the model's flaws were fatal, and it was probably best used as "a
classroom gadget, to be superseded, later on, by something better."3 Subsequent
revisions have taken place for so-called "new" or "optimized" IS-LM frameworks.

The model is a limited policy tool, as it cannot explain how tax or spending
policies should be formulated with any specificity. This significantly limits its
functional appeal. It has very little to say about inflation, rational expectations, or
international markets, although later models do attempt to incorporate these ideas.
The model also ignores the formation of capital and labor productivity.

Monetary versus Fiscal Policy

Monetary policy and fiscal policy are two different tools that have an impact on the
economic activity of a country.

Monetary policies are formed and managed by the central banks of a country and
such a policy is concerned with the management of money supply and interest rates
in an economy.

Fiscal policy is related to the way a government is managing the aspects of

spending and taxation. It is the government’s way of stabilising the economy and
helping in the growth of the economy.

Governments can modify the fiscal policy by bringing in measures and changes in
tax rates to control the fiscal deficit of the economy.

Below are certain points of difference between the monetary and fiscal policy

Monetary Policy Fiscal Policy

Definition
It is a financial tool that is used by the
It is a financial tool that is used by the
central government in managing tax
central banks in regulating the flow of
revenues and policies related to
money and the interest rates in an
expenditure for the benefit of the
economy
economy
Managed By
Central Bank of an economy Ministry of Finance of an economy
Measures
It measures the interest rates applicable It measures the capital expenditure and
for lending money in the economy taxes of an economy
Focus Area
Stability of an economy Growth of an economy
Impact on Exchange rates
Exchange rates improve when there is
It has no impact on the exchange rates
higher interest rates
Targets
Monetary policy targets inflation in an Fiscal policy does not have any specific
economy target
Impact
Monetary policy has an impact on the Fiscal policy has an impact on the budget
borrowing in an economy deficit

Crowding Out Effect :

Definition: A situation when increased interest rates lead to a reduction in private

investment spending such that it dampens the initial increase of total investment
spending is called crowding out effect.

Description: Sometimes, government adopts an expansionary fiscal policy stance

and increases its spending to boost the economic activity. This leads to an increase
in interest rates. Increased interest rates affect private investment decisions. A high
magnitude of the crowding out effect may even lead to lesser income in the
economy.

With higher interest rates, the cost for funds to be invested increases and affects
their accessibility to debt financing mechanisms. This leads to lesser investment
ultimately and crowds out the impact of the initial rise in the total investment
spending. Usually the initial increase in government spending is funded using
higher taxes or borrowing on part of the government.
Definition of crowding out – when government spending fails to increase overall
aggregate demand because higher government spending causes an equivalent fall
in private sector spending and investment.

Question: Why does an increase in public sector spending by the government

decrease the amount the private sector can spend?

If government spending increases, it can finance this higher spending by:

1. Increasing tax
2. Increasing borrowing

Impact of higher government spending on aggregate demand

1. Increasing tax. If the government increases tax on the private sector, e.g.
higher income tax, higher corporation tax, then this will reduce the
discretionary income of consumers and firms. Ceteris paribus, increasing tax
on consumers will lead to lower consumer spending. Therefore, higher
government spending financed by higher tax should not increase overall AD
because the rise in G (government spending) is offset by a fall in C
(consumer spending).
2. Increasing borrowing. If the government increases borrowing. It borrows
from the private sector. To finance borrowing, the government sell bonds to
the private sector. This could be private individuals, pension funds or
investment trusts. If the private sector buys these government securities they
will not be able to use this money to fund private sector investment.
Therefore, government borrowing crowds out private sector investment.