24-10-2023

Errol D’Souza
(Y − T ) − C + T − G = I
The IS LM Model
Private Government
Savings Savings
Errol D’Souza
Private savings is given by: 𝑆pvt = 𝑆pvt 𝑖 , 𝑌 , 𝑇, 𝑌 ∗ , 𝜋 𝑒
(+) (+) (−) (−) (−)

Government savings (T – G) is: Sgovt = T − G = Sgovt  T , G 

 (+ ) (− ) 

The equilibrium condition for the goods or output

market may then be written as:
Indian Institute of
Advanced Study
Rashtrapati Niwas 𝑆pvt 𝑖 , 𝑌 , 𝑇 𝑌∗ , 𝜋𝑒 + 𝑆govt 𝑇 , 𝐺 = 𝐼 𝑎 , 𝑖 , 𝜋𝑒
Shimla (+) (+) (−)(−) (−) (+) (−) (+) (−) (+)
Turin School
of Development

Email: errol@iimahd.ernet.in

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Errol D’Souza Errol D’Souza

𝑆pvt 𝑖 , 𝑌 , 𝑇 𝑌 ∗ , 𝜋 𝑒 + 𝑆govt 𝑇 , 𝐺 = 𝐼 𝑎 , 𝑖 , 𝜋 𝑒 Nominal interest rate

(+) (+) (−)(−) (−) (+) (−) (+) (−) (+)
i
𝑆 𝑖 , 𝑌 , 𝑌 ∗ , 𝑇 , 𝐺 𝜋𝑒
Combine private and government savings into an
(+) (+) (−) (+) (−)(−)

aggregate savings function, S = S pvt + S govt

𝑆 𝑖 , 𝑌 , 𝑌∗ , 𝑇 , 𝐺 𝜋𝑒 = 𝐼 𝑎 , 𝑖 , 𝜋𝑒
(+) (+) (−) (+) (−)(−) (+) (−) (+)

I  a ,  e 
 (+) (+) 

S, I
Savings & Investment

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Errol D’Souza Errol D’Souza

Increase in Y Increase in Government Expenditure -

Reduction in government saving (T − G )

i
𝑆 𝑖 , 𝑌 , 𝑌 ∗ , 𝑇 , 𝐺 𝜋𝑒
(+) (+) (−) (+) (−)(−)
i
𝑆 𝑖 , 𝑌 , 𝑌 ∗ , 𝑇 , 𝐺 𝜋𝑒
(+) (+) (−) (+) (−)(−)

I  a ,  e 
 (+) (+) 

S, I
I  a ,  e 
 (+) (+) 

S, I

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Errol D’Souza Errol D’Souza

Deriving the IS Curve
Nominal interest rate
i 𝑆 𝑖 , 𝑌 , 𝑌 ∗ , 𝑇 , 𝐺 𝜋𝑒
(+) (+) (−) (+) (−)(−)
Savings associated with a given income Y0
Panel A Panel B
i i
𝑆 𝑌0 ; 𝑌 ∗ , 𝑇0 , 𝐺0 , 𝜋0𝑒

i0 P/
P i0

I  a ,  e  I
 (+) (+) 

S, I S, I Y0 Y
Savings and Investment
The interest rate where savings equals investment
Figure 8.1: Aggregate Investment and Savings
at income level Y0 is i0

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Errol D’Souza Errol D’Souza

Increase in Income to Y2 Decrease in Income to Y1

Panel A Panel B Panel A Panel B

i i i 𝑆 𝑌1 ; 𝑌 ∗ , … i
𝑆 𝑌0 ; 𝑌 ∗ , 𝑇0 , 𝐺0 , 𝜋0𝑒 𝑆 𝑌0 ; 𝑌 ∗ , 𝑇0 , 𝐺0 , 𝜋0𝑒
𝑆 𝑌2 ; 𝑌 ∗ , 𝑇0 , 𝐺0 , 𝜋0𝑒 𝑆 𝑌2 ; 𝑌 ∗ , …
R R/
i1
i1
i0 P/ i0 P/
P i0 P i0
Q/ Q/
i2 Q
i2 Q i2
i2
I I

S, I Y0 Y2 Y S, I Y1 Y0 Y2 Y
When income increases to Y2 the savings equals
investment conditions occurs at i2

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Errol D’Souza Errol D’Souza

Panel A Panel B Panel A Panel B

i S (Y1;.......) i i i
𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒

S (Y2 ;.......)
R R/ R R/
i1 i1
i1 i1
i0 P/ i0 P/
P i0 P i0
Q/ Q/
i2 Q i2 i2 Q i2
IS IS
I I

S, I Y1 Y2 Y S, I Y1 Y2 Y
𝑌0 = 𝑌 ∗ 𝑌0 = 𝑌 ∗
Figure 8.4: The IS Curve The interest rate – income combinations where savings
equals investment is the IS curve

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Errol D’Souza Errol D’Souza

Increased government expenditure G1  G0 implies decline in govt.
savings (T − G )

Panel A Panel B Panel A Panel B

i S (Y0 ; G1 ,.....) i i i
𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒 𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒

S (Y0 ; T1 ,.....)
Q
i1 Q/
i1 i0
i0 i0 P/
P i0 P/
i1 P
Q i1 Q/

IS (G1 )
IS (T0 )
I IS (G0 ) I
IS (T1 )
S, I 𝑌0 = 𝑌 ∗ Y S, I 𝑌0 = 𝑌 ∗ Y
Increased government expenditure shifts the IS curve Figure 8.6: Increase in Taxes
to the right

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Errol D’Souza Errol D’Souza

Panel A Panel A
i i
Panel B
i
𝑆 𝑌0 ; 𝑌 ∗ , 𝑇0 , 𝐺0 , 𝜋1𝑒 i Panel B

𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒 𝑆 𝑌0 ; 𝑌 ∗ , 𝑇0 , 𝐺0 , 𝜋0𝑒

Q
Q/
i1 i1
i1 Q i1 Q/
i0 i0
P i0 P/ P i0 P/

( ) ( ) IS 1e ( )
I a1 ,  0e
IS (a1 ) I a0 , 1e

I (
a0 ,  0e ) IS (a0 ) I (
a0 ,  0e ) IS ( )
 0e
S, I Y S0 = I 0 S, I 𝑌0 = 𝑌 ∗ Y

Figure 8.7: Increase in Productivity Figure 8.8: Increase in Expected Inflation

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What can we say about slope of IS schedule?

Panel A Panel B Panel A Panel B

i i i S (Y1;.......) i
𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒 𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒

S (Y2 ;.......)
R
i1 Q i1 Q/ i1 R/
i1
i0 i0 P P/
P i0 P/ i0 C/
i2 A B
i2
Q Q/ IS (b large )
I (b large )
(
I a1 ,  0e ) IS (a1 )
(
I a0 ,  0e ) IS (a0 ) I (b small ) IS (b small )
S, I Y S, I Y1 Y2 Y
𝑌0 = 𝑌 ∗
Figure 8.7: Increase in Productivity
Draw two downward sloping investment curves with
different slopes.

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Errol D’Souza Errol D’Souza

What can we say about slope of IS schedule?

Panel A Panel B Panel A Panel B

i i i i
𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒 𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒

i0 P P/ i0 P P/
i0 i0
A B

I (b large ) I (b large )

I (b small ) I (b small )

S, I Y S, I Y0 Y
𝑌0 = 𝑌 ∗ 𝑌0 = 𝑌 ∗
If i declines by amount PA then income increases by AB
Draw two downward sloping investment curves with along inelastic curve and a larger AC along dashed
different slopes. elastic curve.

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Errol D’Souza Errol D’Souza

Panel A Panel B Panel A Panel B

i i i i
𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒 𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒

S (Y2 ;.......) S (Y2 ;.......)

R
i1
i0 P P/ i0 P P/
i0 C/ i0 C/
i2 A B
Q i2 Q/
i2 A B
Q i2 Q/
I (b large ) I (b large )

I (b small ) I (b small ) IS (b small )

S, I Y2 Y S, I Y2 Y
𝑌0 = 𝑌 ∗ 𝑌0 = 𝑌 ∗
If income increases to Y2 then S = I for dashed elastic Joining points P/ and Q/ and extending in both directions
curve at point C (and C/) and for solid inelastic gives IS curve corresponding to solid interest
curve at point Q (and Q/). inelastic investment curve

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Errol D’Souza Errol D’Souza

Hence, the IS curve is steeper or more inelastic when

Panel A Panel B
i S (Y1;.......) i the investment curve is steeper or more inelastic
𝑆 𝑌0; 𝑌 ∗, 𝑇0 , 𝐺0 , 𝜋0𝑒
with respect to changes in the interest rate.
S (Y2 ;.......)
R
i1 R/
i1 Similarly, it can be shown that the IS curve is steeper
i0 P P/
when savings is insensitive to changes in the
i0 C/
i2 A B interest rate or interest inelastic and the savings
Q i2 Q/ IS (b large ) curve is steeper.
I (b large )

I (b small ) IS (b small )
S, I Y1 Y2 Y
𝑌0 = 𝑌 ∗
Joining points P/ and C/ and extending in both directions
gives IS curve corresponding to dashed interest
elastic investment curve

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Errol D’Souza Errol D’Souza

LM Curve:-
Money supply is indep-
i endent of the nominal i Ms =M

interest rate Md
= f (Y , i ) = h + nY − ei
P
Ms =M

Md
(Y0 )
P0
M M
M0 P M0 P
P0 P0

Real money supply is the nominal stock of money The demand for money is inversely related to the
divided by the price level nominal interest rate

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Errol D’Souza Errol D’Souza

i Ms =M i Ms =M
Md Md
= f (Y , i ) = h + nY − ei = f (Y , i ) = h + nY − ei
P P
Ms =Md Ms =Md

i1

i0 i0
Md Md
(Y0 ) (Y0 )
P0 P0
M M
M0 P M0 P
P0 P0
The nominal interest rate adjusts to achieve equilib-
rium between the stock of money and the demand Suppose the interest rate were i1
for money

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Errol D’Souza Errol D’Souza

S d S d
At higher interest rate i1 , M

M
At higher interest rate i1 , M

M
P P P P

People wishing to hold smaller real money balances People wishing to hold smaller real money balances
than supplied by the central bank will attempt than supplied by the central bank will attempt
to get out of money and hold bonds in its place to get out of money and hold bonds in its place

Demand for bonds ↑

Price of bonds
Supply of bonds
(shift of demand curve to
blue line)
Shift due to increase
in demand for bonds
Price of bonds ↑

Bond prices and interest rates are inversely related

Interest rate  till it reaches equilibrium level, i0

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Errol D’Souza

i1

i0
Md
(Y0 )
P0
M
M0 P
P0

Suppose the interest rate were i1 . The interest rate

would decline to i0 as financial portfolios are readj-
usted.
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