The IS-LM Model

Monetary and Fiscal Policy

in the ISLM Model
The Goods and The Money Market
Equilibrium
 Equilibrium of the goods market is achieved when the
goods market is cleared, i.e. , according to Keynes,
planned saving is equal to planned investment.
S=I
OR
Y=C+I
 Equilibrium of the money market requires equality
between the supply of and the demand for money.
Ms = Md
Equilibrium in the Goods Market
 In developing the IS model, investment is
considered as a function of rate of interest ,
consumption and saving as functionsof income.
Investment Function : I = I(r)
Consumption Function : C = C(Y)
Saving Function : S = S(Y)
 Equilibrium in the goods market is achieved when
:-
S(Y) = I(r)
 However, this relationship may beshown
graphically as follows
IS Curve

Slopes downward because

r I Y

IS

Y
4
Properties of IS Curve
 Downward Sloping,
i  C, I  Y*
 Increase/Decrease in autonomous
expenditure will shift the IS curve
Rightward/Leftward.
 The steepness or flatness of the IS curve
describes the elasticity or responsiveness of
C and I to the nominal interest rate.
-- Steep IS curve: inelastic.
-- Flat IS curve: elastic.
Shifts in IS Curve due to taxes
An increase in taxes
shifts the IS curve to
the left.
Hicks’ Interpretation: LM Curve

r LM Curve (L=M): all

LM those combinations of
real interest rates and
income which bring the
money supply equal to
money demand.

Y
Properties of LM Curve
 Upward sloping,
Y  L  i*
 Increase/Decrease in the real money supply
shift the LM curve Rightward/Leftward.
 The steepness or flatness of the LM curve
describes the elasticity or responsiveness of
money demand (L) to the nominal interest
rate.
-- Steep LM curve: inelastic.
-- Flat LM curve: elastic.
Deriving the LM Curve
 An increase in income leads, rate.
at a given interest rate, to an  Equilibrium in the financial
increase in the demand for markets implies that an
money. Given the money increase in income leads to
supply, this increase in the an increasein the interest
demand for money leads to rate. The LM curve is
an increase in the therefore upward sloping.
equilibrium interest
 Factors that Shift the LM Curve

• Changes in the money supply

• Autonomous changes in money demand
 Shifts in LM Curve due to
change in Money Supply
An increase in money
causes the LM curve
to shift down.
Two – Market Equilibrium
 The intersection point of the IS and LM curve
denotes the equilibrium point between the two
markets.

 There is only one combination of Y and r at which

both the goods market and the money market are
in equilibriumsimultaneously.
IS-LM Equilibrium

r
LM

r*

IS
Y* Y
14
The Equilibrium Curve
 Factors that Shift the IS Curve
• A change in autonomous factors that is unrelated to
the interest rate
– Changes in autonomous consumer expenditure
– Changes in planned investment spending unrelated to the
interest rate
– Changes in government spending
– Changes in taxes
– Changes in net exports unrelated to the
interest rate
 Response to
a Change in Monetary Policy
• An increase in the money supply creates an excess
supply of money
• The interest rate declines
• Investment spending and net exports rise
• Aggregate demand rises
• Aggregate output rises
• The excess supply of money is eliminated
• Aggregate output is positively related to the money
supply
Effects of Fiscal and Monetary
Policy
 Response to
a Change in Fiscal Policy
• An increase in government spending raises
aggregate demand directly; a decrease in
taxes makes more income available for
spending
• The increase in aggregate demand cause
aggregate output to rise
• A higher level of aggregate output increases
the demand for money
 Response to
a Change in Fiscal Policy (cont’d)
• The excess demand for money pushes the
interest rate higher
• The rise in the interest rate eliminates the
excess demand for money
• Aggregate output and the interest rate are
positively related to government spending and
negatively related to taxes
•LM is a stock equilibrium (beginning of period. IS is a flow
equilibrium (end of period).

•The equilibrium is an equilibrium of flows constrained by

stocks. It is a cash-flow equilibrium.

•The time frame is long enough for full adjustment of real

income and interest, short enough so stocks do not change.

•IS-LM equilibrium is not permanent. S>0 implies that wealth

(allocations) are increasing over time. Therefore LM is
shifting due to the stock of bonds. If net investment is
positive, then the capital stock grows.
 ISLM Model in the Long Run

• Natural rate level of output (Yn)

– Rate of output at which the price level has no tendency
to change
• Using real values, so when the price level changes, the IS
curve does not change
• The LM curve is affected by the price level
– As the price level rises, the quantity of money in real
terms falls, and the LM curve shifts to the left until it reaches Yn
(long-run monetary neutrality)
• Neither monetary or fiscal policy affects output in the long
run
 Shifts in the
Aggregate Demand Curve
• ISLM analysis shows how the equilibrium level
of aggregate output changes for a given price
level
• A change in any factor except the price level,
that causes the IS or LM curve to shift, causes
the aggregate demand curve to shift