IS LM Model

By P Banerjee
 Assumptions of the model
(modifications from SKM)
• Two markets: goods market and money
market.
• Investment in the product market is inversely
related to interest rate.
• Money supply is considered here
• Price is kept constant.
 Objective
• The model examines the combined equilibrium of two
markets :
– The goods market, which is at equilibrium when
investments equal savings, hence IS.
– The money market, which is at equilibrium when the
demand for liquidity equals money supply, hence LM.
– Examining the joint equilibrium in these two markets
allows us to determine two variables : output Y and the
interest rate i.
 IS LM Curves
o Concept
The IS curve shows all the combinations of interest
rates r and outputs Y for which the goods market is in
equilibrium .
A simplifying assumption we made initially was that
investment I was exogenous. But here we assume that
investment actually depends negatively on the level of
interest. I= f(r)

IS Curve equation: Y= C(Yd)+I(r)+G

 The LM curve

• The LM curve shows all the combinations of interest rates r and outputs Y for
which the money market is in equilibrium
– It is based on the money market equilibrium .
• Demand for Money:
• There are two motives for demanding real money balances:
– The transaction and precautionary motive L1(Y) : The money demanded
in order to be able to transact in the future (function of the level of
output)
– The speculation motive L2(r) : The money demanded for purposes of
speculation (opportunity cost of the interest rate). When interest is high,
people don’t want to hold money, whereas when the rates are low, money
demanded increases.
Supply of money: Fixed by the central Bank of the country.
 The LM curve
i

Real Money Balances demanded for the

speculation motive (L2) are a decreasing
function of the rate of interest.
Under a given (low) level of interest, the
money demanded becomes infinite: agents do
not want to hold assets, and any money
available is hoarded.

Liquidity Trap
L2(i)

L2(i)
 Macroeconomic equilibrium and policy
Interest rate i

The intersection of IS and LM

represents the simultaneous
LM equilibrium on the goods and
the money market…
…For a given value of
government spending G, taxes
T, money supply M and prices
P
i*

IS

Y* Income, Output Y
 Equilibrium
• The intersection of IS and LM represents the
simultaneous equilibrium on the goods and
the money market…
• …For a given value of government spending G,
taxes T, money supply M and prices P
Macroeconomic equilibrium and policy

• IS-LM can be used to assess the impact of

exogenous shocks on the endogenous
variables of the model (interest rates and
output)
• One can also evaluate the effectiveness of the policy
mix, i.e. the combination of:
– Fiscal policy: changes to government spending and taxes
– Monetary policy: changes to money supply
 Fiscal Policy
• Any change in government expenditure or tax.
• Two types: Expansionary and Contractionary
• Expansionary Fiscal Policy: Any increase in
government expenditure or decrease in tax. It is
represented by a rightward shift of the IS Curve.
Impact: Both Y and r increases.
• Contractionary Fiscal Policy: A decrease in
government expense or increase in tax represented by
a leftward shift of IS curve. Impact: Both Y and r
decreases.
 Monetary Policy
• RBI controlling money supply of the country.
• Expansionary Monetary Policy: when RBI
increases money supply by either printing new
money or reducing the CRR/SLR/Repo/Reverse
repo.
• It is represented by a parallel rightward shift of
LM Curve.
• Impact: Y increases and r decreases.
 CMP
• Contractionary Monetary Policy: When RBI
decreases money supply of the country by
increasing CRR/SLR/Repo/Reverse repo etc.
• It is represented by parallel leftward shift of
LM curve.
• Impact: It decreases Y and increases r.
 Policy and impact
• EFP- GDP rises, interest rate rises
• CFP-GDP falls, interest rate falls
• EMP- GDP rises, interest rate falls
• CMP- GDP falls, interest rate rises

Policy Mix:
• If govt implements EFP and EMP together,
explain its impact.
 Do it

• Investment = 300-10r, transaction money demand

=0.5Y, speculative money demand=250-100r, money
supply =400, government expenditure =200,
tax=300, consumption expenditure =40+0.6Yd.
• Derive the IS and LM functions.
• Find out the initial equilibrium values of interest rate
and aggregate production.
• If r increases from 2.6% to 5%, find crowding out of
investment.
 Solution:
• IS Equation:
Y=40 + 0.6Yd+300-10r+200
Y=540 +0.6(Y-300)-10r
0.4Y=540-180-10r or 0.4Y=360-10r
Y=900-25r………………….(1)
LM Equation:
Money supply= Money demand= transaction+ speculative demand
400=0.5Y+250-100r
0.5Y=150+100r
Y=300 +200 r……………..(2)
Solve Eqn 1 and 2.
 Policy Mix
Case:
An economy wants to increase its market rate of
interest by keeping the national income at the
same level. What policies will the economy
undertake in such situation? Use IS LM Model.
OR
What is crowding out effect and neutralization of
its effect?
 EFP and crowding out effect
• In EFP, a phenomena known as crowding out occurs.
It has two effects:
• Crowding out of investment: As r increases due to
EFP, investment in the product market decreases.
This negative impact on investment is known as
crowding out of investment.
• Crowding out of output: As investment decreases,
there is a negative impact on output. We don’t get
the maximum increase in production or national
income due to this.
 Expansionary Fiscal policy and crowding out effect

1. An increase in spending ΔG pushes IS to

the right …
Interest rate i

2. … By an amount: 1
LM G
1 c

But as Y increases (multiplier effect), so

i2 does money demand. The interest rate
must increase to compensate, which
i1 discourages investment

IS’
IS The difference between Yk and YIS-LM is the
crowding out effect

Y1 YIS-LM YK Income, Output Y

• To neutralize the crowding out effect i.e to
maintain the interest rate at the same level,
government insists expansionary monetary
policy . This is done to get full multiplier effect
on GDP.