The IS-LM Model

By : Prof. Sovik Mukherjee,

Macroeconomics
BMS (Sem III), 2018
St. Xavier’s University
 The Goods Market
and the IS Relation

• Equilibrium in the goods market exists when

production, Y, is equal to the demand for
goods, Z.
• In the simple model (in chapter 3), the
interest rate did not affect the demand for
goods. The equilibrium condition was given
by:
Y  C (Y  T )  I  G
 The IS curve
• The IS curve shows all the combinations of interest
rates i and outputs Y for which the goods market is in
equilibrium
– It is based on the goods market equilibrium we have
examined in the first two weeks

• However, a simplifying assumption we made initially

was that investment I was exogenous
– We know that investment actually depends negatively on
the level of interest
 The Determination of Output

• Taking into account the investment relation

above, the equilibrium condition in the
goods market becomes:

Y  C (Y  T )  I (Y , i )  G
 Shifts and Movements in the IS Curve
 Equilibrium in the goods market implies that an
increase in the interest rate leads to a decrease in
output.
 Changes in factors that decrease the demand for
goods, given the interest rate shift the IS curve to
the left.
• The MPS and interest intensity of investment
are responsible for the rotation in the IS curve.
 WHY LM CURVE IS UPWARD SLOPING?
• An increase in income raises money demand.
• Since the supply of real balances is fixed, there
is now excess demand in the money market at
the initial interest rate.
• The interest rate must rise to restore
equilibrium in the money market.
Shifts and Movements in the LM Curve

 An increase in the money supply shifts the LM curve

down; a decrease in the money supply shifts the LM
curve up.
 An increase in prices lowers the real supply of
money and hence the LM curve goes down.
 LM curve becomes relatively steep when the
demand for money is interest-inealstic in nature.
 SPECIAL CASES OF LM CURVE
• A. The Classical Case:
If the interest elasticity of
demand for money is
zero as in the classical
model which does not
consider speculative
demand for money, we
get the following
equation of the LM curve.
• B. The Keynesian Case:
Another extreme situation is
one in which the speculative
demand for money is
infinitely elastic at a very low
interest rate — the
Keynesian liquidity trap case.
At very low levels of income
Consequently the LM curve
is almost horizontal over this
range of income.
 NOTE ON LIQUIDITY TRAP
• Liquidity trap refers to a situation in which an increase in
the money supply does not result in a fall in the interest
rate but merely in an addition to idle balances : the
interest elasticity of demand for money becomes infinite.
– Under normal conditions an increase in money supply, resulting
in excess cash balances, would cause an increase in bond
prices, as individuals sought to acquire assets in exchange for
money, and a corresponding fall in interest rates.
• In such a situation, described by Keynes as liquidity trap,
individuals believe that bond prices are too high and will
therefore fall, and correspondingly that interest rates are
too low and can’t fall any further.
 IS-LM EQUILIBRIUM
• Joint determination of
equilibrium values of income
and interest rate requires
that both the IS and LM
equations hold good. In this
way both the goods market
and money market
equilibrium will be achieved
at the same interest and
income levels in the two
markets.
DIAGRAMMATICALLY PLOTTING IS-LM
 NUMERICALS

• Calculate the equation

of the IS curve and the
LM curve.
• Find out the
equilibrium rate of
interest and output
level.
THE BIG PICTURE .......
 Fiscal Policy, the Interest Rate and the IS Curve

• Fiscal contraction : a fiscal policy that reduces

the budget deficit.
– Reducing G or increasing T
• Fiscal expansion : increasing the budget
deficit.
– Increasing G or decreasing T
• Taxes (T) and government expenditures (G)
affect the IS curve, not the LM curve.
Monetary Policy, the Interest Rate, and the LM Curve

• Monetary contraction (tightening) refers

to a decrease in the money supply.
• An increase in the money supply is called
monetary expansion.
• Monetary policy affects only the LM
curve, not the IS curve.
U.S. Money Supply during the Great Depression
(1928-1936)
U.S. Fiscal Policy during the Great Depression
(1930-1947)
 Fiscal Policy and Monetary Policy :
Activity and the Interest Rate
The effects of fiscal and monetary policy
Shift in IS Shift in LM Movement in Movement in
Output Interest Rate
Increase in taxes left none down down

Decrease in taxes right none up up

Increase in right none up up

spending
Decrease in left none down down
spending
Increase in money none down up down

Decrease in money none up down up

Slide #25
 Using a Policy Mix
The Clinton-Greenspan Policy Mix

The policy Record high federal budget deficit

dilemma of (4.5% of GNP)
1992: High unemployment and slow growth

Recall: Deficit reduction reduces output

Expansionary fiscal policy increases the deficit

Solution: Deficit reduction and expansionary monetary

Policy Mix policy

Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets

 Using a Policy Mix
The Clinton-Greenspan Policy Mix

Observations:

• Strong consumer confidence and

stock market shifting IS from 1992
to 1998

• The strong expansion automatically

reduced the deficit (1% growth reduces
the deficit to GNP ratio by 0.5%)

Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets

 Adding Dynamics

Observations:

• Changes in output adjust slowly to

changes in the goods market (IS)
• Interest rates adjust instantaneously to
changes in the financial markets (LM)

Blanchard: Macroeconomics Chapter 5: Goods & Financial Markets

 Monetary Policy and Liquidity Traps
The Fed increases the In a liquidity trap, increases
money supply which in the money supply do not
decreases interest rates decrease interest rates, so
and increases investment investment and output do
Real Interest Rate (%)

Real Interest Rate (%)

and output. not increase.

LM0 LM0
LM1
LM1

r0 r0
r1
IS IS

Y0 Y1 Y0
Aggregate Output Aggregate Output
 Ineffective Monetary Policy

• Investment is not sensitive to the interest

rate
– If investment does not respond to interest
rate changes (the IS curve is steep), monetary
policy in ineffective in changing output.
• Liquidity trap
– If increases in the money supply fail to lower
interest rates, monetary policy is ineffective in
increasing output.
CASE STUDY
The U.S. economic slowdown of 2001

What happened ?
1. Real GDP growth rate
1994-2000: 3.9% (average annual)
2001: 1.2%
2. Unemployment rate
Dec 2000: 4.0%
Dec 2001: 5.8%
 ~ Shocks that contributed to the slowdown ~
1. Money Supply fell down
From Aug 2000 to Aug 2001:-25%
Week after 9/11: -12%
2. The terrorist attacks on 9/11
• increased uncertainty
• Both shocks reduced spending and investment
 What is the Fed’s policy instrument?
What the newspaper says:
“the Fed lowered interest rates by one-half point today”
What actually happened:
The Fed conducted expansionary monetary policy to shift
the LM curve to the right until the interest rate fell 0.5
points.

The Fed targets the Federal Funds rate:

it announces a target value,
and uses monetary policy to shift the LM curve
as needed to attain its target rate.
What is the Fed’s policy instrument?
Why does the Fed target interest rates
instead of the money supply?
1) They are easier to measure than the money
supply
2) The Fed might believe that LM shocks are
more prevalent than IS shocks. If so, then
targeting the interest rate stabilizes income
better than targeting the money supply.
The AS-AD Model
 The AS-AD Model versus
the IS-LM Model
• The AS-AD Model is not more complicated than the
IS-LM Model.
• IS-LM can only deal with the demand side of the
economy. Any increase in output is only an increase
in aggregate demand.
• IS-LM cannot deal with important changes related to
the supply side of the economy, such as technological
improvement, population increase or capital
accumulation.
 The AS-AD Model versus
the IS-LM Model
• IS-LM cannot effectively deal with changes in
general price level in the economy. It does not
offer insights on inflation.
• IS-LM works well only when wages and prices
are rigid, or the aggregate supply curve is
horizontal.
• AS-AD is a more complete model.
 Why is the AD Curve Negatively Sloping?

• The AD Curve relates the aggregate quantity of output to the

general price level P
• For any given level of money supply M, an increase in P
implies that the real supply of money M/P must go down. It
becomes harder for people to borrow money, causing the
price of loans, i.e., the interest rate r to go up. When interest
increases, investment demand (and possibly consumption)
decreases. Thus, aggregate demand Y goes down.
• An increase in P can also create the so-called “real balance
effect.” The resulting decline in M/P may lead people to
believe that they are less wealthy. This further implies that
they will reduce consumption. Thus, aggregate demand goes
down.
 Relationship between IS-LM and AD (1)

• Real interest rate r

• LM(P2)

• LM(P1)

• F
• E

• IS

• Y2 Y1 Output Y
 Relationship between IS-LM and AD (2)

• Price Level P

• F
• P2

• E
• P1

• AD

• Y2 Y1 Output Y
 The Phillips Curve

• The Phillips curve is a

graph illustrating the
inverse relationship
between inflation and
the unemployment
rate.
 The Early Consensus
• Economists in the late 1950s and 1960s
thought that all the Federal Reserve or
government had to do was to pick the point
on the short-run Phillips curve where they
wanted the economy to be positioned.
• Less unemployment meant living with more
inflation, and vice versa.
 Breakdown of the Short-Run Phillips Curve

Phillips Curve, 1966 to 1988

16
14 1980
12
1974 1979
1981
Inflation (%)

10
1975
8 1978
1973 1982
6 1969 1976
1970
4 1968
1966 1984
19721987 1983
2 1986
0
0 2 4 6 8 10 12
Unemployment (%)

• In the 1970s and early 1980s the short-run relationship

between inflation and unemployment seemed to break down.
Breakdown of the Short-Run Phillips Curve

• A spiral pattern emerged in the Phillips curve.

• Economists were able to salvage the Phillips
curve by realizing that a significant difference
exists between the short-run and long-run
relationships between inflation and
unemployment.
 The Role of Expectations

• We can express the Phillips curve as an

equation in the following manner:

P = b(U* - U) + Pe

where b > 0,
P is the inflation rate, and
Pe is the expected rate of inflation.
 Inflation, Unemployment,
and the Phillips Curve with supply shocks
The Phillips curve states that  depends on
 expected inflation, e
 cyclical unemployment: the deviation of the
actual rate of unemployment from the natural
rate
 supply shocks, 
e n
    (u u ) 
where  > 0 is an exogenous constant.
 Deriving the Phillips Curve from SRAS
(1) Y  Y   (P  P e )

(2) P  P e  (1  ) (Y Y )

(3) P  P e  (1  ) (Y Y )  

(4) (P  P1 )  ( P e  P1 )  (1  ) (Y Y )  

(5)    e  (1  ) (Y Y )  

(6) (1  ) (Y Y )    (u  u n )

(7)    e   (u  u n )  
 The Phillips Curve and SRAS
SRAS: Y  Y   (P  P e )
Phillips curve:    e   (u  u n )  
• SRAS curve:
output is related to unexpected
movements in the price level
• Phillips curve:
unemployment is related to unexpected
movements in the inflation rate
 Adaptive expectations
• Adaptive expectations: an approach that
assumes people form their expectations of future
inflation based on recently observed inflation.
• A simple example:
Expected inflation = last year’s actual inflation

 e   1

 Then, the P.C. becomes

   1   (u  u n )  
 Inflation inertia
   1   (u  u n )  
• In this form, the Phillips curve implies that
inflation has inertia:
– In the absence of supply shocks or cyclical
unemployment, inflation will continue
indefinitely at its current rate.
– Past inflation influences expectations of
current inflation, which in turn influences
the wages & prices that people set.
 Two causes of rising & falling inflation
   1   (u  u n )  
• cost-push inflation: inflation resulting from
supply shocks.
Adverse supply shocks typically raise production
costs and induce firms to raise prices, “pushing”
inflation up.
• demand-pull inflation: inflation resulting from
demand shocks.
Positive shocks to aggregate demand cause
unemployment to fall below its natural rate,
which “pulls” the inflation rate up.
 Graphing the Phillips curve
e n
In the short      (u u )  
run, policymakers
face a trade-off

between  and u. 1 The short-run
e Phillips Curve

u
n
u
 Shifting the Phillips curve
People adjust
their
 

uue  ( n
)

expectations
over time, so
the tradeoff 2e 
only holds in 1e 
the short run.

E.g., an increase
u
n
in e shifts the u
short-run P.C.
upward.
 The Long-Run Phillips Curve

• Most economists now agree that in the long run there is no

tradeoff between inflation and unemployment.
 The Long-Run Phillips Curve
• The long-run Phillips curve is simply a vertical
line at the natural rate of unemployment, U*.
• Any level of inflation is consistent with the
natural rate of unemployment.
Expansionary Policy, AD/AS, and the Phillips
Curve
Contractionary Policy, AD/AS, and the Phillips
Curve
Shifts in the AS Curve and the Phillips Curve
• When the Aggregate Supply curve shifts, we
can get very different results in the Phillips
curve than when the Aggregate Demand curve
shifts.
• An oil shock, for example, can produce
stagflation.
The Role of Expectations

• The long-run Phillips curve

equation suggests that the
inflation rate is entirely
determined by inflation
expectations. When
inflation expectations rise,
the Phillips curve shifts
upward.
 The Role of Expectations
• The short-run tradeoff between inflation and
unemployment is thought to work because
people have an idea of what inflation
expectations are going to be, and those
expectations change slowly.
• Over time, workers learn that inflation has
changed and they change their inflation
expectations accordingly.
 The sacrifice ratio
• To reduce inflation, policymakers can
contract agg. demand, causing
unemployment to rise above the natural rate.
• The sacrifice ratio measures
the percentage of a year’s real GDP
that must be foregone to reduce inflation
by 1 percentage point.
• Estimates vary, but a typical one is 5.

slide 63
 The sacrifice ratio
• Suppose policymakers wish to reduce inflation from
6 to 2 percent.
If the sacrifice ratio is 5, then reducing inflation by 4
points requires a loss of 45 = 20 percent of one
year’s GDP.
• This could be achieved several ways, e.g.
– reduce GDP by 20% for one year
– reduce GDP by 10% for each of two years
– reduce GDP by 5% for each of four years
• The cost of disinflation is lost GDP. One could use
Okun’s law to translate this cost into
unemployment.
slide 64
 Is the Phillips Curve Dead?
Phillips Curve, 1994 to 2005 •Despite being
4
2000 2005 reconstructed in
3 2001
1996
1995 the 1970s, the
Inflation(%))

1999 1997
2004 1994
2003
Phillips curve
2

2002
relationship was
suspiciously
1998
1

absent again in
0
2 3 4 5 6 7 8
the mid- to late-
Unemployment (%)
1990s.