IS – LM MODEL AND

AGGREGATE DEMAND
(AD) IN CLOSE
ECONOMY
Lecture 2

Mentor: Pham Xuan Truong

(truongpx@ftu.edu.vn)
 Back ground on the model
• The Great Depression caused many economists to question the
validity of classical economic theory. They believed they
needed a new model to explain such a pervasive economic
downturn and to suggest that government policies might ease
some of the economic hardship that society was experiencing.

• In 1936, John Maynard Keynes wrote The General Theory of

Employment, Interest, and Money. In it, he proposed a new way
to analyze the economy, which he presented as an alternative to
the classical theory.

• Keynes proposed that low aggregate demand is responsible for

the low income and high unemployment that characterize
economic downturns. He criticized the notion that aggregate
supply alone determines national income.
Back ground on the model
• The model rests on two fundamental assumptions
• All prices (including wages) are fixed.
• There exists excess production capacity in the economy

• Why can there be insufficient demand ?

• Criticism of Say’s law: Uncertainty can lead to
precautionary saving rather than consumption.
• Monetary criticism: the preference for liquidity can lead to
under-investment as savings are kept in the form of
liquidity.
Back ground on the model
• Differences between “Keynesian” and Classical:
+ Velocity of money is variable and wages are fixed (Classical:
velocity of money is constant and wages are highly flexible)
+ The level of demand determines the level of output and
employment (Classical: level of production determines level of
output and employment)
+ There can be an equilibrium level of involuntary unemployment
(Classical: there is no involuntary unemployment at equilibrium
level of economy)

• The model of aggregate demand (AD) can be split into two parts:
IS model of the “goods market” and the LM model of the “money
market.” “IS stands for Investment Saving, Whereas LM stands
for Liquidity Money.”
Back ground on the model
The Keynesian model can be viewed as showing what causes the
aggregate demand curve to shift. In the short run, when the price level is
fixed, shifts in the aggregate demand curve lead to changes in national
income, Y.
The model of aggregate demand developed in this chapter called the IS-
LM is the leading interpretation of Keynes’ work developed by Sir
J.Hicks (nobel laureate). The IS-LM model takes the price level as
given and shows what causes income to change. It shows what causes
AD to shift.
Content
I The goods market and IS curve
II The money market and LM curve
III Equilibrium of IS – LM model and its implications
IV Coordinate Fiscal policy and Monetary policy
 I The goods market and IS curve
1 The goods market (Keynesian cross – point model)

APE (AE)
Y=APE

APE=C+I+G

APE*

Y
Y*

Next slide, we will add inverse relationship between the interest rate
and investment I = I(r) and then determine how income changes when
the interest rate changes in order to balance goods market. We combine
the investment function with the Keynesian-cross point diagram.
I The goods market and IS curve
2 Deriving IS curve from (b)
goods market equilibrium APE
Y = APE
Planned expenditure,
An increase in the interest rate (in E=C+I+G
graph a), lowers planned
investment, which shifts planned
expenditure downward (in
graph b) and lowers income (in
graph c). Income, output, Y
(a) (c)
r r

I(r) IS
Investment, I Income, output, Y
I The goods market and IS curve
2’ Deriving IS curve from loanable funds market
I The goods market and IS curve
2 Deriving IS curve from goods market equilibrium
The IS curve is the combinations of r and Y that balance the
goods market
+ The shift of APE caused by changes of interest rate will create
the move along a constant IS curve (APE shift up = move along
to the right of IS curve, APE shift down = move along to the left
of IS curve)
+ The shift of APE caused not by changes of interest rate (tax,
household consumption, business confidence, government
spending…) will create the shift of IS curve (APE shift up = IS
shift right/down, APE shift down = IS shift left/up)
I The goods market and IS curve
2 Deriving IS curve from goods market equilibrium
APE
Explain the shift of IS curve APE=Y

(from the goods market) APE=C+I+G2

APE=C+I+G1

Suppose an increase in G ΔG
causes planned expenditure to
shift up by ΔG.
Y
Y1 Y2

r
For any r the increase in G
causes an increase in Y of ΔG
times the government
expenditure multiplier.

r1
Therefore, the IS curve shifts IS´
to the right by this amount. IS
Y
Y1 Y2
I The goods market and IS curve
2 Deriving IS curve from goods market equilibrium
Explain the shift of IS curve
(from the loanable funds market)

r r
S(G2) S(G1)

r2 r2
IS´
r1 r1
I(r) IS
I Y
Y1
I The goods market and IS curve
I The goods market and IS curve
3 IS curve and fiscal policy
Fiscal policy is government’s policy related to changes in
government spending and taxed aiming at stabilize economic
growth and price level
+ Expansionary fiscal policy comprising increase of government
spending and/or decrease of tax will shift up APE, therefore
shifting right IS curve
+ Contractionary fiscal policy comprising decrease of
government spending and/or increase of tax will shift down APE,
therefore shifting left IS curve
 II The money market and LM curve
1 The money market (money liquidity preference theory)

r Money supply(MS)

Money demand (MD)

M/P M/P
Next slide, we determine how interest rate changes when the
income changes in order to balance the money market
II The money market and LM curve
2 Deriving LM curve from the money market

Given money supply and money The LM curve maps

demand suppose an increase in out this relationship
income raises money demand. between
r and Y.

r r
(M/P)s
LM

r2 r2

r1 r1
L(r,Y1) L(r,Y2)
Real
Y
Money Y1 Y2
Balances
II The money market and LM curve
2 Deriving LM curve from money market equilibrium
The LM curve is the combinations of r and Y that balance the
money market
+ The shift of MD caused by changes of income will create the
move along a constant LM curve (MD shift up = move along to
the right of LM curve, MD shift down = move along to the left of
LM curve)
+ The shift of MD caused not by changes of income (stability of
financial market, payment technology…) and the shift of MS will
create the shift of LM curve (MD shift up/down= LM shift
up/down, MS shift left /MS shift right = LM shift left/right)
II The money market and LM curve
2 Deriving LM curve from money market equilibrium
Explain the shift of LM curve

Suppose a decrease in the money stock

shifts real money supply to the left
resulting in a higher equilibrium interest
rate. The LM curve shifts up so that at
the same level of output the
interest rate is higher.

Now there is a higher real

r (M2/P)s (M1/P)s r
interest rate for the current
level of output.
LM´ LM

r2 r2

r1 r1
L(r,Y)
Real
Money Y
Y
Balances
II The money market and LM curve
II The money market and LM curve
3 LM curve and monetary policy
Monetary policy is central bank’s policy related to changes in
money supply aiming at stabilize economic growth and price
level
+ Expansionary monetary policy comprising increase of money
supply will shift right MS, therefore shifting right LM curve
+ Contractionary monetary policy comprising decrease of money
supply will shift left MS, therefore shifting left LM curve
III Equilibrium of IS – LM model and its
implications
1 Equilibrium of IS – LM model
The intersection of IS curve and LM curve implies the only
combination between r and Y that balances both goods market
and money market

How market adjust to the equilibrium with the r > r*

How market adjust to the equilibrium with the r < r*
III Equilibrium of IS – LM model and its
implications
1 Equilibrium of IS – LM model
Finding the equilibrium value of r and Y
Step 1: Formulating IS equation and LM equation
Step 2: Solving the simultaneous equations with two variables r
and Y
Problem example
C = 200 + 0.75(Y – T) I = 225 – 25r G = 75 T = 100
M = 1000 P = 2 MD = Y – 100r
i) Find the equilibrium value of r and Y
ii) G = ? so that Y = 1500
III Equilibrium of IS – LM model and its
implications
1 Equilibrium of IS – LM model
Problem example (continue)
C = 60 + 0.8 (Y – T), T = 100, G = 500, I = 300 – 20r
M = 1080, P = 2, MD = Y – 40r
i) Find the equilibrium value of r and Y
ii) M = ? so that Y = 1300
III Equilibrium of IS – LM model and its
implications
2 Building AD curve from IS – LM model
III Equilibrium of IS – LM model and its
implications
2 Building AD curve from IS – LM model
The shift of LM curve caused by changes of P will create the
move along a constant AD
The shift of LM curve caused not by changes of P or the shift of
IS curve will shift AD curve (LM/IS curve shift right = AD shift
right; LM/IS curve shift left = AD shift left)
Problem example
C = 200 + 0.75(Y – T), T = 100, G = 75, I = 225 – 25r
M = 1000, P, MD = Y – 100r
i) Find the equation of AD
ii) Find the equilibrium price in long run if the natural level of
output is 1000
III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations
in short run

r IS IS´ LM r IS LM
LM
B A
A
B

Y Y

Government increases Central bank decreases reserve

spending after economy requirement to support lending
suffered from crisis of commercial banks
How to analyze effects of policy on IS –
LM model in the short run
Three step method
Step 1: Identify the policy? (fiscal or monetary policy,
expansionary or contractionary policy) → corresponding curve
affected
Step 2: How affected curve shift?
Step 3: Identify new equilibrium of the economy? Compare with
the old one
Always remember: fiscal policy (government spending and tax)
attaches IS curve, monetary policy (OMO, discount rate, reserve
rate requirement) attaches LM curve; expansionary policy shifts
the corresponding curve to the right, contractionary policy shifts
the corresponding curve to the left
III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations
in short run
Try to figure out how interest rate (r) and output/income (Y)
change when
-Government increases spending
-Government increases tax
-Government decreases tax and spending
-Central bank buys government bond
-Confidence of households and firms to economy’s prospective
declines
-Central bank sells government bond, government decreases
spending
III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations
in short run
III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations
in short run
Crowding-out effect

IS shifts to the right. Ideally, economy

will move from E1 to E’1. However,
due to increase of interest rate that
mitigates investment, economy
eventually moves to E2. The gap in
terms of output between E’1 and E2 is
the degree of crowding out investment
effect (in terms of output this gap is
the distance between Y’1 and Y2)
 III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations in short run
Crowding-out effect
How to calculate the degree of crowding-out effect
Step 1: Find the new equation of IS curve as government spending
or/and tax changes and combine with unchanged LM to find new
equilibrium output.
Step 2: Replace the old equilibrium interest rate to the new equation of
IS curve to find without – crowding out effect supposed output
Step 3: Compare this supposed output with the new equilibrium one in
step 1.
(Another way: calculate expenditure multiplier, compare old and
equilibrium of interest rate, estimate change of investment based on
investment function and then change of output based on expenditure
multiplier)
III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations
in short run
Crowding-out effect
C = 40 + 0.8(Y-T) T = 100 I =100 – 20r G =200
M = 1200 P = 2 MD = 2Y – 50r
i) Find the output and interest rate at equilibrium
ii) If G = 300 find the new equilibrium
iii) Estimate the degree of crowding-out effect
III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations
in short run
Case study: the US crisis, FED action and the shift of LM curve
What is liquidity trap
III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations
in short run
Case study: the US crisis, FED action and the shift of LM curve
Monetary policy not only alters LM curve
III Equilibrium of IS – LM model and its implicatio
3 Applying IS – LM model to explain economic fluctuations in
short run
Case study: the US crisis, FED action and the shift of LM
In the time of crisis, FED implemented unprecedented programs such
as TARP (Troubled Assets Release Program); OT (Operating Twist);
QE (Quantitative Ease) to support liquidity of financial system by
buying massive amount of financial assets

FED programs improve

market confidence
III Equilibrium of IS – LM model and its
implications
4 Neutrality of fiscal policy and monetary policy in long run

In the long run,

monetary policy does
not change Y and r,
therefore it is neutral
III Equilibrium of IS – LM model and its
implications
4 Neutrality of fiscal policy and monetary policy in long run

In the long run, fiscal policy

changes r but not Y, therefore
it is non-neutral
How to analyze effects of policy on IS –
LM model in the long run (neutral or
not)
Three step method
Step 1: Assuming that economy is initially at potential output.
Apply the three step method to identify new equilibrium of the
economy in the short run (see slide 28)
Step 2: Compare output in new equilibrium with potential output.
If new output greater than potential one then price level (P)
increases, if new output smaller than potential one then price
level (P) decreases
Step 3: In long run, changes of P shift LM curve. Increase of P
shifts LM to the left, decrease of P shifts LM to the right. Identify
long run equilibrium (always remember, output in long run will
come back potential level)
IV Coordinate Fiscal policy and Monetary
policy
1 Expansionary fiscal policy and expansionary monetary policy

Results: Y increases, r unchanged (used when government wants to

stimulate economy but creates no effect to investment by keeping
interest rate unchanged)
IV Coordinate Fiscal policy and Monetary
policy
2 Contractionary fiscal policy and contractionary monetary policy

Results: Y decreases, r unchanged (used when government wants to reduce

great amount of aggregate demand in order to curb inflation, whereas
creating no effect on investment by keeping interest rate unchanged )
IV Coordinate Fiscal policy and Monetary
policy
3 Contractionary fiscal policy and expansionary monetary policy

Results: Y unchanged, r decreases (used when government wants to

change structure of Y by decreasing government spending and
increasing investment = enhance efficiency of economy and constraint
public debt)
IV Coordinate Fiscal policy and Monetary
policy
4 Expansionary fiscal policy and contractionary monetary policy

Results: Y unchanged, r increases (used when government wants to

change structure of Y by increasing government spending and
decreasing investment = stimulate economy in downturn period but
caution about high inflation)