The Is-Lm Model: ECON 2123: Macroeconomics
The Is-Lm Model: ECON 2123: Macroeconomics
Fei DING
The Hong Kong University of Science and Technology
LEARNING OBJECTIVES
Explain factors that determine the demand for money and write down the
money demand function.
Define and derive equilibrium interest rate in the financial markets.
Describe roles of banks and understand how the supply and demand of money
change with and without the presence of banks.
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SO FAR INTEREST RATE PLAYS NO ROLE IN THE
GOODS MARKET!
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QUOTE OF THE DAY
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Ch5: Goods and Financial Markets:
The IS-LM Model
LEARNING OBJECTIVES
Explain and derive the IS relation and the LM relation.
Define and derive the “grand” equilibrium using the IS-LM Model.
Apply the IS-LM model to predict and explain effects of fiscal and monetary
policy, both separately and together.
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WHAT IS THE IS-LM MODEL?
People trade both goods and financial assets.
The equilibrium of an economy both goods and
financial markets should be at their equilibria.
IS-LM: a framework to analyze both markets at the
same time to define the “grand equilibrium”.
Goods market Y; Financial market i
Focus on the equilibrium in the short run.
Start from the financial market (LM) first.
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LM: LIQUIDITY – MONEY
Recall money market equilibrium: M $YL(i)
YL i
M
Convert to real Ms = real Md :
P
Price level P: GDP deflator or CPI
Income: $Y = YP, or Y = $Y/P
Nominal money stock M is exogenous short run real
money stock M/P is also exogenous. Why?
Endogenous: Y and i not every pair will make LHS = RHS.
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LM: LIQUIDITY – MONEY
a) At a given interest rate, an increase in b) Equilibrium in the financial markets implies
income leads to an increase in the that an increase in income leads to an
equilibrium interest rate. increase in the interest rate. The LM curve
is therefore upward sloping.
YL i
M
P
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THE LM CURVE
Each point on the LM curve an equilibrium
in the money market
Change output (income) new equilibrium
interest rate, given by the intersection of real
money supply and real money demand.
“Higher economic activities puts pressure on
interest rates.” (moving along the curve)
How would a change in monetary policy affect
the LM curve?
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RECALL: EXPANSIONARY MONEY POLICY
Figure 4 - 4 Ms'
The Effects of an Increase
in the Money Supply on the
Interest Rate
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AN EXPANSIONARY MONEY POLICY
Figure 5 - 5
Shifts of the LM curve
An increase in money
causes the LM curve to
shift down.
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A CONTRACTIONARY MONEY POLICY
LM'
i Supply' Supply i LM
i2 i2
i1 i1
Md
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THE LM CURVE
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SHIFTS OF THE LM CURVE
Changes in factors that decrease the supply (or
increase the demand) for money, given Y, shift the LM
curve up (shift in).
Example: monetary contraction
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REFRESH
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REFRESH
2) an increase in output
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IS: INVESTMENT – SAVING
Recall: goods market equilibrium is defined as
Y = Z = C(Y – T) + I + G.
Investment was assumed to be exogenous.
Interest rate would not affect the demand for goods.
But investment depends on
Business volume (level of sales): output ↑ leads to
investment ↑
Interest rate: i ↑ leads to investment ↓
I I (Y , i )
( , )
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IS: INVESTMENT – SAVING
Determining Output Y C(Y T ) I (Y , i ) G
Figure 5 - 1
Equilibrium in the
Goods Market
The demand for goods is
an increasing function of
output, but less than
one-for-one. Equilibrium
requires that the demand
for goods be equal to
output.
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IS: INVESTMENT – SAVING
Goods market equilibrium now becomes
Y C(Y T ) I (Y , i ) G
Endogenous variables: Y and i equilibrium values
are such that LHS = RHS.
All the equilibrium (Y, i) pairs form the IS curve.
Suppose (Y1, i1) constitutes an equilibrium. Would
(Y1, i2 > i1) also constitute an equilibrium?
i2 > i1 I goes down LHS > RHS
What should happen to Y to make LHS = RHS again?
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THE IS CURVE
Figure 5 - 2
The Derivation of the IS Curve
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SHIFTS OF THE IS CURVE
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SHIFTS OF THE IS CURVE
Changes in factors that decrease the demand for
goods, given the interest rate, shift the IS curve to
the left (shift in).
Shifting down ZZ Y ↓ IS curve to the left
Example: fiscal contraction
Changes in factors that increase the demand for
goods, given the interest rate, shift the IS curve to
the right (shift out).
Shifting up ZZ Y ↑ IS curve to the right
Example: fiscal expansion
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THE IS CURVE VS. THE LM CURVE
Each point on the IS curve an equilibrium in the
goods market
Change interest rate new equilibrium output Y, given by
the intersection of (new) demand ZZ and the 45-degree line
in goods market.
Each point on the LM curve an equilibrium in the
money market
Change output (income) Y new equilibrium interest rate,
given by the intersection of real money supply and real
money demand.
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REFRESH
Q1: In the goods market, when we change output level
and derive the corresponding equilibrium level of
interest rate, we can derive the IS curve.
Q2: In the financial market, when we change the
interest rate to derive the corresponding equilibrium
level of output, we can derive the LM curve.
1) True
2) False
3) Uncertain
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IS–LM: THE “GRAND” EQUILIBRIUM
IS relation: Y C(Y T ) I (Y , i ) G
M
LM relation: YL(i )
Figure 5 - 6 P
The IS–LM Model
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QUOTE OF THE DAY
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POLICY APPLICATIONS
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FISCAL CONTRACTION: (G–T) ↓
Figure 5 - 7
The Effects of an Increase in Taxes
An increase in taxes shifts the IS curve to the left and leads to a decrease in the
equilibrium level of output and the equilibrium interest rate.
T ↑ IS shifts left
Y ↓ and i ↓ I ?
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FISCAL CONTRACTION: AN INCREASE IN T
Goods market channel: Higher taxes lower disposal
income lower consumption lower demand lower Y
Lower Y further reducing C and I further reducing Y @ same i
Point D is an EQ in the goods market.
But NOT in the money market above the LM.
At point D, money demand < > money supply ???
Money market channel: lower Y (income) lower money
demand lower i
Lower i higher I higher demand offsetting some decline in Y
IS shifts to the left, new EQ moves along the LM curve to A’.
C ↓ for sure, investment I ambiguous (Y ↓ and i ↓ I ?)
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Deficit Reduction: Good or Bad for Investment?
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Fiscal Contraction: Good or Bad for Greece and for the Euro?
M ↑ Y ↑, i ↓ I ↑
A monetary expansion
is more investment C
friendly, i.e.,
increasing investment.
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MONETARY EXPANSION: MS ↑
Money market channel: higher money supply lower i @
the same Y
Point C is an EQ in the money market.
But NOT in the goods market below the IS.
At point C, demand for goods < > supply for goods ???
Goods market channel: lower i higher investment I
higher demand higher Y
Higher Y (income) higher money demand offsetting some
decline in i
LM shifts down, new EQ moves along the IS curve to A’.
C and I increase for sure (Y ↑ and i ↓ I ↑)
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POLICY SHOCKS
Table 5-1 The Effects of Fiscal and Monetary Policy
Movement Movement in
Shift of IS Shift of LM in Output Interest Rate
Increase in taxes Left None Down Down
Decrease in taxes Right None Up Up
Increase in spending Right None Up Up
Decrease in spending Left None Down Down
Increase in money None Down Up Down
Decrease in money None Up Down Up
LM’
A’
Y
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FISCAL EXPANSION: (G–T) ↑
Compared to Ch3 model,
i fiscal policy less effective due to i changes.
IS IS’
LM
A’
A D
Y
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MIXING FISCAL AND MONETARY POLICY
Fiscal and monetary policy can be used in the
same direction.
Fiscal expansion can be used to stimulate Y.
But the increase in i would partially offset the
effect (as I decreases).
Monetary expansion can be used to cancel
the increase in i,
At the same time enhancing the impact on Y.
Focus box: The US recession of 2001
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The U.S. Recession of 2001
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T ↓, G ↑, (G-T) ↑
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STEP 1: MONETARY CONTRACTION
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STEP 2: FISCAL EXPANSION
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STEP 3: POLICY MIX POSSIBLE OUTCOMES
Outcome 1 Outcome 2
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STEP 3: POLICY MIX POSSIBLE OUTCOMES
Outcome 3
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IS–LM: THE “GRAND” EQUILIBRIUM
The IS relation follows from the condition that the supply of
goods must be equal to the demand for goods.
Tell us how the interest rate affects output: through
investment.
The LM relation follows from the condition that the supply of
money must be equal to the demand for money.
Tell us how output affects the interest rate: through money
demand.
Because the interest rate influences both investment and
money demand, it is the variable that links the two parts of
the IS-LM model.
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IS–LM: THE “GRAND” EQUILIBRIUM
The IS curve is drawn for a given fiscal policy.
Changes in fiscal policy that raise the demand for goods
and services shift the IS curve to the right (shift out).
Changes in fiscal policy that reduce the demand for goods
and services shift the IS curve to the left (shift in).
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ANYTHING ELSE CAN SHIFT THE CURVES?
Other exogenous changes can also shift the IS or LM
curve.
IS: increase or decrease in consumer/investor
confidence will raise or reduce total demand and thus
shift the IS curve.
LM: exogenous changes in money demand can shift
the LM curve, how?
Credit cards and ATMs, doubts about the health of
the banking system, etc.
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DOES THE IS-LM MODEL FIT THE FACTS?
Short answer: Yes!
But the model ignored “dynamics”.
Take time for consumers to adjust their consumption
following a change in income.
Take time for firms to adjust investment spending following
a change in sales.
Take time for firms to adjust investment spending following
a change in the interest rate.
Take the for firms to adjust production following a change in
their sales.
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SEE YOU NEXT TIME
Assigned reading:
Chap. 5 from 6th ed. textbook
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