Keynesian IS-LM
IBS Bangalore
12/29/2020
Meaning – IS LM model
It is a tool that demonstrates the relationship between
interest rates and real output in the goods and services
market and the money market.
IS-LM shows the approximate interest rate in the economy
and the level of GDP.
Different interest rates will have different effects on the
level of GDP.
12/29/2020
The IS-LM model
It was proposed by John Hicks in 1937.
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.
12/29/2020
Assumptions of the model
◦ All prices (including wages) are fixed.
◦ There exists excess production capacity in the
economy
12/29/2020
The IS curve
The investment/saving (IS) curve is a variation of the
income-expenditure model incorporating market
interest rates (demand).
It represents all combinations of income (Y) and the
real interest rate (r) such that the market for goods
and services is in equilibrium.
Every point on the IS curve is an income and real
interest rate pair (Y, r) such that the demand for
goods is equal to the supply of goods.
12/29/2020
Derivation of IS curve
What is the relationship between Investment and the
interest rate?
Firms typically borrow in order to finance investment.
When interest rates are high, the profit incentive for
firms is reduced therefore investment spending will
decline.
To derive the IS curve we apply the investment function
to the Keynesian cross.
The Keynesian cross shows how households, firms and
government expenditures determine the economy’s
income.
At every point on the 45 degree line, aggregate
expenditure equals national income.
12/29/2020
Graphical presentation
12/29/2020
IS curve….
Is the schedule of combinations of the interest rate and the
level of income such that the goods market is in
equilibrium.
Is negatively sloped because an increase in the interest rate
reduces planned (desired) investment spending and
therefore reduces aggregate demand, thereby lowering the
equilibrium level of income.
The smaller the investment multiplier and the less sensitive
investment spending is to interest rate changes, the steeper
is the IS curve.
Is shifted by changes in autonomous spending. An increase
in autonomous spending, such as investment spending or
government expenditure shifts the IS curve to the right.
12/29/2020
Properties of IS Curve
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.
12/29/2020
Goods market equilibrium in 2
sector economy
12/29/2020
A shift in the IS curve
12/29/2020
Factors that shift the IS curve
Rightward Shift
◦ Increase in Spending
◦ Increase in Investment
◦ Decrease in Taxes
◦ Increase in Government Spending
Leftward Shift
◦ Decrease in Spending
◦ Decrease in Investment
◦ Increase in Taxes
◦ Decrease in Government Spending
12/29/2020
LM - Liquidity-Money.
LM stands for Liquidity-Money.
This refers to the financial market, i.e. the demand for
money.
If the economy is not doing well, there will be low
demand for money by businesses for investment.
They will use their excess money to buy bonds so that
their money can earn interest rather than be idle.
12/29/2020
Cont…
Liquidity means money can be spent for various
purposes (the same way a liquid can move around
easily).
If the economy is bad and money is stored in bonds,
liquidity is low.
On the other hand, if the economy is doing really well,
liquidity is high because there is a high demand for
money, meaning a low demand for bonds.
If the demand for money is high and everyone is selling
bonds, the government will increase interest rates to
give banks and businesses more incentive to store
money in bonds.
12/29/2020
Money market equilibrium in 2
sector economy
12/29/2020
Graphical presentation
12/29/2020
A shift in the LM curve
12/29/2020
Shifts in LM curve due to change in
money supply
An increase in money causes the LM
curve to shift down.
12/29/2020
Properties of LM Curve
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.
12/29/2020
Combining the IS LM curve
12/29/2020
Disequilibrium to equilibrium – the
process of adjustment
12/29/2020
How RBI impact IS LM curve
The RBI can move the LM curve by printing money.
The more money the RBI prints, the less aggressively
banks have to raise interest rates to attract deposits.
This causes the LM curve to shift outward.
The lines will now cross at a new point—one where the
interest rate is lower and the economy is larger. In this
way the RBI has the power to control the level of GDP.
Although the RBI can increase the strength of the
economy by printing money, that comes at the cost of a
higher rate of inflation. Higher inflation causes the IS
curve to shift inwards. This causes interest rates to rise
again and the economy to slow.
If the RBI is not careful, its actions can backfire and lead
to an economy with high rates of inflation but not very
high GDP growth.
12/29/2020
Why the IS-LM curve is flat at zero
Another tactic the RBI can use to increase the amount of
money circulating in the economy is to lower interest rates.
Lower interest rates make it easier for households and
businesses to borrow money from banks. The loans that
banks make inject more money into the economy and allow
it to recover from the recession.
When interest rates hit zero, however, increases in the
money supply have no effect.
Households and businesses no longer have an increased
incentive to take out loans. The extra money sits in banks
without being spent. This is the reason the LM curve is flat at
zero.
Economists call the inability of interest rates to go below
zero the zero lower bound.
12/29/2020
The IS-LM model is a controversial economic tool. It
has a number of detractors, including the creator Hicks
himself, who said that the model is best used “as a
classroom tool” rather than in any practical application.
There are, however, pros to using the model.
12/29/2020
The pros of the IS-LM model
The model is commonly used to explain Keynesian
macroeconomics on a basic level.
It is a good introduction to and first approximation of
policy-making.
12/29/2020
The cons of the IS LM model
Does not take into account a huge variety of factors
that come to play in the modern economy, such as
international trade, demand, and capital flows.
Takes a simplistic approach to fiscal policy, the money
market, and money supply. Central banks today in most
advanced economies prefer to control interest rates on
the open market—for example, through sales of
securities and bonds. This model cannot account for
that should not be used as the sole tool in determining
monetary policy.
Does not reveal anything about inflation or international
trade, and does not provide insight or
recommendations toward formulating tax rates and
government spending.
12/29/2020
“The IS-LM model is a great way to explain Keynes’s ideas
about how monetary systems, markets, and
governmental actors can work together to drive
economic growth. However, as a practical model to
advise on fiscal or spending policy, it falls short.” PAUL
KRUGMAN
12/29/2020
Thank you
12/29/2020
