25-10-2023

Errol D’Souza

The IS LM Model Deriving the LM curve

Errol D’Souza Panel A Panel B

i i

i0 i0
P
P/

Indian Institute of
Md
Advanced Study
Rashtrapati Niwas
(Y0 )
P0
Shimla
M0
Turin School P0
Y0 Y
of Development
At income Y0 the interest rate in the money market is i0
Email: [email protected]

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Errol D’Souza Errol D’Souza

Suppose Income increases to Y1

Panel A Panel B Panel A Panel B

i i i i
LM

i1 Q i1 Q/ i1 Q i1 Q/

i0 i0 i0 i0
P P
Md
P/ Md
P/
(Y1 ) (Y1 )
P0 P0
Md Md
(Y0 ) (Y0 )
P0 P0
M0 Y0 M0 Y0 Y1
P0
Y1 Y P0
Y
An increase in income increases the money demand for The combination of real income and nominal interest rate
transactions purposes and raises the interest rate where money demand equals money supply is the LM
curve.

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Errol D’Souza Errol D’Souza

If the Central Bank increases money supply to
M
Interest elasticity of LM
Slope of LM schedule depends on interest elasticity of money demand
Panel A Panel B Panel A Panel B
M 
i i LM  
 P0 
i i
Interest Inelastic Interest Elastic
M  Money Demand
LM   Money Demand
 P0 
 

i1 i1

i0 i0 P/ i0 i0 Md
P (Y0 )
P
i1
i1
d
Q Md Q/ M
(Y0 )
(Y0 ) P
P0

Y0 M 
M M Y M  M 
   
M 
    Y
P0 P0  P 1  P 0  P 1  P 0
An increase in money supply causes agents to purchase
bonds which raises the price of bonds and results in a
decline in the interest rate to i1

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Errol D’Souza Errol D’Souza

Now if there is an increase in income to Y1  Y0

First take the interest inelastic case
Panel A Panel B Panel A Panel B
i i i Md
i
(Y1 )
Md Md P0
(Y0 ) (Y0 )
P0 P0

i1 inelastic
i1 inelastic

P/ P/
i0 P i0 i0 P i0
Md Md
(Y0 ) (Y0 )
P0 P0

M Y0 Y1 Y M Y0 Y1 Y
P0 P0
Let income be Y0 and money demand equals supply at An increase in income to Y1 increases the interest rate
interest rate i0 in the inelastic money demand case to i1 inelastic

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Errol D’Souza Errol D’Souza

Now, the interest elastic case

Panel A Panel B Panel A Panel B

i Md
i i Md
i LM inelastic
(Y1 ) (Y1 )
Md P0 Md P0
(Y0 ) (Y0 )
P0 P0

i1 inelastic i1 inelastic
i1 inelastic LM elastic

i1 elastic i1 elastic
i1 elastic
P/ P/
i0 P Md
(Y1 ) i0 i0 P Md
(Y1 ) i0
P0 P0

Md Md
(Y0 ) (Y0 )
P0 P0

M Y0 Y1 Y M Y0 Y1 Y
P0 P0
For the interest elastic money demand schedule the If the money demand curve is interest elastic (inelastic),
interest rate rises to i1 elastic the corresponding LM curve is interest elastic (inelastic).

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Errol D’Souza Errol D’Souza

Combining IS and LM
i i
LM LM

IS IS
Y Y
𝑌∗ 𝑌∗
Point E is an IS – LM equilibrium where the real
Figure 8.15: IS – LM equilibrium income and nominal interest rate achieve goods (IS)
and Money (LM) market equilibrium simultaneously.

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Errol D’Souza Errol D’Souza

If the Central Bank increases money supply to M

The IS – LM model allows us to understand the

i
immediate impact of a policy change such M 
LM  
as an increase in money supply or govern-  P

ment expenditure when the following M 

conditions hold - LM  
E  P 
 
• wages and prices are fixed
i0
E/
i1
• resources such as labour and capital are i2
not fully utilized IS
The IS – LM model is appropriate when the Y
constraint on output is the lack of demand 𝑌0 = 𝑌 ∗ Y1

First Individuals demand interest earning bonds and interest rate

Effect declines to

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Errol D’Souza Errol D’Souza

Increase in Investment
Increase in Government Expenditure
Reduction in i Rise in Y to Y1
Increase in Consumption
i i
M  LM
LM  
 P

M 
LM  
E  P E
 
i0 i0
E/
i1
i2 IS (G1 )
IS IS (G0 )
Y Y
𝑌0 = 𝑌 ∗ Y1 𝑌0 = 𝑌 ∗ Y2
As income rises to Y1 the demand for money balances First
Real Income rises initially to Y2 Distance Y0Y2
rises which causes the interest rate to rise to i1 Effect

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2) 3)
Errol D’Souza Errol D’Souza
2) Increase in demand for money raises i Decline in I 1)
Decline in C
Distance
Y1Y2 Y = G + I ( i
)
+ C i + C Y --(1)
i
LM 1) Real Income rises initially to Y2

E/ 2) Increase in demand for money raises i

i1
E I C
i0 Decline in Decline in

3) Induced increase in consumption

IS (G1 ) expenditure due to rise in Y

IS (G0 )
Y The second effect or the decline in interest sensitive
𝑌0 = 𝑌 ∗ Y1 Y2 consumption and investment expenditure due
3) Induced increase in consumption Distance Y0Y1 to a rise in the interest rate is referred to as
expenditure due to rise in Y crowding out.

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IS inelastic IS inelastic
i i
Interest rate

Interest rate

LM LM
IS elastic IS elastic

E E
i0 i0

IS (G )

IS (G )
Y Y
∗ ∗
𝑌0 = 𝑌 Aggregate Income 𝑌0 = 𝑌 Y1 Y3 Aggregate Income

Initially the solid inelastic and the dashed line elastic The increase in government expenditure shifts the dashed
IS curves intersect the LM curve at point E. elastic IS curve to right where income crowded out
is Y1Y3 .

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Errol D’Souza Errol D’Souza

IS inelastic IS inelastic
i i
Interest rate

Interest rate
LM LM
IS elastic IS elastic

E E
i0 i0

IS (G ) IS (G )

IS (G ) IS (G )
Y Y
𝑌0 = 𝑌 ∗ Y1 Y2 Y3 Aggregate Income 𝑌0 = 𝑌 ∗ Y1 Y2 Y3 Aggregate Income
A more elastic IS curve is associated with investment and
The increase in government expenditure shifts the solid consumption expenditures that are sensitive to inte-
inelastic IS curve to right where income crowded out rest rate changes. Crowding out is then larger when
is Y2Y3 . investment and consumption are interest elastic.

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Errol D’Souza Errol D’Souza

2nd aspect of crowding out: slope of LM curve

IS (G )
i IS LM i IS LM
inelastic inelastic
Interest rate

Interest rate

LM elastic
LM elastic
E E
i0 i0

Y Y
𝑌0 = 𝑌 ∗ Aggregate Income 𝑌0 = 𝑌 ∗ Y3 Aggregate Income

Initially the solid elastic and the dashed line inelastic The increase in government expenditure shifts the IS curve
LM curves intersect the IS curve at point E. to the right and expands income from Y0 to Y3 at the
initial interest rate, i0 .

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IS (G ) IS (G )
i IS LM i IS LM
inelastic inelastic
Interest rate

Interest rate
LM elastic
LM elastic
E E
i0 i0

Y Y
𝑌0 = 𝑌 ∗ Y1 Y2 Y3 Aggregate Income 𝑌0 = 𝑌 ∗ Y1 Y2 Y3 Aggregate Income
A more inelastic LM curve is associated with an inelastic
Crowding out is larger at Y1Y3 when the LM curve is demand for money. Crowding out is then larger when
inelastic than the income amount Y2Y3 when the the demand for money is interest inelastic.
LM curve is elastic.

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Errol D’Souza Errol D’Souza

Crowding out is larger (or the impact of a fiscal policy

Effectiveness of Fiscal & Monetary Policy
of increased government expenditure on aggregate
income is smaller) when – Fiscal Policy Monetary Policy
Effective Effective
(1)investment is sensitive to interest rate changes
or the investment schedule is interest elastic, Interest Sensitivity Private Expend- Private Expend-
of Private Sector itures interest itures not
(2) consumption is sensitive to interest rate changes Expenditures inelastic perfectly interest
or the consumption function is interest inelastic
elastic, and

(3) the demand for money is relatively insensitive to Interest Sensitivity Demand for Demand for
interest rate changes or the demand for Of the Demand for money interest money interest
money is interest inelastic. Money elastic inelastic

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Errol D’Souza

IS-LM in India

Prior to reforms fiscal policy was the dominant tool

of macroeconomic policy and monetary policy
played a subservient role.

Only with the phasing out of ad hoc Treasury

bills and the reigning in of the fiscal deficit
has the central bank been able to conduct
open market operations and use discretionary
monetary policy.

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Errol D’Souza Errol D’Souza

1994-95 to 2001-02: 2002-03 to 2013-14:

Growth rate of fiscal deficit: 4.9 per cent
Growth rate of fiscal deficit: 10.4 per cent
Growth rate of money supply: 9.3 per cent
Growth rate of money supply: 9.1 per cent
Since they almost offset each other the real Average rate of interest during this period:
interest rate was more or less constant
during this period. 2002-03 to 2013-14 — 1.7 per cent,
1994-95 to 2001-02 — 4.9 per cent
2002-03 to 2013-14:
Reduction in the interest rate as can be seen boosted the
Growth rate of fiscal deficit: 4.9 per cent growth of output in this period and the graph
Growth rate of money supply: 9.3 per cent shows an uptick in the growth rate till 2013-14.
Monetary expansion, though on a declining path, was still large enough
to offset the government borrowing programme due to the fiscal deficit

Rightward shift of LM curve larger than of IS

curve and interest rates declined with a
negative growth rate during this period
of ─ 0.07 per cent.

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Errol D’Souza Errol D’Souza

2014-15 to 2021-22:
The Liquidity Trap
Fiscal deficit again balloons ─ Panel A
i
Growth rate of fiscal deficit: 10.9 per cent
Growth rate of money supply: 5.8 per cent
Md
(Y0 )
P0

Growing fiscal deficit resulted in real interest rates in this

period to grow at a trend rate of 1 per cent.

The rise in real interest rates which averaged 2.3 per cent i0 P
in the period resulted in a reduction in the growth of
GDP.
M0
GDP growth during 2014-15 to 2021-22: 5.9 per cent P0
GDP growth during 2002-03 to 2013-14: 6.74 per cent At income Y0 the interest rate in the money market is i0

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Consumption C
 M
U = U  C ,  = constant
 P

Y2 C2
Y1 + − A
(1 + r1 ) (1 + r1 )
The Liquidity Trap

i
Slope =
E 1+ i

B
M
O
Md* P
Real
P (1 + i1 )  Y + Y2 − C2  Money
i1  (1 + r1 ) (1 + r1 )  Balances
1

Figure 6.2: Equilibrium Money Balances Held

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Errol D’Souza Errol D’Souza

In the section on demand for money we translated the

optimal choices for any given nominal interest If the interest rate i were to turn negative there would
rate i in the indifference curve and budget const- be no optimality condition at all that is possible
raint diagram to a market diagram that traces to depict from the budget line/indifference curve
the quantity of real money demanded as a func- analysis.
tion of its price i.
This indicates that there is a Zero Lower Bound (ZLB)
Using this technique we got the downward slop- restriction on nominal interest rates – i.e., nom-
ing money demand function. inal interest rates cannot fall below zero.

In the money market space diagram this indicates the

If we continue to reduce the interest rate i the budget money demand function is as drawn in the
line would be extremely flat. In fact, if i were to following diagram:
be exactly zero, the optimality condition between
the slope of budget line and indifference curve
seizes to have any economic meaning as indiff-
erence curves are strictly convex to the origin.

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Errol D’Souza Errol D’Souza

ZLB region ZLB region

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Errol D’Souza Errol D’Souza

The Liquidity Trap

Panel A
i

Md
(Y0 )
P0

ZLB region
i0 P

M0
P0
The linearized version of the money demand function
can be depicted as in the diagram here. At income Y0 the interest rate in the money market is i0

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Panel A Panel A Panel B

i i i

Md Md
(Y0 ) (Y0 )
P0 P0

i0 P

Q Q
M0
P0
M 0/ M 0/ Y0 Y
P0 P0
M 0/
Suppose the money supply is ,
the equilibrium point
P0
is at Q where the nominal interest rate is zero.

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Errol D’Souza Errol D’Souza

Suppose Income increases to Y1 Suppose Income increases to Y2

Panel A Panel B Panel A Panel B

i i i Md
i
(Y2 )
P0
Md Md
Md
(Y0 ) (Y1 ) Md
(Y0 ) P0 (Y1 )
P0 P0 P0

i2
i2

i1 i1
i1 i1

Q Q
M 0/ Y0 Y1 Y M 0/ Y0 Y1 Y2 Y
P0 P0
An increase in income increases the money demand for
transactions purposes and raises the interest rate

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Errol D’Souza Errol D’Souza

Panel A Panel B The central bank can increase the money supply
i Md
i by conducting an open market operation.
(Y2 )
P0
Md
Md
(Y0 ) P0 (Y1 ) It buys bonds and pays for that by creating money
P0

i2 However, at a nominal interest rate of zero, people

i2
are indifferent as to how much money or
bonds to hold – the liquidity trap.
i1
i1
With the open market operation people are
Q willing to hold more money at the
M 0/ Y0 Y1 Y2 Y same nominal interest rate of zero.
P0

The LM Curve has a flat segment along the Y axis where

the nominal interest rate is zero.

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Errol D’Souza Errol D’Souza

Panel A Panel B
i
i Md
i
(Y2 )
P0
Md LM
Md
(Y0 ) P0 (Y1 )

Interest rate
P0 IS

LM/

Q A
O Y
Aggregate Income
M 0/ M 0// Y
P0 P0 M 0//
Effect of an increase in money supply to is to Suppose the IS and LM curves intersect at point A.
P0
shift the LM curve to the right
to LM/

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Errol D’Souza Errol D’Souza

i Suppose at the same time the economy is experiencing

deflation
In Japan for instance the collapse of the Nikkei from
LM December 1989 led to a decline in asset prices
Interest rate

IS
and a deflation. Since 1998 the consumer price
LM /
inflation rate has been negative for 6 years.

A
O Aggregate Income
Y

An increase in money supply shifts the LM curve to

LM/. The monetary policy has no impact on the
economy

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Errol D’Souza Errol D’Souza

a + c0 − (1 − c1 )(Y − T ) − (T − G )
i IS = + e
Suppose at the same time the economy is experiencing b + c2
i
deflation

Nominal Interest rate

In Japan for instance the collapse of the Nikkei from
December 1989 led to a decline in asset prices IS/ IS LM
and a deflation. Since 1998 the consumer price
LM /
inflation rate has been negative for 6 years.

r = i − Inflation
With a deflation real interest rates are high.
Loans are expensive in real terms and investment
demand declines. A
Y
O Aggregate Income
With falling prices consumers tend to delay purchases
and this tends to reduce demand further. A rise in deflation – decline in  - shifts the IS curve e

to the left to IS/. A combination of liquidity trap

and deflation occurred in Japan in the 1990s.

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