Macroeconomy.

UNIT 4: IS – LM MODEL.
IS – LM Model is putting the money market and the supply market together.

1- Market of Goods and Services.

a) AS = Y = F(…)
b) AD = C + I + G
c) Equilibrium: AS = AD. Y = C0+ C1 ( Y – t * Y + TR) + Io – bi + G

After some moves of that equation we can conclude:

I = Yd – C + t * Y – G – TR

Yd: Private savings.

Total amount of savings and Total amount of Investment.
t*Y – G – TR: Budget balance

As we can see, in the equilibrium, the total amount of savings should be equal to the total
amount of investment. That is called the IS RELATION.

I for investment.

Stotal for savings.

2- Money market:
a) Money Supply: MS
b) Demand for money: Md (Y ; i)
c) Equilibrium: Md= Ms

Md = Liquidity Preference.

Ms = Money Supply. LM, liquidity and money supply.

Objective: To study both markets at the same time. We will use the:

Y and the i, the supply and the interest rate. We will use this two variables because there are
in both markets.
Exercise 1:
C = 200 + 0,8 Yd.

t = 25 %

I = 3000 – 500i

i=4

G = 400

TR = 0

Y = 200 + 0,8 (Y – Y*0,25 + 0) + 3000 – 500 * 4 + 400

Y = 200 + 0,8Y – 0,2Y + 1400

Y = 1600 + 0,6Y

AS = AD

EQUILIBRIUM = 1600 + 0,6Y

AS = Y = 4000

Answer.

0,4Y = 1600

Y = 4000
b) Then the central bank increases the interest rate to:

i=5

Y = 200 + 0,8 (Y – Y*0,25 + 0) + 3000 – 500 * 5 + 400

Y = 1100 + 0,6 Y

Y = 2750

AS = AD

EQUILIBRIUM = 1600 + 0,6Y

NEW EQUILIBRIUM.

AS = Y = 4000

As we can see because of the change in the interest rate the Y, income, has change which
means, in this case, that the equilibrium is in a lower level.

That is why, when you increase the interest rate there is less demand of money which means
there is less consumption. If there is less consumption there is less income…
 HOW DO WE FIND THE IS curve?

AD
AS = AD
4000

2750

AS
i

IS

2750 4000 Y

Analyzing the negative relationship between i and Y.

ia = 4 ib = 5

I A = 3000 – 500 * 4 = 1000 YA = 4000

IB = 3000 – 500 * 5 = 500 YB = 2750

This means that when the interest rate increases the investment decreases which also means
that the Aggregate Demand decreases and with that also the income in the economy.

The IS Curve it represents a set of combinations of interest (i) and Y for which there is an
equilibrium in the market for Goods and Services.
 Analyzing of the Goods Market off the equilibrium path.

Excesive Supply
i

IS

Excesive Demand
Y

As we can see, on the first point there is (blue) we can see there is an excessive supply because
the IS represents the equilibrium points and in this point there is too much Y ( Y = Supply).

On the other hand, the green point needs more supply to get to the equilibrium. That is why
we can say there is an excessive demand.
 MONEY MARKET
Derive: LM relation.

Ms = 200

Md = 0,1Y – 100i

1) Y = 3000
i=?

Ms = Md

200 = 0,1Y – 100i

200 = 0,1 * 3000 – 100i

i=1

For an income of 3000 an interest of 1 leads to the equilibrium of the money market.

i Ms

Md

200 M
Y = 4000
Ms = Md

200 = 0,1Y – 100i

200 = 0,1 * 4000 – 100i

i=2
 HOW DO WE FIND THE LM curve?

i Ms i

LM

M Y

Conclusions.
After seeing this we can conclude that there is a positive relationship between the i (interest)
and the Y (Income).

Also the definition of the LM curve will be the combination of interest rate and the income
which there is an equilibrium in the money market.

LM

Excessive Supply

Y
Excessive Demand

We can appreciate that in the red point there is a different income but the same interest than
the equilibrium. Luckily we know there is an excessive supply due to there is more people
willing to offer money than the equilibrium.

But on the other side, we have point green which doesn’t have a different income but it does
have a different interest than the equilibrium point. Then we can see that is under the LM
curve which means that more people are willing to ask for borrowed money or liquidity. Then
we can say there is an excessive demand.
 IS – LM model

1. Model that studies the economy in the short-run

- Prices are sticky, which means that prices do not change.
2. There is no full unemployment
- If there is full employment the supply may not be able to adjust to the changes on
the demand.
3. This model is a tool that helps us to study the reaction of the economy to different
economic policy interventions, physcal and monetary policies.

With all that we can find the General Equilibrium.

LM

E (General Equilibrium)

IS

General Equilibrium
The General Equilibrium is a unique point where both markets, Goods and Services and
Money Market, match and create this equilibrium.
 Policy Analysis.
1- Fiscal Policy
2- Monetary Policy
3- Monetary Policy.

Fiscal Policy intervention.

Ø It is made by the Government.
Ø Shifts the IS curve.
Ø It doesn’t affect the LM curve directly.

There are two types of fiscal policies.

a) Expansionary fiscal policy.

§ Increase in Government Spending.
§ Put less taxes.
§ Increase the transfers.

If we make this the IS curve will move to the right.

LM

E (General Equilibrium)

IS

As we can see in the figure, the IS has move to the right.

b) Contractionary fiscal policy.

§ Decrease in the government spending
§ Put less taxes.
§ Increase the transfers.
c) Note:
§ Anything that increases the Aggregate Demand (Increase in the expectations
of the investors, I0, C0 increases, G increases) will shift the IS to the right.
§ Anything that decreases the Aggregate Demand will change the IS to the left.
Crowding out Effect

This happens when the government crowds out the private Investment with the high interest.

Steps:

1. Government increases their spending.

2. Aggregate demand increases.
3. Aggregate supply (Y) increases as well
4. Consumption increases
5. Aggregate demand increases.
6. …

a) Monetary Demand increases because there is the need of money to produce.

b) Interest rate (i) increases
c) Monetary demand decreases.

1) Investment decreases because is to expensive to borrow money to invest.

2) Aggregate demand decreases
3) Supply decreases.

This situation can only be solve if the central banc applies a expansionary policy as well
 Monetary Policy intervention.

Ø Control by the central bank.

Ø It will shift the LM curve.
Ø The IS curve doesn’t change.

a) Expansionary Monetary policy.

§ When the central bank increases the money supply the interest will fall.
§ Decrease the interest rate directly.
§ The LM curve will shift downwards.

b) Contractionary Monetary policy.

§ When central bank decreases the Money supply the interest rate will
increase.
§ Increase the interest rate.
§ The LM curve will shift upwards.

LM

IS

Policy Mix
Ø It is the combination of the fiscal policy and the monetary policy.
Ø It can be in the same direction
Ø Or can be the opposite direction.

a) Same direction
§ Ex: Expansionary monetary policy and contractionary fiscal policy
§ The other way around.

b) Opposite direction
§ Both types of policies are going to go in the same direction.
Review
Shift of IS Shift of LM Movement in Movement in Type of policy
Y i
Increase Taxes Left - Decrease Decrease Contractionary
fiscal policy
Decrease Right - Increase Increase Expansionary
Taxes fiscal policy
Government Right - Increase Increase Expansionary
increase fiscal policy
Government Left - Decrease Decrease Contractionary
decrease fiscal policy
Money Supply - Down Increase Decrease Expansionary
increase monetary
policy
Money Supply - Up Decrease Increase Contractionary
decrease monetary
policy

Exercise 2 (Full exercise).

C = 100 + 0,8Yd
I = 2000 – 50i
G = 500 IS curve
t = 25 % [0,25]
TR = 0

Md = 10Y – 5000i
LM curve
Ms = 30000

a) Find the General point.

Y = 100 + 0,8 (Y – 0,25Y + 0) + 2000 – 50i + 500
Y = 100 + 0,6Y + 2000 – 50i + 500
Y = 2600 + 0,6Y – 50i
0,4Y = 2600 – 50i
Y = 6500 – 125i IS curve.
 Ms = Md
10Y – 5000i = 30000
10Y = 30000 + 5000i
Y = 3000 + 500i LM curve

6500 – 125i = 3000 + 500i

3500 = 125i
i = 5,6
Y = 5800

LM

i = 5,6 E (General Equilibrium)

IS

Y=5800 Y

b) Budget Balance
BB = Y·t – G – TR
BB = 5800 · 0,25 – 500 – 0
BB = 950
In % of GDP = (950 ÷ 5800) · 100 = 16,37 %

c) Private savings
S = Yd – C
Yd = 5800 – 1450 = 4350
C = 3580
S = 4350 – 3580 = 770
 d) Look if the Total Savings match with the investment
Stotal = BB + S = 770 + 950 = 1720
I = 1720

e) Fiscal expansionary policy G = 2000

G = 2000
Y* = 2100 + 0,6Y – 50i + 2000
Y = 10250 – 125i IS curve.
Y = 3000 + 500i LM curve
10250 – 125i = 3000 + 500i
7250 = 625i
i = 11,6
Y = 8800

LM

i = 11,6

i = 5,6

IS

Y=5800 Y=8800 Y

ü Budget Balance
BB = Y·t – G – TR
BB = 8800 · 0,25 – 2000 – 0
BB = 200
In % of GDP = (200 ÷ 8800) · 100 = 2,27 %
 f) What policy should the central bank do in order to maintain the initial
interest. By how much should he increase, or decrease the Ms.
Expansionary fiscal policy.
i = 5,6
Ms = ?

Y = 10250 – 125i
Y = 10250 – (125·5,6)
Y = 9550
Md = Ms
Md = 10·9550 – 5000·5,6
Md = 67500 = Ms
dMs= 67500 – 30000 = 37500

LM

i = 11,6

i = 5,6

IS

Y=5800 Y=8800 Y=9550 Y

Explanation:
a) At first, we can see that the equilibrium where we find the General EQ, which
means that Y and i match in both markets (Goods market and Money market).
The Y (GDP) is 5800 and the interest rate (i) is 5,6.
b) Also, the Government has a budget balance surplus, which means that they
collect more money with the taxes than the money they spent on Government
spending (G) and Transfers (TR).
c) The private savings are 770.
d) If you add the public savings, so the budget balance, and the private savings, you
can see that they both match with the investment, so we did it right.
e) The government applies and expansionary fiscal policy increasing the
government spending. At the same time, we see that this has some
consequences. Firstly, the IS curve, and only the Is curve, moves to the right on
the figure we draw (Only the IS moves because the government spending only
affects the Goods and Services market. When this curve moves to the right
makes the Y and the i increase. The first variable increases because there is more
aggregate demand. As there is more aggregate demand there we need more
supply to have an equilibrium. To make this increase in equilibrium possible, we
need money, so we can invest and produce more for the future. As more people
ask for money the interest rate will increase. When the interest rate increases
means that the Money demand will slow down at some point and decrease. This
two movements happened simultaneously.
f) If the central bank wants to keep the low interest rate we had at the beginning
they need to apply an expansionary monetary policy by increasing the money
supply or decreasing the interest rate. In this case we will se the increasing of the
money supply. We can see that after some mathematical operations they will
increase the money supply by 37500. When they increase the money supply,
there will be more supply of that which means that the interest will fall. Also, the
GDP will increase (Y). So, then we can see that for the fiscal policy to have a real
effect on he economy, we need a monetary policy to follow it. The problem is
that this monetary policy will derive in an inflation problem in the future.