Scribd
Upload
25 views19 pages

IS-LM Notes 1

Uploaded by

Bangura Abdulai F
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
25 views19 pages

IS-LM Notes 1

Uploaded by

Bangura Abdulai F
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 19

Policy analysis with the IS -LM model

Equilibrium in the IS -LM model

The IS curve represents r


equilibrium in the goods LM
market.
Y = C (Y −T ) + I (r ) + G
r1
The LM curve represents
money market equilibrium.
IS
M P = L(r ,Y )
Y
The intersection determines Y1
the unique combination of Y and r
that satisfies equilibrium in both markets.
Equilibrium With Fixed Prices

IS Curve
 

 c + I +G−c T br 
S(Y;G,T )= I(r) or Y = 0 0


1 − 
(+)(-)(+) 1−c 1−c 

 1 1 
LM Curve
M = L(r,Y) (or M =m +kY −hr)
P (-)(+) P 0

Solve for Y and r in terms of G,T, M and P.


Policy analysis with the IS -LM model

Y = C (Y −T ) + I (r ) + G r
LM
M P = L(r ,Y )

We can use the IS-LM


model to analyze the r1
effects of
• Fiscal policy: G and/or T
IS
• Monetary policy: M
Y
Y1
An increase in government purchases
1. IS curve shifts right r
1 LM
by G
1−MPC
r2
causing output & 2. r
income to rise.
1

2. This raises money 1. IS2


demand, causing the
IS1
interest rate to rise…
Y
3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than G
1−MPC
A tax cut

r
The IS curve shifts by LM

−MPC r2
1. T 2.
1−MPC r1
1. IS2
…r rises so the final IS1
2. increase in Y is smaller Y
than the direct effect of a Y1 Y2
tax cut. 2.
Monetary policy: An increase in M

r
1. M > 0 shifts LM1
the LM curve down
(or to the right) LM2

r1
2. …causing the
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.
Using a Policy Mix
• The combination of monetary and fiscal polices is
known as the monetary-fiscal policy mix, or simply, the
policy mix.

The Effects of Fiscal and Monetary Policy.


Shift of Movement of Movement in
Shift of IS LM 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
Liquidity Trap (h=)
Fiscal Expansion Monetary Expansion

r r

LM1
r1 r1 LM
LM 2

IS2
IS1 IS

Y1 Y2 Y Y1 Y

Income and Output Income and Output


Investment Interest-Insensitive (b=0)
Fiscal Expansion Monetary Expansion

r r IS
IS1 IS2 LM1

LM LM2

r2 r1

r2
r1

Y1 Y2 Y Y1 Y

Income and Output Income and Output


Quantity Theory (h=0)
Fiscal Expansion Monetary Expansion

LM LM1 LM2
r r

r2
r1

r1
r2
IS2

IS1 IS

Y1 Y Y1 Y
Y2

Income and Output Income and Output


Fiscal Monetary
Policy Policy
Liquidity Trap (h=) Yes No
(Keynesian Case I)

Autonomous Investment (b=0) Yes No


(Keynesian Case II)

Quantity Theory (h=0) No Yes


(Monetarist Case)
Interaction between Monetary & Fiscal policy

• Model: Monetary & fiscal policy variables (M, G, and


T) are exogenous.
• Real world: Monetary policymakers may adjust M in
response to changes in fiscal policy, or vice versa.
• Such interaction may alter the impact of the original
policy change.
The Monetary Authority’s response to G>0

• Suppose Government expenditure (G) increases.


• Possible Monetary responses:
1. hold M (money supply) constant
2. hold r (interest rate) constant
3. hold Y (output) constant
• In each case, the effects of the G are different:
Response 1: Increase G and hold M constant

If G increases r
the IS curve shifts right. LM1

If money supply constant,


r2
then LM curve doesn’t
r1
shift.
IS2
Results:
IS1
Y = Y2 − Y1 Y
Y1 Y2
r = r2 − r1
Response 2: Increase G and hold r constant

If G increases. then r
the IS curve shifts right. LM1
LM2
To keep r constant,
r2
M increases
r1
And LM shift LM right.
IS2
Results:
IS1
Y
Y = Y3 − Y1 Y1 Y2 Y3

r = 0
Response 3: Increase G and hold Y constant

If G increases, then r LM2


the IS curve shifts right. LM1
To keep Y constant, r3
r2
M decreases, and
r1
LM shift curve to the left.
IS2
Results:
IS1
Y
Y = 0 Y1 Y2
r = r3 − r1
Y2 Y
Deriving the AD curve
r LM(P2)
Intuition for slope
r2 LM(P1)
of AD curve:
r1
P  (M/P )
IS
 LM shifts left
Y2 Y1 Y
 r P
 I P2
 Y P1
AD
Y2 Y1 Y

You might also like