Applying 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.
M P = L (r ,Y ) IS
Y
The intersection determines Y1
the unique combination of Y and r
that satisfies equilibrium in both markets.
 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 effects of r1
• fiscal policy: G and/or T
• monetary policy: M
IS
Y
Y1
 An increase in government purchases
1. IS curve shifts right
r
1 LM
by G
1− MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the 1. IS2
interest rate to rise… IS1
3. …which reduces investment, Y
Y1 Y2
so the final increase in Y
3.

1
is smaller than G
1− MPC
A tax cut
Consumers save r
(1−MPC) of the tax cut, LM
so the initial boost in
spending is smaller for T
than for an equal G… r2
2.
r1
and the IS curve shifts by
−MPC 1. IS2
1. T
1− MPC IS1
Y
Y1 Y2
2. …so the effects on r
2.
and Y are smaller for T
than for an equal G.
Monetary policy: An increase in M

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

2. …causing the r1
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y 1 Y2
output & income to
rise.
 • Model:
Monetary & fiscal policy variables
Interaction (M, G, and T ) are exogenous.
between • Real world:
Monetary policymakers may adjust M
monetary & in response to changes in fiscal policy,
or vice versa.
fiscal policy
• Such interaction may alter the impact of the
original policy change.
The Central Bank’s response to G > 0

• Suppose there is an increase in G.

• Possible RBI (or Fed) responses:
1. hold M constant
2. hold r constant
3. hold Y constant
• In each case, the effects of the G
are different…
Response 1: Hold M constant

Rise in G: r
the IS curve shifts right. LM1

If CB holds M constant,
r2
then LM curve doesn’t
r1
shift.
IS2
Results:
IS1
Y = Y 2 − Y1 Y
Y1 Y2
r = r2 − r1
Response 2: Hold r constant

Rise in G, r
the IS curve shifts right. LM1
LM2
To keep r constant, CB
r2
increases M r1
to shift LM curve right.
IS2
Results: IS1
Y = Y 3 − Y1 Y
Y1 Y2 Y3

r = 0
• https://www.economist.com/briefing/2020/03/19/governments-are-
spending-big-to-keep-the-world-economy-from-getting-dangerously-
sick

• https://www.economist.com/briefing/2020/03/26/rich-countries-try-
radical-economic-policies-to-counter-covid-19

• https://www.economist.com/finance-and-
economics/2020/05/07/emerging-markets-launch-qe-too
 Reduces the
Here, Central
crowding out
banks ( like RBI
effect by
and Fed)
reversing the
complement the
impact on
government.
interest rate.
Other Possibility
• https://www.youtube.com/watch?v=kxL3s4ccVWQ&ab_channel=CN
BCTelevision

• https://www.youtube.com/watch?v=Xk1PP-
cS4nU&ab_channel=CNBCTelevision
Some background

https://www.economist.com/graphic-
detail/2017/11/16/the-trump-tax-cuts-fall-far-short-of-
ronald-reagans-reforms

17 Nov. 2018

16 Nov. 2017

https://www.economist.com/leaders/2018/11/17/the-
biggest-tax-cut-youve-never-heard-of
Response 3: Hold Y constant

Rise in G, r LM2
the IS curve shifts right. LM1

To keep Y constant, r3
r2
CB reduces M r1
to shift LM curve left.
IS2
Results: IS1
Y = 0 Y
Y1 Y2
r = r3 − r1
• Here, Central bank ( RBI or Fed) is acting
contrast to the action of the government.
Other economic
disturbances.
Shocks in the IS -LM model
IS shocks: exogenous changes in the demand for goods & services.
Examples:
• stock market boom or crash
 change in households’ wealth
 C
• change in business or consumer
confidence or expectations
 I and/or C
 Any exogenous change that
impact the autonomous
consumption and autonomous
investment will shift IS Curve.
Shocks in the IS -LM
model
LM shocks: exogenous changes in the demand for
money.
Examples:
• a wave of credit card fraud increases demand for
money.
• more ATMs or the Internet reduce money
demand.
• For as given Income(output), if the economic agent demand more
money then it will lead to higher interest rate.

• We can show this by upward shift of the LM Curve.

Any exogenous changes
that impact the demand of
Money will shift LM Curve.
NOW YOU TRY
Analyze shocks with the IS–LM model
• Use the IS–LM model to analyze the effects of
1. a housing market crash that reduces consumers’ wealth
2. consumers using cash in transactions more frequently in response to
an increase in identity theft

• For each shock,

a. use the IS–LM diagram to determine the effects on Y and r.
b. figure out what happens to C, I .
NOW YOU TRY
Analyze shocks with the IS–LM model, answer, part 1
• IS shifts left, causing r
and Y to fall.

• C falls due to lower

wealth and lower
income
• I rises because r is lower
NOW YOU TRY
Analyze shocks with the IS–LM model, answer, part 2
• LM shifts left, causing r
to rise and Y to fall.
• C falls due to lower
income.
• I falls because r is
higher.
Now, Time has come to bring flexibility to Price.
 IS-LM and aggregate demand
• So far, we’ve been using the IS-LM model to analyze the short run,
when the price level is assumed fixed.
• However, a change in P would shift LM and therefore affect Y.
• The aggregate demand curve captures this
relationship between P and Y.
Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y
Monetary policy and the AD curve
r LM(M1/P1)
The RBI can increase
r1 LM(M2/P1)
aggregate demand:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
P
 I
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y
 Fiscal policy and the AD curve
r LM
Expansionary fiscal
policy (G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
Y1 Y2 Y
 IS shifts right P
 Y at each
value of P P1

AD2
AD1
Y1 Y2 Y
What shift Aggregate Demand Right ?
▪ G ( Expansionary Fiscal policy)
▪ Tax ( -ve) ( Expansionary Fiscal policy)
▪ Money Supply ( Expansionary Monetary policy)
▪ Autonomous Consumption and Autonomous
Investment
 Main take away:
Expansionary Fiscal Policy and Expansionary
Monetary Policy both Shift AD Curve Rightward.
Japan – A Unique Case.
 The Japanese Slump

•The robust growth that Japan had experienced since the end of World
War II came to an end in the early 1990s.

•Since 1992, the economy has suffered from a long period of low
growth—what is called the Japanese slump.

•Low growth has led to a steady increase in unemployment, and a

steady decrease in the inflation rate over time.
 The Japanese Slump
Figure
The Japanese Slump:
Output Growth since
1990 (percent)

From 1992 to 2002, average

GDP growth in Japan was
less than 1%.
 The Japanese Slump

Table GDP, Consumption, and Investment Growth, Japan, 1988-1993

Year GDP (%) Consumption (%) Investment (%)
1988 6.5 5.1 15.5
1989 5.3 4.7 15.0
1990 5.2 4.6 10.1
1991 3.4 2.9 4.3
1992 1.0 2.6 −7.1
1993 0.2 1.4 −10.3

The numbers raise an obvious set of questions:

What triggered Japan’s slump? Why did it last so long? Were
monetary and fiscal policies misused, or did they fail? What are the
factors behind the current recovery?
 The Japanese Slump
Figure
Unemployment and
Inflation in Japan since
1990 (percent)
Low growth in output has
led to an increase in
unemployment. Inflation has
turned into deflation.
 Disinflation, Deflation,
and the Liquidity Trap
The value of the real interest rate corresponding to a zero nominal
interest rate depends on the rate of expected inflation. For example, if
expected inflation is 10%, then:

▪ At a negative real interest rate of 10%, consumption and

investment are likely to be very high. The liquidity trap is unlikely
to be a problem when inflation is high.
r = i −  e = 0% − 10% = − 10%
▪ If a country is in a recession, and the rate of inflation is negative,
say 5%, then even if the nominal interest rate is zero, the real
interest rate remains positive.

r = i −  e = 0% − ( − 5%) = 5%
In this situation, there is nothing monetary policy can do to bring output
above the natural level of output.
The Failure of Monetary and Fiscal Policy
Figure
The Nominal Interest
Rate and the Real
Interest Rate in Japan
since 1990
Japan has been in a liquidity
trap since the mid-1990s:
The nominal interest rate
has been close to zero, and
the inflation rate has been
negative. Even at a zero
nominal interest rate, the
real interest rate has been
positive.
The effects of falling prices:
Expected by Classical Theory
• The stabilizing effects of deflation:
• P  (M/P)  LM shifts right  Y
• Pigou effect:
• P  (M/P )
•  consumers’ wealth 
•  C
•  IS shifts right
•  Y
But In reality, there is precautionary saving.
• https://www.businesstoday.in/latest/world/story/dont-buy-tv-fridge-
hold-onto-your-money-jeff-bezos-sees-a-recession-coming-353364-
2022-11-18
The effects of falling prices
• The destabilizing effects of expected deflation:
• E π
•  r  for each value of i
•  I  because I = I (r)
•  planned expenditure and aggregate demand 
•  income and output 
The Failure of Monetary and Fiscal Policy

Monetary policy was used, but it was used too late, and when it
was used, if faced the twin problems of the liquidity trap and
deflation.

The Bank of Japan (BoJ) cut the nominal interest rate, but it did so
slowly, and the cumulative effect of low growth was such that
inflation had turned to deflation. As a result, the real interest rate
was higher than the nominal interest rate.
The Liquidity Trap

Figure
Money Demand, Money
Supply, and the
Liquidity Trap
When the nominal interest
rate is equal to zero, and once
people have enough money
for transaction purposes, they
become indifferent between
holding money and holding
bonds. The demand for
money becomes horizontal.
This implies that, when the
nominal interest rate is equal
to zero, further increases in
the money supply have no
effect on the nominal interest
rate.
 The Liquidity Trap
• Now consider the effects of an increase in the money supply:

• Starting from the equilibrium of Ms and i at point A, an increase in the money

supply leads to a decrease in the nominal interest rate.

• Now consider the case where the money supply is at point B or C. In either
case, the initial nominal interest rate is zero, and an increase in the money
supply has
no effect on the nominal interest rate at this point.
 The Liquidity Trap
• The liquidity trap describes a situation in which
expansionary monetary policy becomes powerless.
The increase in money falls into a liquidity trap:
People are willing to hold more money (more
liquidity) at the same nominal interest rate.

• The central bank can increase “liquidity” but the

additional money is willingly held by financial
investors at an unchanged interest rate, namely,
zero.
 Draw the IS-LM
graph of Liquidity
trap.
Balance sheet Recession : Liquidity trap in
real life

Economist Richard Koo explained that Japan experienced a

“balance sheet recession” in 1990.

A sharp decline in land and stock prices caused this

recession, leading to Japanese companies having more
liabilities than assets.

Despite efforts to encourage borrowing through zero interest

rates and increasing the money supply, Japanese companies
used their own profits to pay off debts instead of investing.
Corporate investment, an important factor in
GDP, experienced a significant drop from 1990 to
its lowest point in 2003, reaching 22% of GDP.

After 1998, Japanese companies shifted from

being borrowers to becoming net savers.
Is expansionary Fiscal policy
good policy prescription in
such situation ?
 The Japanese Slump
The Failure of Monetary and Fiscal Policy

Figure
Government Spending
and Revenues (as a
percentage of GDP) in
Japan since 1990
Government spending
increased and government
revenues decreased
steadily throughout the
1990s, leading to steadily
larger deficits.
It was massive fiscal stimulus (borrowing and spending by the
government) that offset this decline and enabled Japan to maintain its
level of GDP.
Finally, it APPEARS the sun is
rising…
• The Bank of Japan (BOJ) introduced
Quantitative and Qualitative Monetary
Easing (QQE) in April 2013, under which it
has conducted large-scale purchases of
Japanese government bonds (JGBs).

• In September 2016, the BOJ introduced the

framework of yield curve control (YCC), in
which it sets both short-term and long-term
interest rates as policy rate targets, and
since then has conducted JGB purchases in a
more flexible manner in order to achieve its
long-term interest rate target.

• In this sense, YCC is a special form of

quantitative easing.
• https://x.com/i/status/1858458964247134284
• https://www.wsj.com/economy/central-banking/boj-governor-
reaffirms-stance-on-raising-rates-further-despite-uncertainties-
83cc950c?mod=Searchresults_pos3&page=1
Timely and efficient use
of monetary and Fiscal
policy is very critical.