Goods and Financial Markets:

The IS-LM Model

Chapter 5: Goods and Financial Markets: The ISLM Model

Chapter 5
Q:How are output and the interest rate determined
simultaneously in the short run?
A:By simultaneous equilibrium in the goods and money
markets.

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Outlines

Chapter 5: Goods and Financial Markets: The ISLM Model

Chapter 5 will be discussed in four parts.

Part 1 Equilibrium in goods market, IS curve
Part 2 Equilibrium in money market, LM curve
Part 3 The IS-LM Model
(Equilibrium in Goods and Money Market)
Part 4 Use the IS-LM to study the effects of fiscal
policy and monetary policy

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Introduction

Chapter 5: Goods and Financial Markets: The ISLM Model

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.

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5-1 The Goods Market and the IS Relation

Goods Market
Chapter 5: Goods and Financial Markets: The ISLM Model

In Chapter 3, the equilibrium condition in goods market was given by:

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5-1 The Goods Market and the IS Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

Investment, Sales, and the Interest Rate

Investment depends primarily on two factors:
The level of sales (+)
The interest rate (-)

I I (Y ,i)

( , )

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5-1 The Goods Market and the IS Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

Determining Output
Taking into account the investment relation, the
equilibrium condition in the goods market becomes:

Y C (Y T ) I (Y ,i) G

(5.2)

For a given value of the interest rate i, demand Z is an

increasing function of output, for two reasons:
An increase in output leads to an increase in
income and also to an increase in disposable
income.
An increase in output also leads to an increase in
investment.
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5-1 The Goods Market and the IS Relation

Determining Output
Chapter 5: Goods and Financial Markets: The ISLM Model

Note two characteristics of ZZ:

Because its not assumed that the consumption
and investment relations in Equation (5.2) are
linear, ZZ is, in general, a curve rather than a line.
ZZ is drawn flatter than a 45-degree line because
its assumed that an increase in output leads to a
less than one-for-one increase in demand.

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5-1 The Goods Market and the IS Relation

Determining Output
Chapter 5: Goods and Financial Markets: The ISLM Model

Figure 5 - 1
Equilibrium in the Goods
Market
The demand for goods is an
increasing function of output.
Equilibrium requires that the
demand for goods be equal to
output.

Note two characteristics of ZZ:

ZZ is, in general, a curve rather
than a line.
ZZ is drawn flatter than a 45degree line.

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5-1 The Goods Market and the IS Relation

Deriving the IS Curve
Chapter 5: Goods and Financial Markets: The ISLM Model

Figure 5 - 2
The Derivation of the IS
Curve
(a) An increase in the interest rate
decreases the demand for goods
at any level of output, leading to a
decrease in the equilibrium level
of output.

(a) Equilibrium in the goods market

implies that an increase in the
interest rate leads to a decrease
in output. The IS curve is
therefore downward sloping.

Slopes downward because

i I Y

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5-1 The Goods Market and the IS Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

IS curve:
IS: all those combinations of Y and i which make the capital market
clear.
Higher interest rates are associated with less output in goods market
equilibrium, so IS curve slopes downward.
IS gives the equilibrium level of output as a function of the interest rate.
For any level of output, IS shows the interest rate needed to clear the
goods market.

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5-1 The Goods Market and the IS Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

Shifts of the IS Curve

We have drawn the IS curve in Figure 5-2, taking as given the
values of taxes, T, and government spending, G.
Changes in either T or G will shift the IS curve.
An increase(decrease) in T IS shifts to the left (right)
An increase(decrease) in G IS shifts to the right (left)

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5-1 The Goods Market and the IS Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

Shifts of the IS Curve

Figure 5 - 3
Shifts of the IS Curve
An increase in taxes shifts the
IS curve to the left.

(T)

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5-1 The Goods Market and the IS Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

To summarize:
Equilibrium in the goods market implies that an increase in the interest
rate leads to a decrease in output. This relation is represented by the
downward-sloping IS curve.
Changes in factors that decrease the demand for goods, given the
interest rate, shift the IS curve to the left.
e.g. T, G, Consumer confidence, etc.

Changes in factors that increase the demand for goods, given the
interest rate, shift the IS curve to the right.
e.g. T, G, Consumer confidence, etc.

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Chapter 5: Goods and Financial Markets: The ISLM Model

Sample Question

Which of the following is definitely true for any given

point on the IS curve
A) there is zero inventory investment
B) production is equal to demand
C) the goods market is in equilibrium
D) all the above
E) none of the above

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5-2 Financial Markets and the LM Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

Financial Markets
The interest rate is determined by the equality of the supply of
and the demand for money:

M $ Y L (i)
M = nominal money stock
$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate

The equation M $ Y L ( i ) gives a relation between money (M),

nominal income ($Y), and the interest rate (i).

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5-2 Financial Markets and the LM Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

Financial Markets / Assets Market / Money Market Equilibrium

Recall:
People are holding wealth in two forms:
Money: riskless, liquid but pays no interest
Bonds: risky, illiquid and pay interest(i)
The proportions of money and bonds you wish to hold depend
mainly on two variables:
Your level of transactions
The interest rate on bonds
Walras' Law
Money market clears

Bond market clears

Hence, ignore bond market equilibrium if money market in

equilibrium.
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5-2 Financial Markets and the LM Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

Real Money, Real Income, and the Interest Rate

Recall: Nominal GDP = Real GDP multiplied by the GDP
deflator (from Chapter 2):

$Y YP
Equivalently:

Hence,

$Y
Y
P

M $YL i

M PYL i

Rearrange, LM relation:

M
YL i
P
The LM relation: In equilibrium, the real money supply (M/P) is
equal to the real money demand (YL(i)), which depends on real
income, Y, and the interest rate, i:
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5-2 Financial Markets and the LM Relation

Deriving the LM Curve
Chapter 5: Goods and Financial Markets: The ISLM Model

Figure 5 - 4
The Derivation
of the
LM Curve

a) An increase in income leads, at a given

b) Equilibrium in the financial markets
interest rate, to an increase in the demand for
implies that an increase in income
money. Given the money supply, this increase
leads to an increase in the interest
in the demand for money leads to an increase
rate. The LM curve is therefore
in the equilibrium interest rate.
upward sloping.

(Y)

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5-2 Financial Markets and the LM Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

LM curve:
This relation between output and the interest rate is represented by the
upward sloping curve in Figure 5-4(b), called the LM curve.
Higher level of output (Y), higher demand for money (M), and therefor
higher equilibrium interest rate (i).
For a given money stock, equilibrium in financial markets implies that
the interest rate is an increasing function of the level of income.
For any level of output, LM curve shows the interest rate needed to
clear the money market (money supplied = money demanded).

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5-2 Financial Markets and the LM Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

Shifts of the LM Curve

Figure 5 - 5
Shifts of the LM curve
An increase in money causes
the LM curve to shift down.

(MS)

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5-2 Financial Markets and the LM Relation

Chapter 5: Goods and Financial Markets: The ISLM Model

To summarize:
Equilibrium in financial markets implies that, for a given real money supply,
an increase in the level of income, which increases the demand for money,
leads to an increase in the interest rate. This relation is represented by the
upward-sloping LM curve.

An increase in the money supply shifts the LM curve down.

A decrease in the money supply shifts the LM curve up.

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5-3 Putting the IS and the LM Relations

Together

Chapter 5: Goods and Financial Markets: The ISLM Model

IS r e la tio n : Y C (Y T ) I (Y ,i ) G

Figure 5 - 6

M
L M r e la tio n :
Y L (i)
P

The ISLM Model

Equilibrium in the goods market
implies that an increase in the
interest rate leads to a decrease in
output. This is represented by the
IS curve.
Equilibrium in financial markets
implies that an increase in output
leads to an increase in the interest
rate. This is represented by the LM
curve.
Only at point A, which is on both
curves, are both goods and
financial markets in equilibrium.

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Chapter 5: Goods and Financial Markets: The ISLM Model

Sample Question

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5-3 Putting the IS and the LM Relations

Together

Chapter 5: Goods and Financial Markets: The ISLM Model

Fiscal Policy, Activity, and the Interest Rate

Fiscal contraction, or fiscal consolidation, refers to

fiscal policy that reduces the budget deficit (G-T).
An increase in the deficit (G-T) is called a fiscal
expansion.
Taxes affect the IS curve, not the LM curve.

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5-3 Putting the IS and the LM Relations

Together
Fiscal Policy,
Activity, and

Chapter 5: Goods and Financial Markets: The ISLM Model

the Interest Rate

Figure 5 - 7
The Effects of and
increase in Taxes
An increase in taxes shifts the
IS curve to the left and leads to
a decrease in the equilibrium
level of output and the
equilibrium interest rate.

What happen to the

components of demand?
- G?
- C?
- I? (crowding out and crowding in)

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5-3 Putting the IS and the LM Relations

Together

Chapter 5: Goods and Financial Markets: The ISLM Model

Monetary Policy, Activity, and the Interest Rate

Monetary contraction, or monetary tightening, refers to a

decrease in the money supply.
An increase in the money supply is called monetary expansion.
Monetary policy does not affect the IS curve, only the LM curve.
- e.g. an increase in the money supply shifts the LM curve down.

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5-3 Putting the IS and the LM Relations

Together

Chapter 5: Goods and Financial Markets: The ISLM Model

Monetary Policy, Activity, and the Interest Rate

Figure 5 - 8
The Effects of a
Monetary Expansion
A monetary expansion leads to
higher output and a lower
interest rate.

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5-3 Putting the IS and the LM Relations

Together

Chapter 5: Goods and Financial Markets: The ISLM Model

Table 5-1

The Effects of Fiscal and Monetary Policy

Shift of IS

Shift of LM

Movement
in Output

Movement in
Interest Rate

Left

Down

Down

Right

Up

Up

Right

Up

Up

Left

Down

Down

MS

Down

Up

Down

MS

Up

Down

Up

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5-3 Putting the IS and the LM Relations

Together

Chapter 5: Goods and Financial Markets: The ISLM Model

Notes:
This all shortrun analysis: effects of productivity, capital, labor,
and debt accumulate but are ignored in the short run.
Remember: prices are sticky only in short run
LM maybe flat at low nominal interest rates
Japanese Liquidity Trap
i IS IS

LM

Y
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Chapter 5: Goods and Financial Markets: The ISLM Model

5-4 Using a Policy Mix

The combination of monetary and fiscal polices is
known as the monetary-fiscal policy mix, or simply,
the policy mix.
Sometimes, the right mix is to use fiscal and
monetary policy in the same direction.
Sometimes, the right mix is to use the two policies in
opposite directionsfor example, combining a fiscal
contraction with a monetary expansion.

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Focus: The U.S. Recession of 2001

Chapter 5: Goods and Financial Markets: The ISLM Model

Figure 1 The U.S. Growth Rate, 19991 to 20024

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Focus: The U.S. Recession of 2001

Chapter 5: Goods and Financial Markets: The ISLM Model

Figure 2 The Federal Funds Rate, 19991 to 20024

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Focus: The U.S. Recession of 2001

Chapter 5: Goods and Financial Markets: The ISLM Model

Figure 3 U.S. Federal Government Revenues and Spending (as Ratios to GDP),
19991 to 20024

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Focus: The U.S. Recession of 2001

Chapter 5: Goods and Financial Markets: The ISLM Model

Figure 4 The U.S. Recession of 2001

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Chapter 5: Goods and Financial Markets: The ISLM Model

The U.S. Recession of 2001

What happened in 2001 was the following:

The decrease in investment demand led to a sharp
shift of the IS curve to the left, from IS to IS.
The increase in the money supply led to a downward
shift of the LM curve, from LM to LM.
The decrease in tax rates and the increase in spending
both led to a shift of the IS curve to the right, from IS
to IS.

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Chapter 5: Goods and Financial Markets: The ISLM Model

Key Terms

IS curve
LM curve
fiscal contraction, fiscal consolidation
fiscal expansion
monetary expansion
monetary contraction, monetary tightening
monetaryfiscal policy mix, policy mix
confidence band

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Chapter 5: Goods and Financial Markets: The ISLM Model

Sample Question
1. In the IS-LM model, if a Single factor leads to output and interest rate
moving in the opposite direction, we know
A) There is a shift in the LM curve
B) Investment and Output must move in the same direction
C) Consumption and Output must move in the same direction.
D) All of the above.
E) None of the above.
2. Assume that investment does NOT depend on the interest rate. A
reduction in the money supply will cause which of the following for
this economy?
A) no change in the interest rate
B) no change in output
C) a reduction in investment
D) an increase in investment
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Chapter 5: Goods and Financial Markets: The ISLM Model

Sample Question
3. Suppose there is a simultaneous fiscal expansion and monetary
expansion. We know with certainty that
A) output will increase.
B) output will decrease.
C) the interest rate will increase.
D) the interest rate will decrease.
E) both output and the interest rate will increase.
4. Which of the following will shift IS curve to the Left?
A) an increase in the money supply
B) a reduction in the interest rate
C) an increase in government spending
D) all of the above
E) none of the above

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Sample Questions

Chapter 5: Goods and Financial Markets: The ISLM Model

5. An Economy has the following information:

C=10+0.5*(Y-T); T=20
I=40+0.3Y-100*i
G=20
Price is fixed at P=1, Md/P=Y*(1-2.5i); Ms=100
Derive the IS curve
Derive the LM curve
Solve for Y and i in equilibrium.

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