IS-LM

Part II
By Shikha Singh
 Objectives
Understanding that there are two new variables in a three-sector model, government expenditure and taxation, G and T.
Explaining that simultaneous equilibrium in the goods and money market exists only at one combination of income
and the interest rate.
Analyzing an increase in government expenditure by ΔG leading to a shift in the IS curve to the right by an amount
equal to 1/1 − b x ΔG.
Explaining that the impact of taxes is felt through a change in the consumption level.
Analyzing how a change in the money supply disturbs the money market equilibrium causing a shift in the LM curve.
Explaining that the change in the national income in response to the monetary and fiscal policies depends on the
elasticities of the IS and the LM curves.
Analyzing an expansionary fiscal policy shifting the IS curve to the right and leading to an increase in both, the
income level and the interest rate.
Analyzing an expansionary monetary policy shifting the LM curve to the right and leading to an increase the income
level but a decrease in the interest rate.
The IS-LM Model for a Three-Sector Economy
• In a three-sector model two new variables are included, government expenditure and
taxation,
G and T.
Assumptions
The price level is constant.
At that price level, the firms are willing to supply whatever output is demanded.
The short-run aggregate supply curve is perfectly elastic till the full employment level of
output.
Govt. Exp is autonomous. Tax is linear function of income :Autonomous tax and
proportional income tax rate: T+ ty)
 The Goods Market Equilibrium in a Three-Sector Economy: The IS
Curve

There are two approaches to determine the equilibrium level of income.

According to the Aggregate Demand-Aggregate Supply Approach, Y = C
+ I +G
According to the Injections equal Leakages Approach I + G = S + T

A graphical approach to the derivation of the IS curve can be developed

using the two equilibrium conditions.
The Money Market Equilibrium in a Three-Sector Economy: The LM
Curve

• In a three-sector economy, the analysis of the money market will remain

the same as in the two sectors.
Equilibrium in the Two Markets: The Goods Market and Money Market Three-Sector
Economy
There is only one combination of income and the rate of interest at which both the goods
and the money market are in equilibrium.
This combination exists at the point at which the IS and LM curves intersect as in Figure

Figure : Equilibrium in the Goods and the Money Market in a Three Sector
At all points towards the right of the IS curve there exists an excess supply of goods and thus the
level of income will fall.
At all points towards the left of the IS curve there exists an excess demand for goods and thus
there will increase in the income level.
At all points towards the right of the LM curve there is an excess demand for money and hence
the rate of interest will rise.
At all points towards the left of the LM curve there is an excess supply of money and hence the
rate of interest will fall.
The equilibrium in both the goods and money markets will remain unchanged until a shift in the
IS or LM curve disturbs the equilibrium.
 Shift in the IS Curve Due to Changes in Fiscal Policy
:A Change in Government Expenditure

The increase in the income due to the increase in the government

expenditure should be equal to 1/1 – b X ΔG.
Due to the crowding out effect the increase in income is much smaller
than 1/1 – b X ΔG.
Crowding out is a situation which arises when an expansionary fiscal
policy leads to an increase in the rate of interest thus leading to a decrease
in private investment.
Shifts in the IS curve due to Fiscal policy – Crowding out effect

The initial equilibrium is at point E 1 determined by the intersection

of the IS1 and LM curves with equilibrium income level Y 1 and
interest rate r1.
An increase in government expenditure by ∆G shifts the IS curve to
the right by an amount equal to the multiplier times the change in
government expenditure i.e. 1/1-b∆G.
However the new IS2 is at new equilibrium E2 with income level Y2
and interest rate r2. But increase in income should be from Y1 to Y’
and actually it is from Y1 to Y2 only. This is due to crowding out
effect.
Crowding out is a situation when an expansionary fiscal policy
i.e. an increase in government expenditure leads to increase in
interest rate thus leading to a decrease in private investment.
Shifts in the IS curve due to Fiscal policy – Crowding out effect

• With the increase in government expenditure, IS1 curve will shift to the right to IS2. There
will be an increase in equilibrium income level from Y1 to Y’.
• At E’ there exists goods market equilibrium, there is money market disequilibrium. This is
because the increase in income has generated an excess demand for money. Therefore there
will occur an increase in interest rate leading to decrease in investment and hence in the
aggregate demand. After all the adjustments for the increase in government expenditure
and the dampening effects of higher interest rate on investment are taken into
consideration, both the goods and money market are in equilibrium at E 2. It is only at this
point that planned spending equals output and money demand equal money supply.
 Shifts in the IS curve due to Fiscal policy – Crowding out
effect

• Thus increase in government expenditure does lead to an increase in the income level, but it is to be
noted that the increase in interest rate has a dampening effect on the expansion. Hence increase in
income is from Y1 to Y2 (and not Y’).
We consider 2 cases:
• 1. Crowding out and full employment: In an economy with the level of output at full employment
level, an increase in government expenditure will cause an increase in aggregate demand and hence an
increase in interest rate. This will continue till the initial increase in aggregate demand is totally
crowded out.
• 2. In an economy with level of output below full employment, with an increase in government
expenditure firms will hire more workers to increase the output and hence both the interest rate and
income rises but there will not be full crowding out.
 A Change in Taxes

As far as the impact of an increase in tax is concerned, the decrease in the
interest rates are responsible for an increase in investment thus offsetting
the decrease in the consumption levels to some extent.
As far as the impact of a decrease in tax is concerned, the increase in the
interest rates are responsible for a decrease in investment thus offsetting
the increase in the consumption levels to some extent.
 Shift in the LM Curve Due to Monetary Policy

The monetary policy operates through the changes in the supply of money.
A change in the money supply disturbs the money market equilibrium causing
a shift in the LM curve.
The shift in the LM curve influences the income level and the rate of interest.
The monetary transmission process is the mechanism by which the changes in
the monetary policy affect the aggregate demand and thus the income level.
 Shift in the LM Curve Due to Monetary Policy

The initial equilibrium is at E1 and the

equilibrium income is Y1 and rate of The diagram shows how the open
interest is r1. market purchase works. Initial
An increase in the real money stock shifts equilibrium point E1 is on the initial
the LM curve down and to the right. LM curve that corresponds to real
Interest rates immediately decline from E 1 money supply. With increase in money
to E’ and the through their effect on supply LM curve shifts down to LM2.
investment, cause income to rise until a Therefore the new equilibrium point
new equilibrium is reached at E2. Once all will be at point E2 with lower interest
adjustments have taken place, a rise in real rate and higher level of income. The
money stock raises equilibrium income and equilibrium level of income rises
lowers interest rates. because the open market purchase
reduces the interest rate and thereby
increases investment spending
Shifts in the LM curve due to monetary policy
Consider the adjustment process to monetary expansion. At the initial equilibrium point E1 the
increase in money supply creates an excess supply of money to which the public adjusts by buying
bonds. In the process, bond price increases and interest rate decline. Money market adjust rapidly,
and we move to point E’ where money market clears and people hold large cash balances because
the interest rate has decline sufficiently. At point E’ however there is excess demand for goods. In
response output starts moving the LM2 schedule and in the process interest rate rise because
increase in output raises demand for money and that has to be checked by higher interest rate.
Thus increase in money stock first causes interest rates to fall as the public adjusts portfolios and
then through lower interest rates increases aggregate demand.
 Monetary Transmission mechanism
• The process by which changes in monetary policy affect aggregate
demand and thus income is called monetary transmission mechanism.
• This happens in two stages: first change in the money supply changes
interest rates and second when change in interest rates affect aggregate
demand
1 2 3 4
Change in real money Portfolio adjustments Investments adjust to Output adjust to
supply lead to a change in change interest rate change in aggregate
bond prices and demand
interest rate
 The Elasticities of IS and LM Curves and
the Effectiveness of Monetary and
Fiscal Policies
 The Elasticities of IS and LM Curves and the
Effectiveness of Monetary and Fiscal Policies
The changes in the national income in response to monetary and fiscal
policies depend on the elasticity's of the IS and the LM curves.
An expansionary fiscal policy shifts the IS curve to the right and leads to
an increase in both the income level and the interest rate.
An expansionary monetary policy shifts the LM curve to the right and
leads to an increase the income level but a decrease in the interest rate.
 Shift in the LM Curve Due to Monetary Policy :Three Ranges

The LM curve has a positive slope which can be divided into three ranges.
In the Keynesian range, the LM curve is horizontal and the interest
elasticity is infinity.
In the classical range, the LM curve is vertical and the interest elasticity is
zero.
In the intermediate range, the interest elasticity is greater than zero.
 Elasticity of LM curve: three ranges

• Keynesian range: At this interest rate, speculative demand for money becomes
perfectly elastic. In other words demand for money is extremely interest sensitive
(h is very large and k is zero). LM curve is horizontal implying a situation of
liquidity trap. In this range no amount of monetary expansion can lower the interest
rate, the extra liquidity which is created by the monetary authorities is trapped in the
form of cash balances with public.
• Classical range: At some very high interest rate, the speculative demand for money
becomes interest inelastic. In other words demand for money is extremely income
sensitive (k is very large and h is zero). This range is called classical range as
according to classical theory , money is demanded for conducting transactions. In
this range, LM curve is vertical.
• Intermediate range: This is the range between the Keynesian and classical range.
Here, both the transactions and speculative demand or money exists. In this range
both h and k are greater than zero.
 The Elasticity of IS Curve
The elasticity of the IS curve depends on the responsiveness of investment
to changes in the interest rate and on the magnitude of the multiplier.
1. If investment is insensitive (or independent) to the rate of interest, then
investment curve will be perfectly inelastic. The IS curve will be perfectly
inelastic.
2. if investment is sensitive to interest rate or is interest elastic, then
investment curve will be elastic.
 Effectiveness of Monetary and Fiscal Policies

• The effectiveness of a policy in achieving the economic objectives

depends on the elasticity of the IS and LM curves
 Effectiveness of Fiscal policy
• Fiscal policy has an immediate impact on the goods market and thus leads to shift in
the IS curve. Effectiveness of fiscal policy is examined in three different ranges of
the LM curve.
• Keynesian range or liquidity trap: Here fiscal policy is very effective. Initially
the equilibrium exists at the intersection of the IS 1 and LM curves where income
level is Y1 and interest rate r1,
• A fiscal expansion leads to a shift of IS 1 to IS’1.
• It is important to note that in the range of liquidity trap, an increase in government
expenditure does not affect the interest rate and thus the level of investment. Hence
there is full multiplier effect of the increase in the government spending and no
dampening effects occur. The income level rises from Y 1 to Y’1while interest rate
remain unchanged at r1. Hence fiscal policy is completely effective in Keynesian
range.
 Effectiveness of Fiscal policy
• Classical range: Here fiscal policy is not effective.
Initially the equilibrium exists at the intersection of IS 3 and LM
curves to determine equilibrium income level Y3 and interest rate
r3. A fiscal expansion leads to a shift of IS3 to IS’3. The income
level remains unchanged at Y3 while interest rate increases to from
r3 to r’3.
• An increase in government expenditure and the interest rate and an
unchanged income level imply that there occurs an offsetting
decrease or crowding out of private investment which equals the
increase in government expenditure. Hence there is full crowding
out and fiscal policy is completely ineffective in classical range.
 Effectiveness of Fiscal policy
• Intermediate range: Here fiscal policy is effective but is not as
effective as in the Keynesian range. Initially equilibrium exists at the
intersection of IS2 and LM curves to determine equilibrium income
level Y2 and interest rate r2. A fiscal expansion leads to a shift of the
IS2 curve to IS’2 . Thus income level increase from Y2 to Y’2 while
the interest rate increase from r2 to r’2.
• In this range, the expansionary effect of the fiscal policy does
succeed in raising the income level. However the increase in the
income is not as much as in the Keynesian range. This is due to the
increase in interest rate because of which investment decrease and
thus expansionary effect of the fiscal policy gets negated to some
extent. Thus fiscal policy is less effective in the intermediate range
as compared to the Keynesian range.
Effectiveness of Fiscal policy :conclusion
In the Keynesian range or the liquidity trap, fiscal policy is completely
effective.
In the classical range, there is full crowding out and fiscal policy is
completely ineffective.
In the intermediate range, fiscal policy is effective but not as effective as
in the Keynesian range.
 Effectiveness of Monetary policy
• Monetary policy relates to changes in the supply of money by the central
bank to achieve the objectives relating to growth, employment and others.
• Effectiveness of monetary policy can be examined in the three ranges
of the LM curve with the help of two IS curves, one elastic and other
inelastic.
 Effectiveness of Monetary policy
(a) Keynesian range: Here monetary policy is ineffective:
Elastic IS curve, IS1: Initial equilibrium exists at the intersection of the IS 1
and LM1 to determine the equilibrium income at Y1 and interest rate r1. In
this range a monetary expansion, shift in the LM curve from LM 1 to LM2,
does not lead to increase in income level or any change in interest rate
which remain at Y1 and r1 respectively. All increase in money supply are
held as cash balances. Hence monetary policy is ineffective in the
Keynesian range.
Relatively inelastic IS curve, IS’1: However IS’1 yields the same income
level Y1 and interest rate r1.
Monetary policy is ineffective in liquidity trap irrespective of the
elasticity of IS curve.
 Effectiveness of Monetary policy
• (b)Classical Range: Here monetary policy is completely effective:
• (b1.)Elastic IS curve, IS3: Initially equilibrium exists at the intersection
of IS3 and LM1 curves to determine the equilibrium income Y 3 and interest
rate r3. A monetary expansion shifts the LM 1 curve to LM2. The income
level increases from Y3 to Y’3 while the interest rate decreases from r 3 to
r’3.
• In the classical range, the speculative demand for money is zero due to
high interest rates and money is demanded only for transaction purposes.
In such a situation, monetary expansion will push down the interest rates
and thus encourage investment leading to an increase in income level.
Monetary policy is completely effective in the Classical range whatever
be the elasticity of the IS curve
 Effectiveness of Monetary policy
• (b2.)Classical Range: Here monetary policy is completely
effective:
• Relatively inelastic IS curve, IS’3. Similar to IS3, IS’3also yields
same equilibrium income at Y3 and interest rate r3. But due to
monetary expansion, the increase in income will be lower while
the decrease in interest rate will be much larger than for the
elastic IS curve.
• Monetary policy is completely effective in the classical range
whatever the elasticity of the IS curve.
 Effectiveness of Monetary policy
• (c) Intermediate range: Monetary policy is effective but not as much as
in the classical range because the increase in money is absorbed partly
as transactions money balances and partly as speculative money
balances.
• (
(c1)Elastic IS curve, IS2: Initial equilibrium exists at the intersection of
the IS2 and LM1 curves to determine equilibrium income Y 2 and interest
rate r2. A monetary expansion shifts LM curve to LM 2. The income level
rises from Y2 to Y’2 while interest rate decreases from r 2 to r’2.
• In the intermediate range, a monetary expansion will push down the rate
of interest to some extent, and thus encourage investment but the
increase in the income level is not as much as the increase in the
classical range.
 Effectiveness of Monetary policy
• (c2.)Relatively inelastic IS curve: For IS’2 initial
equilibrium income level is at Y2 and r2. Regarding the
effect of monetary expansion, the increase in income
will be smaller than in the case of the elastic IS curve.
• Thus to sum up: Monetary policy is most effective in
the classical range, less effective in the intermediate
range and ineffective in the Keynesian range.
• Fiscal policy is most effective in the Keynesian range,
less effective in the intermediate range and ineffective
in the classical range.
Thank you