The IS-LM Model

Dr Sumeetha M

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The Goods Market
5-1
and the IS Relation

 Equilibrium in the goods market exists when

production, is equal to the demand for goods
 The equilibrium condition

Y  C (Y  T )  I  G

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Investment, Sales,
and the Interest Rate

 We can capture the effects of two factors

affecting investment:
 The level of sales (+)
 The interest rate (-)

I  I (Y , i )

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The Determination of Output

I  I (Y , i )
 Taking into account the investment relation
above, the equilibrium condition in the goods
market becomes:
Y  C (Y  T )  I (Y , i )  G

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The Determination of Output

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: The ZZ line is flatter

than the 45° line only if
increases in consumption
and investment do not
exceed the corresponding
increase in output.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Deriving the IS Curve

The Effects of an
Increase in
the Interest Rate on
Output
An increase in the
interest rate decreases
the demand for goods at
any level of output.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Deriving the IS Curve

The Derivation of the IS

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

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Shifts of the IS Curve

Shifts of the IS
Curve
An increase in taxes
shifts the IS curve to
the left.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Financial Markets
5-2
and the LM Relation

 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

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Real Money, Real Income,
and the Interest Rate

 The LM relation: In equilibrium, the real money

supply is equal to the real money demand, which
depends on real income, Y, and the interest rate, i:
M
 Y L (i )
P
 From chapter 2, recall that Nominal GDP = Real GDP
multiplied by the GDP deflator:
$Y  Y P
Equivalently: $Y
Y
P
© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard
 Deriving the LM Curve

The Effects of an
Increase in Income on
the Interest Rate
An increase in income
leads, at a given interest
rate, to an increase in
the demand for money.
Given the money
supply, this leads to an
increase in the
equilibrium interest rate.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Deriving the LM Curve

The Derivation of the

LM Curve
Equilibrium in financial
markets implies that an
increase in income
leads to an increase in
the interest rate. The
LM curve is upward-
sloping.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Shifts of the LM Curve

Shifts of the LM
Curve
An increase in
money leads the
LM curve to shift
down.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Putting the IS and the
5-3
LM Relations Together

The IS-LM Model

IS relatio n: Y  C ( Y  T )  I ( Y , i )  G
Equilibrium in the goods
market implies that an M
L M relatio n:  Y L (i )
increase in the interest rate P
leads to a decrease in output.
Equilibrium in financial
markets implies that an
increase in output leads to an
increase in the interest rate.
When the IS curve intersects
the LM curve, both goods and
financial markets are in
equilibrium.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Fiscal Policy, Activity,
and the Interest Rate

 Fiscal contraction, or fiscal consolidation,

refers to fiscal policy that reduces the budget
deficit.
 An increase in the deficit is called a fiscal
expansion.
 Taxes affect the IS curve, not the LM curve.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Fiscal Policy, Activity,
and the Interest Rate

The Effects of an
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.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 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. For example, an increase
in the money supply shifts the LM curve down.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Monetary Policy, Activity,
and the Interest Rate

The Effects of a
Monetary Expansion
Monetary expansion
leads to higher
output and a lower
interest rate.

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 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.
Table 5-1 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

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Policy analysis with the IS-LM model

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

 We can use the IS–

LM model to analyze
the effects of
• fiscal policy: G and/or T
• monetary policy: M
An increase in government purchases
A tax cut
Monetary policy: An increase in M
Interaction between monetary and fiscal
policy
• Model:
• Monetary and 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 interactions may alter the impact of the original
policy change.
The Fed’s response to ΔG > 0
• Suppose Congress increases G.
• Possible Fed responses:
1. Hold M constant
2. Hold r constant
3. Hold Y constant
• In each case, the effects of Δ G are different . . .
Response 1: Hold M constant
Response 2: Hold r constant
Response 3: Hold Y constant
Shocks in the IS-LM model, part 1
 IS shocks: exogenous changes in the demand
for goods and services.
 Examples:
• stock market boom or crash
 change in households’ wealth
 ΔC
• change in business or consumer confidence or
expectations
 ΔI and/or ΔC