IS and LM Curve

Qazi Muhammad Adnan Hye

IS-LM Model IS Curve LM Curve Keynesian cross Government-purchases multiplier Tax multiplier

Long run
prices flexible output determined by factors of production & technology unemployment equals its natural rate

Short run
prices fixed output determined by aggregate demand unemployment negatively related to output

This chapter develops the IS-LM model, the basis of the aggregate demand curve. We focus on the short run and assume the price level is fixed (so, SRAS curve is
horizontal).

The Keynesian model - shows what causes the aggregate demand curve to shift. In the short run, when the price level is fixed, shifts in the aggregate demand curve lead to changes in national income, Y. The IS-LM model = the leading interpretation of Keynes work. The goal of the model: to show what determines national income for any given price level.

Price Level, P

SRAS
AD'' AD' AD

Y* Y*'Y*'' Income, Output, Y

1. The goods market and the IS curve

The basic textbook Keynesian model: an elaboration and extension of the classical theory.

The model of aggregate demand (AD) can be split into two parts: - IS (investment and saving)model of the goods market - LM (liquidity and money) model of the money market.

The IS curve (which stands for investment and saving) plots the relationship between the interest rate and the level of income that arises in the market for goods and services.

The LM curve (which stands for liquidity and money) plots the relationship between the interest rate and the level of income that arises in the money market. The variable that links the two parts of the IS-LM model: the interest rate (it influences both investment and money demand).

In the General Theory of Money, Interest and Employment (1936), Keynes proposed: an economys total income was, in the short run, determined largely by the desire to spend by households, firms and the government.
Thus, the problem during recessions and depressions, according to Keynes, was inadequate spending.

How to model this insight? - The Keynesian Cross

 Planned expenditure is the amount households, firms and government plan to spend on goods and services. Actual expenditure differs from planned expenditure when firms are forced to make inventory- that is when firms unexpectedly rise or lower their stock of inventories in response to unexpectedly low or high sales.

The Keynesian Cross

Notation:
I = planned investment PE = C + I + G = planned expenditure Y = actual expenditure=GNP

Difference between actual & planned expenditure = unplanned inventory investment

Graphing planned expenditure

MPC 1

income, output, Y

Graphing the equilibrium condition

PE =Y

45
income, output, Y

The equilibrium value of income

PE =Y
E C (Y T ) I G

income, output, Y

Equilibrium income

An increase in government purchases

B
E C (Y T ) I G

G
so firms increase output, and income rises toward a new equilibrium.

Y
PE1 = Y1

PE2 = Y2

If government spending were to increase by $1, then you might expect equilibrium output (Y) to also rise by $1. But it doesnt! The multiplier shows that the change in demand for output (Y) will be larger than the initial change in spending. Heres why: When there is an increase in government spending (G), income rises by G as well. The increase in income will raise consumption by MPC G, where MPC is the marginal propensity to consume. The increase in consumption raises expenditure and income again. The second increase in income of MPC G again raises consumption, this time by MPC (MPC G), which again raises income and so on. So, the multiplier process helps explain fluctuations in the demand for output. For example, if something in the economy decreases investment spending, then people whose incomes have decreased will spend less, thereby driving equilibrium demand down even further.

An increase in taxes
PE
Initially, the tax increase reduces consumption, and therefore PE:
E C1 (Y T ) I G

E C2 (Y T * ) I

C = MPC T
so firms reduce output, and income falls toward a new equilibrium

At Y1, there is now an unplanned inventory buildup

Y
PE2 = Y2

PE1 = Y1

is negative: A tax increase reduces C, which reduces income. is greater than one (in absolute value): A change in taxes has a multiplier effect on income. is smaller than the govt spending multiplier: Consumers save the fraction (1 MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.
20

The tax multiplier

Lets now relax the assumption that the level of planned investment is fixed. - We write the level of planned investment as: I = I (r). The investment function - downward-sloping (it shows the inverse relationship between investment and the interest rate) The IS curve summarizes the relationship between the interest rate and the level of income. It is downward-sloping. The IS curve combines: the interaction between I and r expressed by the investment function the interaction between E and Y demonstrated by the Keynesian cross.

An increase in the (b) interest rate (in graph a), E lowers planned investment, which shifts planned expenditure downward (in graph b) and lowers income (in graph c). (a) (c) r r

Y=E Planned Expenditure, E=C+I+G

Income, Output, Y

I(r) Investment, I

IS
Income, Output, Y

An increase in government purchases

How fiscal policy shifts the IS curve?

Y=E Planned Expenditure, E=C+I+G

An increase in government purchases or a decrease in taxes - IS curve shifts outward.

Income, Output, Y r

A decrease in government purchases or an increase in taxes - IS curve shifts inward.

IS2 IS1 Income, Output, Y

Summary The IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right.

Changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left.

LM curve = the relationship between the interest rate and the level of income that arises in the market for money balances The theory of liquidity preference - how the interest rate is determined in the short run r
The supply of real money balances - vertical Supply The demand for real money balances downward sloping The supply and demand for real money balances determine the equilibrium interest rate. Demand, L (r) M/P M/P

L(r) = M/P

Money Demand

equals

Real Money Balances

A Reduction in the Money Supply: -M/P

Demand, L (r,Y) M/P M/P

Since the price level is fixed, a reduction in the money supply reduces the supply of real balances. Notice the equilibrium interest rate rose.

(M/P)d = L (r,Y)
The quantity of real money balances demanded is negatively related to the interest rate (because r is the opportunity cost of holding money) and positively related to income (because of transactions demand).

Supply

LM

r2 r1 L (r,Y)' L (r,Y) M/P M/P Y An increase in income raises money demand, which increases the interest rate; this is called an increase in transactions demand for money. The LM curve summarizes these changes in the money market equilibrium.

Supply' Supply

LM' LM

r2 r1 L (r,Y)

r2 r1

Y A contraction in the money supply raises the interest rate that equilibrates the money market. Why? Because a higher interest rate is needed to convince people to hold a smaller quantity of real balances. As a result of the decrease in the money supply, the LM shifts upward.

M/P M/P

M/P

Summary The LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances. The LM curve is drawn for a given supply of real money balances Decreases in the supply of real money balances shift the LM curve upward Increases in the supply of real money balances shift the LM curve downward

r IS

LM(P0)

r0

Y The IS curve/equation Y= C (Y-T) + I(r) + G The LM curve/equation M/P = L(r, Y) The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.

Y0

The Big Picture

Theory of Liquidity Preference

LM curve

Explanation of short-run fluctuations

Agg. demand curve Agg. supply curve

Model of Agg. Demand and Agg. Supply

Chapter Summary
1. Keynesian cross
basic model of income determination
takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income

2. IS curve
comes from Keynesian cross when planned

investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services

Chapter Summary
3. Theory of Liquidity Preference
basic model of interest rate determination
takes money supply & price level as exogenous an increase in the money supply lowers the interest

rate

4. LM curve
comes from liquidity preference theory when

money demand depends positively on income shows all combinations of r and Y that equate demand for real money balances with supply

Chapter Summary
5. IS-LM model
Intersection of IS and LM curves shows the unique

point (Y, r ) that satisfies equilibrium in both the goods and money markets.