The IS-LM Model Ing. Mansoor Maitah Ph.D.

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1 The IS-LM Model Ing. Mansoor Maitah Ph.D.

2 Constructing the Keynesian Cross Equilibrium is at the point where Y = C + I + G. If firms were producing at Y 1 then Y > E Because actual expenditure exceeds planned expenditure, inventory accumulates, stimulating a reduction in production. Similarly at Y 2, Y < E E* E Inventory drops Inventory accumulates. 1 MPC Y=E E=C+I+G Because planned expenditure exceeds actual expenditure, inventory drops, stimulating an increase in production. Y 2 Y* Y 1 Y

3 Investment, Sales (Y), and the Interest Rate (i) Now, we no longer assume I (investment) is constant We capture the effects of two factors affecting investment: The level of sales/income (+) The interest rate (-) I = I( Y, i)

4 The Goods Market and the IS Relation Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z. In the simple model, the interest rate did not affect the demand for goods. The equilibrium condition was given by: Y = C( Y T) + I + G

5 The Determination of Output Taking into account the investment relation above, the equilibrium condition in the goods market becomes: Y = C( Y T) + I( Y, i) + G

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

7 An increase in the interest rate decreases the demand for goods at any level of output. Deriving the IS curve

8 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. Deriving the IS curve

9 An increase in taxes shifts the IS curve to the left. Deriving the IS curve

10 What is the IS curve? The IS curve shows the combinations of the interest rate and the level of income that are consistent 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.

11 The IS curve maps the relationship between r and Y for the goods market. E E=Y Let the interest rate This decrease in investment increase So from Y decreases r 1 to r 2 reduce from The causes IS curve the planned maps out this planned investment Y from expenditure function 1 to Y 2. relationship between to shift the I(r 1 ) to I(r 2 ). interest down. rate, r, and output (or income) Y. I Y 2 Y 1 E=C+I(r 1 )+G E=C+I(r 2 )+G Y r r r 2 r 2 r 1 I(r) I I(r 2 ) I(r 1 ) Y 2 Y 1 r 1 IS Y

12 While changing r allows us to map out the IS curve, changes in G, T, or MPC cause Y to change for any level of r. This causes a shift in the IS curve. E E=Y Suppose an increase in G causes planned expenditure to shift up by G. G Y 1 Y 2 Y For any r the increase in G causes an increase in Y of G times the government expenditure multiplier. r r 1 Therefore, the IS curve shifts to the right by this amount. Y 1 Y 2 IS IS Y

13 Financial Markets and the LM Relation The interest rate is determined by the equality of the supply of and the demand for money: M = $ YL( i) M = nominal money stock L(i) ) = demand for money $Y = nominal income i = nominal interest rate

14 Real Money, Real Income, and the Interest Rate Recall that Nominal GDP = Real GDP multiplied by the GDP deflator: $Y P = Y 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 P = YL( i) $Y = YP Recall: before, we had the same equation but in nominal instead of real terms (nominal income and nominal money supply). Dividing both sides by P (the price level) gives us the equation above.

15 Money Demand (M/P) d = L (r,y) (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).

16 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, this is called an increase in transactions demand for money, this leads to an increase in the equilibrium interest rate.

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

18 What is the LM curve? LM curve shows the relationship between interest rate and income and when the money market is in equilibrium for a given supply of money. A decrease in the supply of real money balances shifts the LM curve upward, and vice versa an increase shifts the curve downward.

19 An increase in money causes the LM curve to shift down Shifts of the LM Curve

20 A Financial Market Interpretation Rate of interest (r) r 2 r 1 b a LM 2 LM 1 IS Y 2 Y 1 National income (Y) Price level (P) P 2 P 1 b' a' AD Y 2 Y 1

21

22

23 The LM curve maps the relationship between r and Y for the money market. Building the LM curve Given money supply and money demand suppose an increase in income raises money demand. The LM curve maps out this relationship between r and Y. r (M/P) s r LM r 2 r 2 r 1 L(r,Y 1 ) L(r,Y 2 ) Real Money Balances r 1 Y 1 Y 2 Y

24 Shifting the LM curve While changing money demand allows us to map out the LM curve, changes in M or P cause r to change for any level of Y. This causes a shift in the LM curve. Given money supply and Now money there demand is a higher suppose real a decrease interest rate in the for money the current stock shifts level real money of output. supply to the left resulting in a higher equilibrium interest rate. The LM curve shifts up so that at the same level of output the interest rate is higher. r (M 2 /P) s (M 1 /P) s r LM LM r 2 r 2 r 1 L(r,Y) Real Money Balances r 1 Y

25 Investment Investment = Private saving + Public saving I = S + (T G) A fiscal contraction may decrease investment. Or, looking at the reverse policy, a fiscal expansion a decrease in taxes or an increase in spending may actually increase investment.

26 Fiscal Policy, the Interest Rate and the IS Curve

27 Shifting of IS and LM

28 Using a Policy Mix The Effects of Fiscal and Monetary Policy Shift of IS Shift of LM Movement of Output Movement in Interest Rate Increase in taxes left none down down Decrease in taxes right none up up Increase in spending Decrease in spending right none up up left none down down Increase in money none down up down Decrease in money none up down up

29 The IS and the LM Relations Together Equilibrium in the goods market implies that an increase in the interest rate 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. IS relation: Y = C( Y T) + I( Y, i) + G LM relation: M P = YL( i)

30 AD from IS-LM 1. Price levels are increased, with P 0 <P 1 <P LM shifts to the left with increasing P because real money balances decline. 3. Interest rates rise. 4. Investment and durable goods expenditures fall as interest rates rise. r 2 r 1 r 0 Y 2 LM(P 2 ) LM(P 1 ) LM(P 0 ) Y 1 Y 0 IS Y 5. Plot price levels against the resulting output (Y) levels. P 2 P 1 7. Thus AD is embedded in the logic of IS-LM. P 0 AD Y 1 Y 0

31 Thank You for your Attention

32 Literature 1 - John F Hall: Introduction to Macroeconomics, Fernando Quijano and Yvonn Quijano: Introduction to Macroeconomics 3 - Karl Case, Ray Fair: Principles of Economics, Boyes and Melvin: Economics, James Gwartney, David Macpherson and Charles Skipton: Macroeconomics, N. Gregory Mankiw: Macroeconomics, Yamin Ahmed: Principles of Macroeconomics, Olivier Blanchard: Principles of Macroeconomics, 1996

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