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Chapter Ten
The IS-LM Model
1
The purposes


This chapter is to introduce a basic
macroeconomic model to help us
analyze the short-run economic
fluctuations, business cycles.
We then adopt this model to explain
why business cycles take place, their
outcomes, and how policies can be
used to cure these problems.
2
The origin of the IS-LM model

The IS-LM model was developed in
1937 by Nobel laureate Sir John Hicks,
who intended to interpret the ideas of
Keynes in the book, The General Theory
of Employment, Interest, and Money, by
graphs.
3
The meaning of the IS-LM
model


The IS-LM model represents the
simultaneous equilibrium of the goods
and services market and the asset
market.
I represents investment, S represents
saving, L represents real money
demand, and M represents money
supply. During equilibrium, I=S, L=M.
4
The idea of the IS-LM model



The IS-LM model originally reflected the idea
that prices and wages are rigid in the short
run. It represented the Keynesian ideas and
approaches.
This model can also be adapted easily to
discuss classical approaches.
The IS-LM model can be used to derive the
more general aggregate demand and
aggregated supply model.
5
The IS-LM model

This model uses graphs on the
coordinates of the real interest rate, r,
and the real income, Y, to represent the
combinations of the real interest rate
and the real income that give rise to the
equilibria in the goods market (the IS
curve) and in the asset market (the LM
curve).
6
The IS curve


The IS curve represents all the
combinations of the real interest rate
and the real income that equate the
demand for goods and services and the
supply of goods and services ( the
equilibrium of goods and services
market), given other things being equal.
Y  C  I  G ( in a closed economy)
7
The IS curve

The goods market equilibrium can be
expressed as
Y  C  Gc  I  Gi
S  I  Gi

National saving equals total domestic
investment.
8
The slope of the IS curve




For any pair of the real income levels,
Y1 and Y2, Y1  Y2 , we want to know the
relative levels of the corresponding real
interest rates that give rise to the equilibrium
of the goods market.
If r1  r2, then the IS curve has a positive
slope.
If r1  r2, then the IS curve has a negative
slope.
9
r
I  Gi
S (Y2 ) S (Y1 )
r
IS curve
r2
r2
r1
r1
I  Gi , S
Y2Y1
Y
10
The slope of the IS curve


When the real income is increased, the
national saving curve will move to the
right. In order to restore the equilibrium
in the goods market, the real interest
rate must fall to stimulate the
investment.
The IS curve is a downward slopping
curve. (negative slope)
11
Factors that shift the IS curve

Given the real income level, any factor
that will make the equilibrium real
interest rate to rise (fall) will shift the IS
curve to the right (left).
12
Factors that shift the IS curve







Expected future marginal product of
capital
Effective tax rate on capital
Government investment
Expected future output
Wealth
Government consumption
Taxes.
13
Expected future marginal
product of capital

When expected future marginal product
of capital, MPK, increases, firms’
desired investment will increase. The
total investment curve moves to the
right, and the equilibrium real interest
rate increases. So the IS curve shifts to
the right.
14
Effective tax rate on capital

When effective tax rate on capital
increases, firms’ desired investment will
fall. The total investment curve moves
to the left, and the equilibrium real
interest rate decreases. So the IS curve
shifts to the left.
15
Government investment

When government investment increases,
the total investment curve moves to the
right, and the equilibrium real interest
rate increases. So the IS curve shifts to
the right.
16
Expected future output

When expected future output increases,
people’s desired consumption will
increase and national saving will fall.
The national saving curve moves to the
left, and the equilibrium real interest
rate increases. So the IS curve shifts to
the right.
17
Wealth

When wealth increases, people’s
desired consumption will increase, and
the national saving will fall. The national
saving curve moves to the left, and the
equilibrium real interest rate increases.
So the IS curve shifts to the right.
18
Government consumption

When government consumption
increases, the national saving will fall.
The national saving curve moves to the
left, and the equilibrium real interest
rate increases. So the IS curve shifts to
the right.
19
Taxes

When taxes increase, people’s desired
consumption will fall (people do not
consider the future effect). The national
saving will increases and moves the
national saving curve to the right. The
equilibrium real interest rate falls. So
the IS curve shifts to the left.
20
Factors that shift the IS curve

Given the real income level, any factor
that raises (reduces) the aggregate
demand for goods and services will shift
the IS curve to the right (left).
21
The LM curve

The LM curve represents all the
combinations of the real interest rate
and the real income that equate the
demand for assets and the supply of
assets ( the equilibrium of assets
market), given other things being equal.
22
The LM curve

The LM curve represents all the
combinations of the real interest rate
and the real income that equate the
demand for real money and the supply
of real money ( the equilibrium of the
money market), given other things
being equal.
M
 L(Y , i )
P
23
The slope of the LM curve




For any pair of the real income levels,
Y1 and Y2, Y1  Y2 , we want to know the
relative levels of the corresponding real
interest rates that give rise to the equilibrium
of the asset market.
If r1  r2, then the LM curve has a positive
slope.
If r1  r2, then the LM curve has a negative
slope.
24
M
P
r
L(Y2 ) L(Y1 )
LM curve
r
r1
r1
r2
r2
Y2Y1
Y
25
The slope of the LM curve


When the real income level increases,
the real money demand will increase
too. Given the real money supply, the
equilibrium real interest rate will rise.
The LM curve is an upward slopping
curve ( positive slope).
26
Factors that shift the LM curve

Given the real income level, any factor
that will make the equilibrium real
interest rate to rise (fall) will shift the
LM curve to the left (right).
27
Factors that shift the LM curve







Nominal money supply
The price level
Wealth
Nominal interest rate on nonmoney assets
Expected inflation
Relative risk of nonmoney assets to money
assets.
Relative liquidity of nonmoney assets to
money assets.
28
Nominal money supply

When the nominal money supply
increases, the real money supply curve
moves to the right and the equilibrium
real interest rate falls. So the LM curve
shifts to the right.
29
The price level

When the price level increases, the real
money supply falls and the real money
supply curve moves to the left. The
equilibrium real interest rate rises. So
the LM curve shifts to the left.
30
Wealth

When the wealth increases, the real
money demand will increase. The real
money demand curve moves to the
right and the equilibrium real interest
rate rises. So the LM curve shifts to the
left.
31
Nominal interest rate on
nonmoney assets

When the nominal interest rate on
nonmoney assets increases, the real
money demand falls and the real money
demand curve moves to the left. The
equilibrium real interest rate falls. So
the LM curve shifts to the right.
32
Expected inflation

When the expected inflation increases,
the real money demand falls and the
real money demand curve moves to the
left. The equilibrium real interest rate
falls. So the LM curve shifts to the right.
33
Relative risk of nonmoney
assets to money assets

When the relative risk of nonmoney
assets to money assets increases, the
real money demand rises and the real
money demand curve moves to the
right. The equilibrium real interest rate
increases. So the LM curve shifts to the
left.
34
Relative liquidity of nonmoney
assets to money assets

When the relative liquidity of nonmoney
assets to money assets increases, the
real money demand falls and the real
money demand curve moves to the left.
The equilibrium real interest rate
decreases. So the LM curve shifts to the
right.
35
Factors that shift the LM curve


Given the real income level and the real
money supply, any factor that raises
(reduces) the demand for real money
will shift the LM curve to the left (right).
Given the real income level, any factor
that raises (reduces) the supply of real
money will shift the LM curve to the
right (left).
36
The IS-LM model


We can put the IS curve and the LM
curve together to determine the
aggregate demand for goods and
services, given the price level.
For a fixed price level, the intersection
of the IS and the LM curves determines
the equilibrium real income of an
economy in the short run.
37
r
LM curve
IS curve
Y
d
Y
38
Business cycles determination

In the short run, if the price level is
fixed as suggested by the Keynesian,
any factor that will shift the IS curve or
the LM curve will make the short-run
equilibrium output to change. These
fluctuations are called business cycles.
Those factors can be regarded as the
causes of business cycles.
39
Keynesian’s animal spirit

Keynes thought that if the confidence of
the public is weak about the future
perspective of the economy, the desire
of the business investment will be low.
This shifts the IS curve to the left and
the intersection of the IS and LM curves
will move to the left. The equilibrium
output is reduced in the short run.
40
Technological advancement

When there is technological
advancement, the marginal product of
capital will increase, and the desired
business investment will increases too.
This shifts the IS curve to the right and
the intersection of the IS and LM curves
to the right as well. The equilibrium
output rises in the short run.
41
Monetary contraction

If the central bank reduces the money
supply, the LM curve will shift to the left.
The equilibrium output will reduce
accordingly in the short run.
42
The FE curve

The FE curve represents all the
combinations of the real interest rate
and the real income that equate the
demand for labor and the supply of
labor ( the equilibrium of the labor
market), given other things being equal.
43
The FE curve


The FE curve is called the full
employment curve.
The full employment level of
employment in the labor market gives
rise to the full employment output Y ,
given the capital stock and the
production function.
44
The FE curve

The full employment level and the full
employment output do not depend on
the real interest rate, so the FE curve is
a vertical line at the full employment
output, Y .
45
r
FE curve
Y
Y
46
The General equilibrium of an
economy


When all the markets, the labor market,
the goods and services market, and the
asset market, are in equilibrium, it is
said that the entire economy reaches
the general equilibrium.
When the FE curve, the IS curve, and
the LM curve intersect on the same
point, the general equilibrium reaches.
47
r
r
FE curve
IS curve
LM curve
*
Y
Y
48
Determination of the long run
equilibrium


Given the full employment level of
employment and the production
function, the position of the FE curve
stays at the full employment output Y .
If the IS curve or the LM curve shifts,
the original equilibrium is broken. The
three curves no longer intersect at the
same point.
49
r
FE curve
IS curve
Y
LM curve
Y
50
When the price level is fixed in
the short run

If the price level is fixed in the short run
as the Keynesian is suggested, the
equilibrium
d output is determined by the
Y
aggregate demand , which is the
output corresponding to the intersection
of the IS and LM curves.
51
When the price level is fixed in
the short run


If the aggregate demand is smaller than the
full employment output, that is, the
intersection point of the IS and LM curves is
at the left of the FE curve, the economy is
said to have a recession.
If the aggregate demand is greater than the
full employment output, that is, the
intersection point of the IS and LM curves is
at the right of the FE curve, the economy is
said to have an expansion.
52
Economic expansion
FE curve
r
The short run
equilibrium
'
output is Y
IS curve
LM curve
A
Point B is the
equilibrium in the
short run
B
Y Y
'
Y
53
Price adjustment in the long
run


In the long run, the price level can be
adjusted to restore the long run
equilibrium, which is the intersection of
the three curves, the FE, IS, and LM
curves.
The long run equilibrium output will
again equal the full employment output
Y
54
A recession caused by an
adverse demand shock

If the IS and LM curves intersect at the
left of the FE curve due to an adverse
demand shock, the aggregate demand
is smaller than the full employment
output an economy can supply. In the
short run, because the price level is
fixed, the aggregate demand
determines the equilibrium output of
the economy.
55
The long run adjustment of
the price level


Now if the price level can be adjusted as time
goes by, the weak aggregate demand will
force the price level to go down in the long
run.
This decline of the price level will shift the LM
curve to the right. As long as the aggregate
demand is still less than the full employment
output, the price adjustment will go on and
the LM curve will continue to shift to the right
until the three curves intersect at the same
point again. The new equilibrium is reached.
56
r
FE curve
IS curve
LM curve
P
A
P
B
Y
Y
57
The adjustment process in the
long run (a recession case)





Because the aggregate demand is smaller
than the full employment output,
1. There is an excess supply situation
2. The price level will decrease over time.
3. The nominal money demand will decrease.
4. People will want to transform the money
asset into the nonmoney assets by buying
bonds in the bond market.
58
The adjustment process in the
long run (a recession case)


5. The bond prices will increase due to higher
demand, and the interest rate will fall.
6. The reduced interest rate will stimulate the
investment, and the aggregate demand will
increase to eliminate the excess supply. The
original equilibrium is restored in the long run
due to the adjustment of the price level.
59
An expansion due to a positive
demand shock

If the IS and LM curves intersect at the
right of the FE curve, the aggregate
demand is greater than the full
employment output an economy can
supply. In the short run, because the
price level is fixed, the aggregate
demand determines the equilibrium
output of the economy.
60
The long run adjustment of
the price level


Now if the price level can be adjusted as time
goes by, the excess aggregate demand will
force the price level to go up in the long run.
This rise in the price level will shift the LM
curve to the left. As long as the aggregate
demand is greater than the full employment
output, the price adjustment will go on and
the LM curve will continue to shift to the left
until the three curves intersect at the same
point again. The new equilibrium is reached.
61
r
FE curve
IS curve
B
LM curve
P
A
P
Y
Y
62
The adjustment process in the
long run (an expansion case)





Because the aggregate demand is greater
than the full employment output,
1. There is excess demand
2. The price level will increase.
3. The nominal money demand will increase.
4. People will want to transform the
nonmoney assets into the money asset by
selling bonds in the bond market.
63
The adjustment process in the
long run (an expansion case)


5. The bond prices will decrease due to
higher supply, and the interest rate will rise.
6. The higher interest rate will reduce the
investment, and the aggregate demand will
decrease to eliminate the excess demand.
The original equilibrium is restored in the long
run due to the adjustment of the price level.
64
The complete crowding-out
effect in the long run


If the IS curve’s shift to the right is due to an
increase in the government purchase, the
initial increase in the output in the short run
will be eliminated due to the complete
crowding-out effect.
This will happen because the interest rate
increases to crowd out the private
investment.The original increases in the
output will be completely offset by the equal
amount of decrease in the output.
65
The adjustment process due
to a money supply increase



When the central bank increases the money
supply, the people’s money demand does not
change.
People will want to buy bonds with the
additional money supply. So the bond prices
increase and the interest rate falls.
The reduced interest rate stimulate the
private investment and the aggregate
demand. If the price level is fixed, the
equilibrium output in the short run increases.
66
An expansion case due to an
increase in the money supply
P
r
IS curve FE curve
LM curve
M
P
B
M
P
Y
A
Y
67
The adjustment process in the
long run





Because the aggregate demand is greater
than the full employment output,
1. There is excess demand
2. The price level will increase.
3. The nominal money demand will increase.
4. People will want to transform the
nonmoney assets into the money asset by
selling bonds in the bond market.
68
The adjustment process in the
long run


5. The bond prices will decrease due to
higher supply, and the interest rate will rise.
6. The higher interest rate will reduce the
investment, and the aggregate demand will
decrease to eliminate the excess demand.
The original equilibrium is restored in the long
run due to the adjustment of the price level.
69
Money neutrality in the long
run


The increase in the money supply will
result in an increase in the price level
by an equal proportion, and will not
change any of the real variables, such
as the real output, and the real interest
rate.
This outcome is called money neutrality.
70