Download The IS-LM Framework for Macroeconomic Analysis

Purpose of the IS-LM framework
 To explain general equilibrium of the economy using
the three markets Labor market
 Goods market and
 Money market
 To explain response of the economy against any shock
 While using the IS-LM framework to understand the
general equilibrium of the economy we shall, in this
lecture, assume that the economy is closed (just to
keep things simple).
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The FE line: equilibrium in the labor market
r
FE line
Y
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Shift of FE line
 A beneficial
supply shock
will shift the
FE line to the
right.
 On the other
hand, an
adverse
supply shock
will shift the
FE line to the
left
r
Adverse supply
shock
Favorable
supply shock
FE line
Y
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The IS curve: equilibrium in the goods market
 The goods market is in equilibrium when savings is equal to
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investment.
The IS curve shows the real interest rate for which the goods
market is in equilibrium.
The IS curve is so called because at all points on it savings is
equal to investment
The IS curve slopes downward because if output (income)
increases, savings also increases reducing the interest rate and
vice versa.
For constant output, any change in the economy that changes
national savings relative to investment will change the interest
rate that clears the market and shift the IS curve.
We plot IS curve only by changing savings curve (NOT
investment curve), because savings determine the level of
investment.
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The IS curve
r
r
I
S1
IS
S2
D
D
7%
F
5%
F
S, I
Y1
Y2
Y
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Shift of the IS curve: an example
1. A decrease in
expenditure increases
savings
2. and reduces
interest rate
r
r
S1
I
IS2
S2
r1
4. Therefore, IS1
shifts to the left to
IS2 to match the
constant output
level
IS1
A
A
B
r2
B*
B
S, I
Y*
3. But the
output is
fixed at Y*
Y
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Factors that shift IS curve
An increase in
Shifts the IS curve
Reason
Expected future
output
Up and to the right
Wealth
Up and to the right
Government
purchases
Up and to the right
Expected future
MPK
Up and to the right
Investment increases, interest rate
rises
Tax
No change
(Ricardian
Equivalence)
If the consumers think that in future
they will get an equivalent amount
of tax-cut
Consumption rises, savings falls,
interest rate rises
Down and to the left If the consumers reduce
consumption because of the tax
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The LM curve: equilibrium in the asset market
 From the study of asset market we know that equilibrium in the asset
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market will be established at the point where demand for and supply of
asset will be equal.
We also found that this condition can be reduced to: Equilibrium at the
point where demand for and supply of money will be equal.
Demand for money depends on interest rate paid to nonmonetary
assets. If interest rate on nonmonetary assets rise people will hold
more nonmonetary assets and lesser money. This means that there is
an inverse relationship between demand for money and interest rate.
For this reason, the demand for money curve always slopes downward.
On the other hand, as the money supply is fixed, it is always vertical
irrespective of the interest rate.
The LM curve, like the IS curve, represents a locus of equilibrium
points of the money market at various interest rates.
LM curve is called so because on all points of the curve the demand for
money (L) is equal to the supply of money (M).
In our closed economy, we assume that money supply is determined by
Bangladesh Bank and is fixed. Therefore, determination of equilibrium
will depend on the demand for money.
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The LM curve
r
r
M/P
LM
C
C
r2
r1
A
A
M1/P
Y1 Y2
At output level Y1 equilibrium is at point A and equilibrium interest rate is r1.
If output level changes to Y2 it will increase demand for money and
equilibrium will be established at point C where the equilibrium interest rate
will be r2. Interest rate rises because by increasing interest rate the excess
demand for money imposed by the increased level of output can be offset.
Y
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Shift of the LM curve
 For constant output, any change in the real money supply
relative to real money demand will change the real interest rate
and cause the LM curve to shift.
r
r
MS1
LM1
MS2
LM2
r1
r2
MD
M1/P
M2/P
Y
Y*
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Shift of the LM curve
 For constant output, any change in the real money demand
relative to real money supply will change the real interest rate
and cause the LM curve to shift.
r
r
LM1
MS
LM2
r1
r2
MD1
MD2
Y
Y*
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Factors that shift the LM curve
An increase in
Shifts the LM curve
Reason
M
Down and to the right
Reduces r as M/P increases
P
Up and to the left
Increases r as M/P falls
Down and to the right
Reduces r as demand for
money falls
Wealth
Up and to the left
Demand for money increases
and r increases
Payment technology
Down and to the right
Demand for money falls and
r falls
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General equilibrium in the IS-LM model
 The whole economy comes to a general equilibrium when
all the three markets (labor market, goods market and the
asset market) come to equilibrium at the same time.
r
IS
FE
LM
General
Equilibrium point
Y
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Effect of a change on the IS-LM framework
r
•
The initial
general
equilibrium
is at point E
IS
FE
LM
E
Y
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Effects of a change in the IS-LM framework
 A 10% increase
in the money
supply will
shift the LM
curve to the
right.
 IS and LM
curves meet at
F, but the FE
line does not.
 At F people
will want more
goods and
firms will
respond.
r
IS
FE
LM1
LM2
E
F
Y1
Y
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Effects of a change in the IS-LM framework
 But as the
firms are out
of the FE line
they will
want to go
back to it.
 To do so they
will push the
price up so
that LM
curve shifts
back again to
E.
r
IS
FE
LM1
LM2
E
F
Y
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Effects of a change in the IS-LM framework
 Suppose money supply changes by 10%.
 Price level is fixed.
 This change will shift the LM curve to the right and bring down the
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interest rate.
The IS and LM curves meet at a new point.
But the FE line stays the same.
If we assume that asset and goods market adjust more quickly than the
labor market then output will be at the new point. This will be so
because at the lower interest rate people will consume more and firms
will invest more.
But this point is not optimum for the firms as this is out of the FE line.
Therefore, firms will want to go back to FE line and will push price up
to do so.
This action of the firm will set the equilibrium at the original point.
The only difference will be that the price level will higher by 10%.
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General equilibrium in the IS-LM framework:
Classical vs. Keynesian debate
 We have seen that an increase in the money supply will reduce the
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interest rate and shift the LM curve to the right to intersect the IS curve
in a new point, where a temporary equilibrium only in the goods and
asset market will be established.
The labor market will not be in this equilibrium and consequently
firms will push the price up to return to the general equilibrium state.
The question is how fast this adjustment process takes place?
According to the Classical view the adjustment process takes place very
quickly.
On the other hand, the Keynesian view proposes that the adjustment
process may take long time and as a result the state out of general
equilibrium may persist for a long time.
About the monetary neutrality, both agrees. The difference in their
view is that- the Classical economists thinks money is always neutral
and the Keynesians think that money is neutral but takes a
considerable time to be neutral.
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Aggregate Demand (AD) and Aggregate Supply
(AS) model
 AD-AS model is equivalent to the IS-LM model.
 The difference between the two is that the IS-LM
model relates output (Y) with the interest rate (r);
whereas the AD-AS model relates output (Y) with the
price level.
 IS-LM model is useful when we need to look at the
effect of a change in the interest rate on important
variables like savings and investment.
 AD-AS model is useful to analyze variables that are
directly related to the price level such as inflation and
unemployment.
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Aggregate demand curve
 The aggregate demand curve
shows the relationship
between the aggregate
quantity of goods demanded
and the price level.
 The intersection point of the
IS and the LM curves
determine the aggregate
demand for goods.
 Therefore, if the IS or the LM
curve shifts it will indicate a
different price level and a
different aggregate quantity
demanded.
 At the intersection of IS and
LM1, Y1 output will be
demanded. But if the price
level increases it will shift the
LM curve up and to the left
and the corresponding
intersection point will show a
reduced level of output, Y2.
r
LM2
LM1
IS
Y
P
P2
P1
AD
Y2
Y1
Y
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Shift of the AD curve
r
LM
 For any given price level,
any change in the quantity
demanded will shift the
AD curve.
 For example, if the
government reduces
expenditure it will shift the
IS curve to the left.
 For constant price level
this will result in a shift of
the Ad curve.
 Any factor that shifts the
IS-LM intersection point to
the left will shift the AD
curve to the left and vice
versa.
IS1
IS2
Y
P
P1
AD1
AD2
Y2
Y1
Y
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Factors that shift the AD curve
 Some factors that shift the AD curve to the right:
 Increase in expected future output
 Increase in wealth
 Increase in government expenditure
 Increase in expected future MPK
 Increase in the nominal money supply
 Rise in expected inflation
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Aggregate supply (AS) curve
 The AS curve shows the relationship between the price level and
the aggregate amount of output that firms supply.
 In reality firms’ supply actions are different than our theoretical
model of supply studied in microeconomics.
 Our assumptions for aggregate supply are1. Prices remain fixed in the short run and firms supply the quantity
of output at that fixed price level.
2. In the long run price and wages adjust fully and market clears
completely. Therefore, in the long run the market is in full
employment level.
 Assumption 1 indicates that our short run aggregate supply
(SRAS) curve is horizontal.
 Assumption 2 indicates that out long run aggregate supply
(LRAS) is vertical.
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SRAS curve in the Keynesian view
P
LRAS
SRAS
Y
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Equilibrium in the AD-AS model
P
1. In the AD-AS model
long run equilibrium
will be established at
the point where LRAS,
SRAS and AD meet
(point E in the graph)
LRAS
E
SRAS
2. Output will
be at the full
employment
level.
AD
Y
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SRAS curve in the classical view
 The horizontal SRAS
curve is proposed by the
Keynesians.
 The classical economists
does not agree to this.
According to classical
view prices adjust
quickly and therefore
horizontal SRAS does
not exist.
 Classical view proposes
the usual left to right
upward moving SRAS.
 However, they agree
with the vertical LRAS.
P
LRAS
SRAS
Y
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