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Chapter 24
Linking the Financial System and
the Economy: The IS-LM-FE
Model
Copyright © 2002 Pearson Education, Inc.
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A Model for Goods and Assets
Markets: Assumptions
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General equilibrium occurs when all the
markets are in simultaneous equilibrium.
The goods market includes trade in all
goods and services that the economy
produces.
The money market includes trade in all
assets used as the medium of exchange.
Nonmoney asset market includes trades of
nonmonetary assets that are stores of value.
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The IS Curve
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The goods market is in equilibrium when
Y = C + I + G.
When the goods market is in equilibrium,
national saving equals national investment.
The IS curve summarizes the equilibrium in
the goods market.
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Determinants of National Saving
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National saving increases when current
income or current output rise.
A rise in expected future income causes
national saving to fall.
National saving increases with the interest
rate, although the effect probably isn’t large.
Holding current output constant, an increase
in government purchases reduces saving.
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Determinants of National Investment
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An increase in expected future profitability
of capital increases investment.
An increase in the expected real interest rate
lowers the demand for investment.
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Figure 24.1 The IS Curve Graph
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Figure 24.2 Excess Demand and
Supply in the Goods Market
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Table 24.1
Accounting
for Shifts of
the IS Curve
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Determining Output:
The Full Employment Line
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Full-employment output is the production
level when all production factors are used.
On the IS diagram, full employment is
represented as a vertical line at Y *.
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Table 24.2
Accounting for Shifts of the FE Line
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The LM Curve
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In the asset market: Md + Nd = Ms + Ns.
Equilibrium in the nonmoney asset market
implies equilibrium in the money market.
The LM curve is the set of combinations of
current output and the real interest rate for
which the money market is in equilibrium.
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Figure 24.4 The LM Curve Graph
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Figure 24.5 Points Off the LM Curve
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Table 24.3
Factors Shifting
the LM Curve
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The IS-LM-FE Model
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The financial and goods market are both in
equilibrium when IS, FE, and LM intersect.
The economy will restore equilibrium if the
IS curve, the LM curve, or the FE line
shifts.
The neutrality of money implies that a onetime change in the nominal money supply
affects only nominal variables.
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Figure 24.7 Changing the Equilibrium
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Figure 24.8 Price Level Adjustment to
Restore Equilibrium
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