11/12/2015

Product(Goods)andFinancial(Money)
MarketEquilibrium:

The IS-LM Model

IS-LM Analysis
IS-LM analysis represents an interpretation of Keynes'
General Theory stemming from J.R. Hick's classic article
entitle "Keynes and the Classics.
Hicks argues that the essence of Keynes' theory is his
theory of liquidity preference. Individuals hold money
(liquidity) for transactions, for speculative reasons, and for
emergencies.
IS-LM model was developed by Hicks and Hansen
incorporating Consumption Functions, Investment
Functions, Demand and Supply of Money function into
the national income and output determination model.

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IS-LM Analysis
IS-LM analysis allows us to solve for income(Y) and the interest
rate(i) simultaneously.
It enables to analyse the impacts of Monetary and Fiscal Policy
changes on the economy.
A dichotomy between the goods market and the money markets
and equilibrium in both markets.

Fundamental inflexibility
assumptions:
W : Fixed
P : Fixed
i : Flexible
In all these cases W and P are assumed
to be constant

IS-LM analysis:
Two sector Model
Three Sector Model
Four Sector Model

MoneyMarket

ProductMarket

IS LMModel:Introducevariableinterestrate
Simple Model

Keynesian

IS-LM

Income

Fixed

Variable

Variable

Interest Rates
Price

Fixed
Fixed

Fixed
Fixed

Variable
Fixed

Consumption

Autonomous

Functions of
Income

Functions of
Income

Investment

Autonomous

Autonomous

Functions of
Interest Rate

Money Supply

Not Included

Not Included

Autonomous.

Not Included

Functions of
Income and
Interest Rate

Functions of
Income and
Interest Rates

Money
Demand

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IS-LM Analysis: Two Sector Model

1.TheGoodsMarketEquilibrium:
andtheIS 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:
Product Market Eq(Keynes) :
Y= C+ I
or
Y= C (Y) + I0(1)
Keynes assumes I as fixed as I0 i.e. autonomous
Investment

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InterestRate(i),Investment(I)andOutput(Y).

Hicks, now, we no longer assume investment is constant i.e. I0

We capture the effects of two factors affecting Investment:
The level of sales/income (+)
The interest rate (-)
So, I = f(Y,i)

Product Market Eqm(Hicks ):

Y = C(Y)+ I(i).(2)
Or S = I
Where C = Co+cY
I = I0-hi ,
=> Y = C0+cY+I0-hi
=> Y-C0+cY = I0-hi
=> S(Y) = I(i)..(3)

0<c<1
h>0

Taking into account the investment relation above, the equilibrium condition in the goods
market becomes:
Y=C0+cY+I0-hi.(4)
=>Y= 1 (C0+I0-hi)
(1-c)

h>0

The Determination of Output

Demand , Z

Equilibrium in the
Goods Market

Z
A

C0+cY+I0-hi

450
Y
Output, Y
The demand for goods is an increasing function of output. Equilibrium
requires that the demand for goods be equal to output.

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Deriving the IS Curve

IS Curve: The IS curve shows the relationship between
the rate of interest(i) and national income (output, Y),
with the product market equilibrium.
Anincreaseintheinterestratedecreasesthedemand
forgoodsatanylevelofoutput
TheIScurveisthelocusofpointshowingequilibriumpointof
theproductmarketatdifferentlevelsofinterestrate,savings
andincome.

TheEffectsofanIncreaseintheInterestRateonOutput

Deriving the IS Curve

Product Market Eq: Y= C(Y)+I(i)
=> Y=C0+cY+I0-hi
=> Y= (1/1-c) C0+I0-hi (5)
Y=f(i)(5a)
Example:
Let C(Y)=10+0.5Y
I(i)=200-2000i
So Y= C+I
=>Y=10+0.5Y+200-2000i
=>Y=420-4000 i
If i = 6%, then Y= 180

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Deriving the IS Curve

Deriving the IS Curve

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2.Financial(Money)Markets
Equilibrium:andtheLM Relation

Money Market Equilibrium achieves when Demand for Money(Md) is equal

to Supply of Money (Ms). The interest rate is determined by the equality of
the supply of and the demand for money:

Keynes:
Supply of Money is fixed : MS M s.......... .( 6 )
Demand for Money
: M d M d M d ..........(7)
T

SP

Where, M T kY , and , M SP L(i)

d

MTd= Transaction and Precautionary Demand for Money

MdSp= Speculative Demand for Money
Ms = nominal money stock
Y = nominal income
i = nominal interest rate

RealMoney,RealIncome,andtheInterestRate
Money Market Equilibrium: when demand for money is
equal to supply of money
Ms M

or , M s kY L ( i )

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:
Ms
kY L ( i )

P
P
Recall: before, we had the same equation nominal terms (nominal income
and nominal money supply). Dividing both sides by P (the price level)
gives us the above equation in real terms.

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MoneyMarketEquilibrium
The Effects of an Increase in
Income on the Interest Rate

DerivationofLMCurve
LM curve shows the relationship between interest rate(i)
and national income(Y) with Money Market Equilibrium.

Equlibrium : Ms M d
Ms kY L(i )
Ms kY L li
1
Y ( Ms L li )
k
So, Y f (i ).........(8)

M d M T M SP
d

Where , M T kY , and , M SP L (i )
d

Let , M SP L li
d

l >0

LM curve is the locus of point showing equilibrium parts

of the money market at different levels of interest rate,
income and demand for money.

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DerivationofLMCurve
Example:
Let : M s 150
Mt kY 0 . 5 Y
Msp L li 150 1500 i
Md ky L li 0 . 5 Y 150 1500 i
1
Y
(150 150 1500 i )
0 .5
Y 3000 i
If , i 6 %, Y 180

DerivationofLMCurve

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DerivationofLMCurve

3.ProductandMoneyMarketEquilibrium
Simultaneously:ISLMModel
1
( C 0 I 0 hi )
Product Market: Y=f(i)
1 c
1
Money Market : Y=f(i)
LM Re lation : Y ( M s L li )
k
IS Re lation : Y

Ms>Md
S>I

When the IS curve intersects

the LM curve, both goods and
financial markets are in
equilibrium.

Md>Ms
I>S

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Shift in the IS-LM curves and the Equilibrium

a. Shift in IS Curve ( due to Demand shocks, I )

Shift in the IS-LM curves and the Equilibrium

a. Shift in IS Curve ( due to Demand shocks, I )

Shifting from IS1 to IS2 is due to shift in I.

what is the source of I?
Might be due to sale of bond to acquire fund
as result, bond price go down and interest
rate increase. So when IY, S MdT.

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Shift in the IS-LM curves and the Equilibrium

b. Shift in LM Curve: due to (i) shift in MdT or Mdsp i.e. Md

Shift in the IS-LM curves and the Equilibrium

b. Shift in LM Curve: (ii) due to shift in Money supply

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4.ShiftinISLMCurveandEquilibrium
Simultaneous Shift in IS and LM Curve

IS-LM Analysis: Three Sector Model

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FiscalPolicyandMonetaryPolicy:TheISLMModel
A. Fiscal Policy: Refers to the discretionary changes made in the government
spending and taxes intended to achieve certain economic goals.
Fiscal Policy (spending and taxes)
Shifts IS curve
increase in spending or cut in taxes shifts IS curve to the right and
vice versa
B. Monetary Policy: Refers to the discretionary use of the powers of the
monetary authority to cane the demand for and supply of money
in accordance with the need of the economy.
Monetary Policy (money supply)
Shifts LM curve
increase in money supply shifts LM curve to the right and vice versa

Fiscal Policy, the Interest Rate and the IS Curve

Fiscalcontraction: afiscalpolicythatreduces
thebudgetdeficit.
ReducingGorincreasingT

Fiscalexpansion: increasingthebudgetdeficit.
IncreasingGordecreasingT
Taxes(T)andgovernmentexpenditures(G)affectthe
IS curve,nottheLM curve.

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FiscalPolicy,theInterestRateandtheISCurve
The Effects of an
Increase in Taxes

MonetaryPolicy,
InterestRateandLMCurve
Monetary contraction (tightening) refers
to a decrease in the money supply.
Monetary expansion refers to an
increase in the money supply.
Monetary policy affects only the LM curve,
not the IS curve.

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MonetaryPolicy,
InterestRateandLMCurve
The Effects of a
Monetary Expansion

Product Market Equilibrium With Govt Sector:

The IS Curve
Assumption:
1. Govt. Exp. is determined exogenously and fixed
2. Tax means only income tax at flat rate (t) and tax
function is given by T=T0+tY
3. Govt. follows a balanced budget policy
ProductMarketEquilibrium:Y=C+I+G
Alternatively,
=>Y=C+S+GsinceS=I
=>Y=C+S+T
ifG=Tmeansgovtexp isfinancedthroughTax

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Derivation of the IS Curve

ProductMarketEquilibrium:Y=C+I+G
Where,C=C0+c(YT)
I=I0hi,h>0
G=G0
T=T0+tY,0<t<1
Substitutingthesevalues,Y=C0+c(YT0tY)+I0hi+G0
=>Y=(1/1c+ct)(C0cT0+I0+G0hi)
Letsdefine,C0cT0+I0+G0=A0and (1/1c+ct)=Gm
Measuring Shift in IS Curve

Then,Y=Gm(A0hi)
Y=f(i)(1)

Y=(1/1-c)G
Or
Y=(1/1-c+ct)(Co-cT0+I0+G0-hi)

Derivation of the IS Curve

Example:Y=C+I+G
Let C=100+0.75(YT)
S=100+0.25(YT)
Y=(1/1-c)G
I=2002000i;G0=100
T=80+0.20Y
Now Y=Co+c(YT0tY)+I0hi+G0
=>Y=(1/10.75(10.20))*(1000.75*80+2002000i+100)
=>Y=8505000i
Alternatively:I+G=S+T
S=100+0.25(YT)
Now,I+G=S+T
=>2002000i+100=100+0.25(Y(80+0.20Y))+80+0.20Y
=>Y=8505000i
Ifi=6%,ThenY=550

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Derivation of the IS Curve: Graph

So+T
(T=0)

Fiscal Policy and Shift in IS Curve

a.
b.
c.
d.

Change(increaseordecrease)inG
ChangeinTaxrate(t)
ChangeinbothGandt
DifferentcombinationsofchangeinGandt

a.Change(increaseordecrease)inGnoTax
LetGovtExpenditureisG=100andTisT=0,andinterestratei=6%,
thenwhatwillbeY?????
Y=(1/1c)G
=> Y/G=(1/1c) theGovtmultiplier
Y=(1/10.75)*100=400
SoequilibriumincomewillincreasesfromRs720toRs1120i.e.
720+400.andequilibriumpointwillshiftfromAtoB.
SoIScurvewillbeISG=>16008000i=Y
Ifi=6%,Y=1120

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Fiscal Policy and Shift in IS Curve

b.NowLetGovtImposeTax,DuetothistheISCurveShift
WeknowS+T=I+G
So,S=100+0.25(YT)
=>S+T=100+0.25(YT)+T=80+0.20Y
S+T=40+0.40Y
NowwiththeintroductionoftaxfunctiontheshiftinIScurve
willbeS0+TleftwardsandwillbeISGT=>8505000i=Y
Ifi=6%,Y=550
SonetreductioninoutputwillbeY=170

Fiscal Policy and Shift in IS Curve

1.IncreaseinG:duetothistheISCurveShiftrightward.
LetGovt.Expenditureincreasefrom100to200,andinterestrateis6%,
withthistheproductmkt equilibriumwillbe,atY=800meansY
increasesfrom550to800
WeknowI+G=S+T
Since,S=100+0.25(YT),I=2002000i
andT=80+0.20Y
=>2002000i+100=100+0.25(Y(80+0.20Y))+80+0.20YinitialISCurve
Now=>2002000(0.06)+200
=100+0.25[Y(80+0.20Y)]+80+0.20Y
=>280=40+0.40Y
=>Y=800

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Fiscal Policy and Shift in IS Curve

2.DecreaseinTaxRate(t):duetothistheISCurveShift
rightward.
Letthetaxratedecreasesfromt=0.20to0.15%,andinterestrateis6%,
(withsimultaneousincreaseinG=100),withthistheproductmkt
equilibriumwillbeatY=888.88
WeknowI+G=S+T
Since,S=100+0.25(YT),I=2002000i
andT=80+0.20Y
2002000i+100=100+0.25(Y(80+0.20Y))+80+0.20YinitialIScurve
Now=>2002000(0.06)+200=100+0.25[Y(80+0.15Y)]+80+0.20Y
=>280=40+0.36Y
=>Y=888.8

Fiscal Policy and Shift in IS Curve

3.DeficitFinancing:duetothistheISCurveShiftrightwards
Lettheinitialinvestmentfunctionandtaxfunctionisasbelow
I=1002000iandT=0.20Y
Soequim:I+G=S+T
withS=100+0.25(YT),
=>1002000i+100=100+0.25(Y 0.20Y))+0.20YinitialIScurve
=>Y=7505000i..(A)
NowifGovtfinancethespendingbyprintingadditionalcurrency(borrowingfrom
centralbankorabroad)ofRs100billion,thenwhatwillhappento
output????
I+G+G=S+T
=>200200i+100=100+0.4Y
=>Y=10005000i.(B)
At6%interestrate,YwillbeAB
Y=(10005000i)(Y=7505000i)
Y=(1005000*0.06)(7505000*0.06)
Y=250billion

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Fiscal Policy and Shift in IS Curve

FiscalPolicyandShiftinISCurve
Measuring Shift in IS Curve
Y=(1/1-c)G
Or
Y=(1/1-c+ct)(Co-cT0+I0+G0-hi)

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Monetary Policy and Derivation of LM Curve

LM curve shows the relationship between interest rate(i) and
national income(Y) with Money Market Equilibrium.
Equlibrium

: Ms M

M s kY L ( i )
M s kY L li
1
Y ( M s L li )
k
SO , Y f ( i )

M d M T M SP
d

Where , M T kY , and , M SP L (i )
d

Let , M SP L li

l0

LM curve is the locus of point showing equilibrium parts of the

money market at different levels of interest rate, income and
demand for money.

Monetary Policy and Shift in LM Curve

Example:
MoneyMarketEquilibrium:Ms=Md
Md=MdT+MdSp.(2)
LetMS=200billion
MdT=ky=0.5Y
MdSp=L0li=1002500i
ThenMs=Md MoneyMarketEquilibrium
=>200=0.5Y+1002500i
=>Y=200+5000iLMCurve
Fori=6%,Y=500

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MonetaryPolicyandShiftinLMCurve
1. ChangeinMoneySupplyshifttheLMCurve
2. ChangeinMoneyDemandShifttheLMCurve
1.ChangeinMoneySupplyandShift
intheLMCurve
LetMoneySupplyincreasesanother100billion,
thentheshiftinLMwillbe
NowEq:Ms+Ms=Md
=>200+100=0.5Y+1002500i
=>Y=400+5000i
Fori=6%,Y=700
LMcurveshiftrightwardandIncome
increases
Equlibrium : M s kY L li
1
Y ( M s L li )......... LMCurve
k

ShiftinLM:=Ms(1/k)
=100(1/0.5)=200

Point c, if households decided to keep Mt unchanged then

eqm will fall from A to C, causing interest rate to fall and
Msp to increases,. It means they spend money to buy bond
and securities and hence interest rates falls

Equilibrium with Product and Money Market:

Three Sector Model
ProductMktEquilibrium
C=100+0.75(YT)
I=2002000i;G0=100
T=0.20Y
=>Y=7505000i
MoneyMarketEquilibrium:
LetMS=200billion
MdT=ky=0.5Y
MdSp=L0li=1002500i
ThenMs=Md MoneyMarket
Equilibrium
=>200=0.5Y+1002500i
=>Y=200+5000i
BothMktwillbeinequilibrium
Ifi=5.5,equilibriumY=475

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A. Change in Fiscal Policy : IS-LM Curve

LetG=100,thisshifttheIScurvetoIS1andYincreasesfrom475to600LMremainingthesame,
interestrateincreaseto8%,calledascrowdingouteffect.

B. Change in Monetary Policy : IS-LM Curve

LetM=100,i.e.Moneysupplyincreasesto100,thisshifttheLMcurvetoLM1andY
increasesfrom545to575,ISremainingthesame,interestratedecreasesto3.5%.

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C. Change in both Monetary and Fiscal Policy:

IS-LM Model

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

right

none

up

up

Decrease in
spending

left

none

down

down

Increase in money

none

down

up

down

Decrease in money

none

up

down

up

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The U.S. Recession of 2001

The U.S. Growth Rate, 1999:1 to 2002:4

The Federal Funds Rate, 1999:1 to 2002:4

The U.S. Recession of 2001

U.S. Federal Government Revenues and Spending (as

Ratios to GDP), 1999:1 to 2002:4

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The U.S. Recession of 2001

What happened in 2001 was the following:
The decrease in investment demand led to a sharp
shift of the IS curve to the left, from IS to IS.
The increase in the money supply led to a downward
shift of the LM curve, from LM to LM.
The decrease in tax rates and the increase in
spending both led to a shift of the IS curve to the
right, from IS to IS.

The U.S. Recession of 2001

The U.S. Recession of 2001

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IS-LM Analysis: Four Sector Model

ISLMwithForeignSectors
OpenEconomy:
1.RealFlowofgoodsandservices
2.FinancialFlowofcapitalandforeignexchange.
Twotypesoftransaction
1.AutonomousTransaction:i.e.XandMofconsumer
andcapitalgoods.
2.InducedTransaction:Transactionsoccursinterms
ofmoneytopayforbalanceoftradeeitherdeficit
ofsurplus

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Product Market Equilibrium and IS Curve with

Foreign Sectors
Equilibrium:Y=C+I+G+XM
orC+I+G+XM=C+S+T
LetX=X0andM=M0+mY
Where,C=Co+c(YT);S=C0+(1c)(YT);I=I0hi,h>0;
G=G0;T=T0+tY,0<t<1
Substitutingtheseweget
Y=Co+c(YT0tY)+I0hi+G0+X0M0mY
SolvingforY,weget
Y=(1/1c+ct+m)(Co+cT0+I0hi+G0+X0M0)(1)
SoY=f(i)

Product Market Equilibrium and IS Curve with

Foreign Sectors
Example:Y=C+I+G+XM
Let,C=100+0.75(YT)andhenceS=100+0.25(YT)
I=2002000i;G0=100;T=80+0.20Y;Xo=50and
M=20+0.10Y
NowsolvingforY=(1/1c+ct+m)(Co+cT0+I0
hi+G0+X0M0)
=>Y=(1/10.75(1
0.20)+0.10))*(100+(0.75)(80)+200
2000i+100+5020)
=>Y=7404000iistheIScurve
Fori=0.06%,Y=500

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Product Market Equilibrium and IS Curve with

Foreign Sectors

Money Market Equilibrium and LM Curve with

Foreign Sectors
There is no change in the LM curve with foreign sector. The
same LM curve which is derived for two sector is relevant here,

Equlibrium

: Ms M

M s kY L ( i )
M s kY L li
1
Y ( M s L li )
k
SO , Y f ( i )

M d M T M SP
d

Where , M T kY , and , M SP L (i )
d

Let , M SP L li
d

LM curve is the locus of point showing equilibrium parts of the

money market at different levels of interest rate, income and
demand for money.

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Monetary Policy and Shift in LM Curve

Example:MoneyMarketEquilibrium:Ms=Md
Md=MdT+MdSp.(2)
LetMS=200billion
MdT=ky=0.5Y
MdSp=L0li=1002500i
ThenMs=Md MoneyMarketEquilibrium
=>200=0.5Y+1002500i
=>Y=200+5000iLMCurve
Fori=0.06%,Y=500

Equilibrium in both Product and Money market

with IS-LM Model

Example:
ISFunction:Y=7404000iIScurve
LMFunction:Y=200+5000iLMCurve
MarketEquilibrium:IS=LM
=>7404000i=200+5000i
=>540=9000i
=>i=0.06(6percent)
NowY=7404000(0.06)
=500

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Equilibrium in both Product and Money market

with IS-LM Model

References
1. Ch 16-18, Macroeconomic Theory and
Policy by D N Dwivedi
2. Ch 5 Macroeconomics by Blanchard
3. Ch 10-11 Macroeconomics by N Gregory
Mankiw

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Thank You All

German Unification and the German MonetaryFiscal Policy Mix

Selected Macro Variables for West Germany, 1988-1991
1991

1992

1993

1994

GDP growth (%)

3.7

3.8

4.5

3.1

Investment growth (%)

5.9

8.5

10.5

6.7

Budget surplus (% of GDP)

(minus sign = deficit)

2.1

0.2

1.8

2.9

Interest rate (%)

4.3

7.1

8.5

9.2

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German Unification and the German MonetaryFiscal Policy Mix

34