Lecture Notes

IS - LM Model

MBA (BM)

IS - LM Model in Closed Economy Case

In earlier classes we read about equilibrium in goods market and money market separately. In this lecture
note we will discuss about joint equilibrium of goods and services market and financial (money) market.
This model is known as IS - LM model or Hicks - Hansen model. This model was proposed by John
Hicks in 1937, and was further developed by Alvin Hansen in 1953.

IS Curve

The expanded form of IS curve is investment - saving curve. As you know in equilibrium for an economy,
Y = C + I(r) + G
Lets look at this problem in a different way. The total saving of the economy is defined as
Total Saving (S) = Y T C +
| {z }
Private Saving

T G
| {z }

=Y C G

Government Saving

In equilibrium
Y = C + I(r) + G, = Y C G = I(r)
S = I(r)
The above equation shows that in equilibrium savings are equal to investment. The left hand side (S) is a
function of income, while right hand side is a function of interest rate. This relationship between income
and interest rate is known as investment saving curve.
The IS curve is locus of (Y,r) in Y r plane when goods and services market is in equilibrium.
Exercise: In an economy, C = 100 + 0.6(Y T ), I = 20 r, G = 40, T = 30. Derive the IS curve for
this economy.
Exercise: In an economy, C = 100 + 0.6(Y T ), I = 20 r, G = 40, T = 0.3Y . Derive the IS curve for this
economy.

1.1

Excess Demand and Excess Supply in Goods and Services Market

Excess Demand in Goods and Services Market (EDG) : The case where aggregate demand is more
than aggregate supply is known as excess demand case.
Mathematically,
Y < C + I + G, = S < I
The area below the IS curve shows the excess demand in goods and services market.
Excess Supply in Goods and Services Market (ESG) : The case where aggregate supply is more
than the aggregate demand is known as excess supply.
Mathematically
Y > C + I + G, = S > I
The area above the IS curve shows the excess supply in goods and services market.
Therefore, the points on the IS curve are combinations of (Y,r), where goods and service markets are in
equilibrium. If we deviate from this line, then we will land in an region where there is excess demand or
excess supply.
Exercise: Draw the regions of excess demand and excess supply in goods and services market of the
previous exercises.
Hicks, J. R. (1937). "Mr. Keynes and the Classics: A Suggested Interpretation. Econometrica. 5 (2): 147159.
doi:10.2307/1907242
Hansen, A. H. (1953). A Guide to Keynes. New York: McGraw Hill.

Lecture Notes

IS - LM Model

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LM Curve

LM curve stands for liquidity preference - money supply curve. Hicks and Hansen followed Keynes liquidity
preference theory for demand for money. This theory says that the demand for money depends positively on
income and negatively on interest rate. The money market will be in equilibrium when demand for money
is equal to supply of money. That is, if Ms is money supply by the central bank, then in equilibrium
Ms
= L(Y, r)
P
Taking Ms is an exogenous variable, the curve that plots relationship between Y and r when money market
is in equilibrium is called LM curve.
The LM curve is defined as locus of the (Y,r) in Y r plane when money market is in equilibrium.
Exercise: In an economy, the demand for money is given by
Md
=Y r
P
Ms = 120, P = 12
Derive the LM curve for the economy.
Exercise: In an economy, the demand for money is given by
1
Md
=Y +
P
r
Ms = 120, P = 12
Derive the LM curve for the economy.

2.1

Ranges in LM Curve

LM curve has three ranges:

Keynesian Case (Liquidity Trap): In this case the LM curve is flatter and slope almost above 0.
Intermediate Range: In this range the LM curve is positively sloped.
Classical Range : In this range the LM curve is vertical to income axis.

Figure 1: LM Curve

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2.2

IS - LM Model

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Excess Demand and Excess Supply in Money Market (EDM)

Excess Demand in Money Market (EDM): In money market when interest rate is below the equilibrium
rate, then people demand more money, then excess demand for money. The area below LM curve represent
the excess demand for money.
Excess Supply in Money Market (ESM) : In money market when interest rate is higher than equilibrium
interest rate then people prefer to hold less money as interest cost is higher. Therefore, there is supply of
money in the money market.

Simultaneous Equilibrium in Goods and Money Market

From Section 1 we derived IS curve, which represents combinations of (Y, r) when goods market is in
equilibrium. In Section 2 we have derived LM curve which represents the combinations of (Y, r) when money
market is in equilibrium. Now we will discuss the simultaneous equilibrium in goods and money market.
In Figure 2, the simultaneous equilibrium of the goods and money market attains at point E. As we can
observe that at point E, both goods and money market is in equilibrium. In this figure (Fig. 2) different
regions have been shown. Each region represents

Figure 2: IS - LM Model : ESG - Excess supply in goods market, EDG - Excess demand in goods market,
ESM - Excess supply in money market, EDM - Excess demand in money market

Comparative Statics

In this section we will discuss how the equilibrium interest rate and equilibrium output get affected by
changes in different exogenous variables. In fiscal policy we will discuss the effects on r and Y . In monetary
policy we will discuss the effects on equilibrium r and Y by changing the money supply.

4.1

Changes in Government Expenditure

As we know, the changes in government expenditure shifts the aggregate demand. An increase in government
expenditure shifted the IS curve in north east direction. Therefore, the equilibrium interest rate and output
(income) increases. Similarly, decrease in government expenditure leads to decrease in both interest rate
and income. This has been shown in Fig. 3. It has to be noted that if equilibrium falls in Keynesian
Cont.

Lecture Notes

IS - LM Model

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range (Fig 1) , then increase in government expenditure affects only output but interest rate remains same.
Similarly, increase in government expenditure in classical range affects only the interest rate and output
remains constant.

Figure 3: IS - LM Model : Effects on Equilibrium Output and Interest Rate When Government Expenditure
Increases

4.2

Changes in Tax

Since tax (T) affects negatively to the aggregate demand as it reduces the disposable income and hence
consumption (C). Therefore an increase in tax shifts the IS curve downward. Which leads to decrease in
interest rate and output. Similarly, both increases in equilibrium when tax amount decreases.This has been
shown in Fig. 4. In Keynesian range of LM curve there is no effect on interest rate, every changes in tax
amount results in shifting output. In classical region, the changes in tax rate brings changes in interest rate
and output remains at full employment level unaffected.

Exercise: In an economy
r = 60 Y : IS curve
r = Y 10 : LM curve
Draw both curves in an appropriate plane and find equilibrium interest rate and output when both the
markets are in equilibrium.
Exercise: Suppose the expenditure increases by G and lump sum tax increases by T such that G = T .
As per this IS - LM for an closed economy, what will be its impact on equilibrium interest rate and output ?
Exercise: Do you think the slope of LM curve plays very important in effectiveness of changes in fiscal policy? If yes, explain it with an appropriate diagram.

Cont.

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IS - LM Model

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Figure 4: IS - LM Model : Effects on Equilibrium Output and Interest Rate When Tax Increases

4.3

Changes in Money Supply

When central bank of an economy increases money supply, then LM curve shifts right-ward (south - east
direction). This leads to decrease in interest rate and increase in output. This has been shown in Fig

Figure 5: IS - LM Model : Effects on Equilibrium Output and Interest Rate When Money Supply Increases

If equilibrium lies in Keynesian range, then increase in money supply will not have any impact both in
interest rate and output. Therefore, monetary policy in this range becomes helpless in affecting the interest
rate and output in equilibrium.

Cont.

IS - LM Model

Lecture Notes

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IS - LM Model: Open Economy Case

In this part we will discuss about IS - LM Model in open economy case. As we have discussed, in closed
economy case the saving is equal to investment. In that case saving was consisting of private saving and
government saving. In open economy case the equilibrium condition can be written as
Y =C +I +G+X M

(1)

Lets define saving by

Total Saving = Private Saving + Govt. Saving + External Saving
S = Y C T +
| {z }
Private Saving

T G
| {z }

Govt. Saving

M X
| {z }

External Saving

From Eqn (1), we can write

S =Y C G+M X =I

(2)

This is the equation for open economy IS curve.

Large Open Economy Case

A large open economy is defined as an open economy which can influence the world interest rate(rf ). Since
it can influence the world interest rate, therefore the policy implications of this economy is similar to a closed
economy.

Small Open Economy Case

A small open economy we mean an open economy which cannot influence the world interest rate. We will
discuss the change in money supply and fiscal policy for both fixed and flexible exchange rate system.

6.1

Fixed Exchange Rate System - Expansionary Monetary Policy

Expansionary monetary policy is ineffective in case of small open economy with fixed exchange rate.
Mechanism
M = LM curve outward = Y , rd = rd < rf = Reserve outflow = Money Supply Down to Intial Level
Here rd is domestic interest rate

Figure 6: IS - LM Model - Small Economy Fixed Exchange Rate : Effect of an Expansionary Monetary
Policy

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Lecture Notes

6.2

IS - LM Model

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Fixed Exchange Rate System - Expansionary Fiscal Policy

Expansionary fiscal policy is very effective in case of small open economy with fixed exchange rate.
Mechanism
G = IS Outward = Y , rd > rf = Reserve Inflow = M = Y , rd = rf

Figure 7: IS - LM Model - Small Economy Fixed Exchange Rate : Effect of an Expansionary Fiscal Policy

6.3

Flexible Exchange Rate System - Expansionary Monetary Policy

Expansionary monetary policy is very effective in case of small open economy with flexible exchange rate.
Mechanism

M oney = LM outward = Y , rd (rd < rf ) = Capital Outflow = e = X , M (N X ) = IS outwa

Figure 8: IS - LM Model - Small Economy Flexible Exchange Rate : Effect of an Expansionary Monetary
Policy

Cont.

IS - LM Model

Lecture Notes

6.4

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Flexible Exchange Rate System - Expansionary Fiscal Policy

Expansionary fiscal policy is very ineffective in case of small open economy with flexible exchange rate.
Mechanism
G = IS outward = Y , rd (rd > rf ) = Capital Intflow = e = X , M (N X ) = IS downward

Figure 9: IS - LM Model - Small Economy Flexible Exchange Rate : Effect of an Expansionary Fiscal Policy

Monetary Expansion
Fiscal Expansion
Monetary Contraction
Fiscal Contraction

IS - LM Model- Open Economy Case

Large Open Economy
Small Open Economy - Flexible Exchange Rate
Y , rd
Y , rd = rf
Y , rd
No Effect
Y , rd
Y , rd = rf
Y , rd
No Effect

Small Open Economy - Fixed Exchange Rate

No Effect
Y , rd = rf
No Effect
Y , rd = rf

Table 1: Summary Table : IS - LM Model - Open Economy Case

The End.