Macroeconomic Analysis and Policy

IS-LM Model

Sessions:17-18

Prof. Biswa Swarup Misra

Dean, XIMB

Learning Objectives

Derive the IS curve

Derive the LM curve
How equilibrium is achieved simultaneously in
the Goods market and the Money market

How equilibrium is restored when the economy

is not in equilibrium.

IS-LM Model

Biswa Swarup Misra

slide 1

The IS curve
def: a graph of all combinations of r and Y that
result in goods market equilibrium

i.e. actual expenditure (output)

= planned expenditure
The equation for the IS curve is:

Y C (Y T ) I (r ) G

IS-LM Model

Biswa Swarup Misra

slide 2

IS-LM Model

Biswa Swarup Misra

slide 3

Deriving the IS curve

E =Y E =C +I (r )+G
2

E =C +I (r1 )+G

E
Y

I
r

Y1

Y2

r1
r2

IS
Y1

IS-LM Model

Y2

Biswa Swarup Misra

slide 4

Why the IS curve is negatively

sloped

A fall in the interest rate motivates firms to

increase investment spending, which drives up
total planned spending (E ).

To restore equilibrium in the goods market,

output (a.k.a. actual expenditure, Y )
must increase.

IS-LM Model

Biswa Swarup Misra

slide 5

Deriving IS Curve from Loanable Funds Model

The IS curve can also be derived from the (hopefully now

familiar) loanable funds model .

Recall, S = Y-C-G
A decrease in income from Y1 to Y2 causes a fall in national
saving.
The fall in saving causes a reduction in the supply of loanable
funds. The interest rate must rise to restore equilibrium to the
loanable funds market.
Now we can see where the IS curve gets its name:

When the loanable funds market is in equilibrium, investment

= saving.

The IS curve shows all combinations of r and Y such that

investment (I) equals saving (S). Hence, IS curve.
IS-LM Model

Biswa Swarup Misra

slide 6

The IS curve and the loanable funds

model
(a) The L.F. model

S2

(b) The IS curve

S1

r2

r2

r1

r1

I (r )
S, I
IS-LM Model

IS

Y2
Biswa Swarup Misra

Y1

slide 7

Fiscal Policy and the IS curve

We can use the IS-LM model to see

how fiscal policy (G and T ) affects
aggregate demand and output.

Lets start by using the Keynesian cross

to see how fiscal policy shifts the IS curve

IS-LM Model

Biswa Swarup Misra

slide 8

Shifting the IS curve: G

At any value of r,
G E Y

E =Y E =C +I (r )+G
1
2

E =C +I (r1 )+G1

so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals

Y1

Y2

r1

1
G
1 MPC

Y1
IS-LM Model

IS1

Y2

IS2
Y

Biswa Swarup Misra

slide 9

Shifting the IS curve: G

The previous slide has two purposes. First, to show
which way the IS curve shifts when G changes. Second,
to actually measure the distance of the shift.

We can measure either the horizontal or vertical distance

of the shift. The horizontal distance of the IS curve shift
is the change in Y required to restore goods market
equilibrium AT THE INITIAL INTEREST RATE when G is
raised.

Since the interest rate is unchanged at r1, investment will

also be unchanged. This is why, in the upper panel, we
write I(r1) in the E equation for both expenditure curves
to remind us that investment and the interest rate are
not changing.
IS-LM Model

Biswa Swarup Misra

slide 10

Exercise: Shifting the IS curve

Use the diagram of the Keynesian cross or
loanable funds model to show how an increase in
taxes shifts the IS curve.

In case you are not too sure, you will get a clear
picture when we derive the IS curve algebraically
and discuss what factors can shift the IS curve when
we discuss the effectiveness of fiscal and monetary
policy in session-18.(Refer: slides 42-44 in this
power point file)
IS-LM Model

Biswa Swarup Misra

slide 11

The Theory of Liquidity Preference

Due to John Maynard Keynes.

A simple theory in which the interest rate
is determined by money supply and
money demand.

IS-LM Model

Biswa Swarup Misra

slide 12

Money supply
r

The supply of
real money
balances
is fixed:

interest
rate

P M P
s

M P

IS-LM Model

Biswa Swarup Misra

M/P
real money
balances
slide 13

Money demand
r

Demand for
real money
balances:

interest
rate

L (r )

L (r )
M P

IS-LM Model

Biswa Swarup Misra

M/P
real money
balances
slide 14

Equilibrium
r

The interest
rate adjusts
to equate the
supply and
demand for
money:

interest
rate

r1

L (r )

M P L (r )
M P

IS-LM Model

Biswa Swarup Misra

M/P
real money
balances
slide 15

How the Fed raises the interest rate

r
To increase r,
Fed reduces M

interest
rate

r2
r1

L (r )
M2
P
IS-LM Model

M1
P

Biswa Swarup Misra

M/P
real money
balances
slide 16

CASE STUDY:

Monetary Tightening & Interest Rates

Late 1970s: > 10%
Oct 1979: Fed Chairman Paul Volcker
announces that monetary policy
would aim to reduce inflation

Aug 1979-April 1980:

Fed reduces M/P 8.0%

Jan 1983: = 3.7%

How do you think this policy change
would affect nominal interest rates?
IS-LM Model

Biswa Swarup Misra

slide 17

Monetary Tightening & Rates, cont.

The effects of a monetary tightening
on nominal interest rates

model

short run

long run

Liquidity preference

Quantity theory,
Fisher effect

(Keynesian)

(Classical)

prices

sticky

flexible

prediction

i > 0

i < 0

actual
outcome

8/1979: i = 10.4%

8/1979: i = 10.4%

4/1980: i = 15.8%

1/1983: i = 8.2%

Real vs. Nominal Interest Rates

Real Interest Rate = Nominal Interest Rate

- Inflation

If inflation is positive, which it generally is,

then the real interest rate is lower than the
nominal interest rate.

If we have deflation and the inflation rate is

negative, then the real interest rate will be
larger.
IS-LM Model

Biswa Swarup Misra

slide 19

Nominal Interest Rates Rises or Falls

Following a Monetary Contraction?
Since prices are sticky in the short run, the Liquidity
Preference Theory predicts that both the nominal and
real interest rates will rise in the short run. And in fact,
both did. (However, the inflation rate was not zero, and
in fact it increased, so the real interest rate didnt rise as
much as the nominal interest rate did during the period
shown.)

In the long run, the Quantity Theory of Money says that

the monetary tightening should reduce inflation. The
Fisher Effect says that the fall in should cause an
equal fall in i.
IS-LM Model

Biswa Swarup Misra

slide 20

Nominal Interest Rates Rises or Falls

Following a Monetary Contraction?
By January of 1983 (which is the long run from the
viewpoint of 1979), inflation and nominal interest rates
had fallen.
(However, they did not fall by equal amounts. This
doesnt contradict the Fisher Effect, though, as other
economic changes caused movements in the real
interest rate.)

Lesson: The liquidity preference theory predicts the

movement of the nominal interest rates better in the short
run and the Fisher effects predicts the movements of the
nominal interest rates better in the medium to long run.
IS-LM Model

Biswa Swarup Misra

slide 21

The LM curve
Now lets put Y back into the money demand
function:
d

L (r ,Y )

The LM curve is a graph of all combinations of

r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:

M P L (r ,Y )
IS-LM Model

Biswa Swarup Misra

slide 22

Deriving the LM curve

(a) The market for

real money balances

(b) The LM curve

r
LM

r2

r2
L (r , Y2 )

r1

r1

L (r , Y1 )
M1
P

M/P
IS-LM Model

Y1

Y2

Biswa Swarup Misra

slide 23

Why the LM curve is upward sloping

An increase in income raises money demand.

Since the supply of real balances is fixed, there
is now excess demand in the money market at
the initial interest rate.

The interest rate must rise to restore equilibrium

in the money market.

IS-LM Model

Biswa Swarup Misra

slide 24

How M shifts the LM curve

(a) The market for

real money balances

(b) The LM curve

LM2
LM1

r2

r2

r1

r1

L ( r , Y1 )
M2
P

M1
P

M/P

IS-LM Model

Y1
Biswa Swarup Misra

slide 25

Exercise: Shifting the LM curve

Suppose a wave of credit card fraud causes
consumers to use cash more frequently in
transactions.

Use the liquidity preference model

to show how these events shift the
LM curve.

IS-LM Model

Biswa Swarup Misra

slide 26

The short-run equilibrium

The short-run equilibrium is
the combination of r and Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:

r
LM

Y C (Y T ) I (r ) G

IS
Y

M P L (r ,Y )
Equilibrium
interest
rate
IS-LM Model

Equilibrium
level of
income

Biswa Swarup Misra

slide 27

The IS-LM Framework

The equilibrium levels of real GDP and the

interest rate occur at the point where the IS and
LM curves intersect
the economy is in equilibrium in both the goods
market and the money market

IS-LM Model

Biswa Swarup Misra

slide 28

Figure - The IS-LM Diagram

Real
Interest
Rate, r

LM curve

Equilibrium
interest rate

IS curve
Equilibrium
real GDP

IS-LM Model

Real GDP, Y

Biswa Swarup Misra

slide 29

Figure - Off of the IS Curve

A relatively high real interest
rate means that planned
expenditure < production;
inventories are growing;
production is about to fall

Real interest
rate, r

S>I

A relatively low real

interest rate means
that planned expenditure
> production; inventories
are falling; production is
about to rise
I>S

IS-LM Model

IS Curve

Equilibrium
real GDP

Biswa Swarup Misra

slide 30

Figure - Off of the LM Curve

Real interest
rate, r

At this point money

demand Would be less
as interest rate remaining
the same, a lower income
level would dampen the
Transactions Demand
for money
Md<Ms
At this point money demand
Would be more as interest rate
remaining the same, a higher
income level would increase the
Transactions Demand for money
Md>Ms

LM Curve

Equilibrium
real GDP

IS-LM Model

Biswa Swarup Misra

slide 31

Off-Equilibrium to Equilibrium in the

IS-LM framework

Please refer to the distributed material from

Shapiro (Chapter-12) to supplement the class
room discussion on how starting from a
disequilibrium position the system moves
towards the equilibrium combination of Y and r

IS-LM Model

Biswa Swarup Misra

slide 32

The Big Picture

Keynesian
Cross
Theory of
Liquidity
Preference

IS
curve

IS-LM
model

LM
curve

Agg.
demand
curve
Agg.
supply
curve
IS-LM Model

Explanation
of short-run
fluctuations

Model of
Agg.
Demand
and Agg.
Supply
Biswa Swarup Misra

slide 33

Effectiveness of Monetary and

Fiscal Policy in IS-LM
Framework

Learning Objectives

The algebraic derivation of IS and LM curves.

The factors which govern the slope of the IS and
LM curves

The factors which shift the IS and LM curves.

How to use the IS-LM model to analyze the
effects of shocks, fiscal policy, and monetary
policy

How to derive the aggregate demand curve from

the IS-LM model
IS-LM Model

Biswa Swarup Misra

slide 35

The IS Curve

By definition, the IS curve is simply a plot in (i, Y) space

(with interest rates and GDP growth on the two axes)
comprising points where the goods market is in equilibrium-here there is no shortage, or excess supply
(inventory) in the goods market.

Ignoring the trade sector, the condition for equilibrium in

the goods market is IS: Y=C+I+G

Substituting the expressions discussed earlier for

consumption, C = C + b*Y and capital investment, I = I0
f*i , we obtain:

Y = (C0+ bY) + (I0 f*i) + G

IS-LM Model

Biswa Swarup Misra

slide 36

The IS Curve
Simplifying, and solving for i, we get the IS curve:
i=A/f - Y(1-b) / f -----------------(1)
where A is simply a term for notational convenience
comprising consumer confidence C0, investor confidence
I0, and government spending, G (say G0).

On close examination, we find equation (1) to be a

straight line presented in slope-intercept form in Fig. 1
(next slide) with intercept (A/f) and slope (1- b)/f.

IS-LM Model

Biswa Swarup Misra

slide 37

Figure-1
IS Curve - Graphical Depiction
Interest
Rate

GDP

IS-LM Model

Biswa Swarup Misra

slide 38

Some IS Exercises
1. How will the IS curve respond to a collapse in
investor confidence?

As I0 falls, the intercept term (A/f) will fall. With

no change in the slope (b and f are held
constant), the IS undergoes a parallel drop from
ISo to IS1.

The opposite holds true: a surge in investor

confidence (perhaps due to news of an
impending tax cut, or some such uplifting
announcement or expectation) will cause the IS
to shift up from ISo to IS2, again, without any
change in slope.
IS-LM Model
Biswa Swarup Misra

slide 39

Some IS Exercises
2.

How would the IS shift with a collapse in consumer

confidence ?

The intercept term falls, dropping the IS curve from ISo to

ISj with no change in slope, since b and f are constants.
Similarly, a surge in consumer confidence results in the
IS shifting up from ISo to IS2 with no change in slope.
3. How will changes in government spending affect the IS
curve?

Increases in government spending G will also increase

the intercept term (A/f), thereby shifting the IS up from
ISo to IS2. Cutbacks in government spending outlays will
cause the IS to shift down from ISo to 1St as G drops,
decreasing the intercept component. Once again, neither
of these shifts will cause the slope of the IS to vary.
IS-LM Model

Biswa Swarup Misra

slide 40

Introducing Taxes into the IS Curve

Let t be some average tax rate prevailing in the economy under
consideration.

We now define CT as the after-tax consumption function given

by:
CT = C0 + bYD -------------(2)

Where YD is the disposable (after-tax) income defined as:

YD= Y(I- t)
Substituting this expression for after-tax income into ( 2), we
obtain the consumption function incorporating a tax rate t:

CT = C0 + bYD bY(1 - t)
IS-LM Model

Biswa Swarup Misra

slide 41

Introducing Taxes into the IS Curve

Using the equilibrium condition for the goods market and
the after-tax consumption function, we obtain the
expression for the IS curve with taxes.
i = A/f- [1- b(1- t) Y] /f (3)
We can see that the intercept term Alf is exactly the
same as with the ISo curve presented earlier in
expression in (1). But the slope in expression (3), [1- b(1
- t)] / f, now includes the tax rate t.

The slope of the IS curve will be now larger with the

incorporation of the tax rate.
IS-LM Model

Biswa Swarup Misra

slide 42

Some IS Exercises
4. If the tax rate were to be increased from some to = 35%. to
a higher rate t1 = 43%, how would the IS be affected?

An increase in the tax rate with all other variables held

constant would increase the absolute value of the slope,
making the IS steeper from IS(to) to IS(t1). The intercept
term, however, does not specifically incorporate the tax
rate t; so, in the absence of any additional macroeconomic
changes, the intercept will remain the same. The final
result here will be a clockwise pivot in the IS

A tax-cut from to to some lower rate t2 (30%, perhaps)

would decrease the absolute value of the slope term

causing the IS to be flatter without changing the intercept
term. In this case, the IS pivots counter-clockwise from
IS(to) to IS(t2) with the cut in taxes.
IS-LM Model

Biswa Swarup Misra

slide 43

Some IS Exercises
5. How would the IS react to increases in tax rates in an
economy struggling to recover from a prolonged
recession? Or how would an economy, nervously eyeing
an approaching slowdown, react to tax increases?

This extremely important IS exercise helps to explain part

of the problem faced by the Japanese economy in the
2000s. After struggling to recover from years of stagnation
and collapsed equity prices, the Japanese economy was
showing a glimmer of recovery in the mid-1990s when the
government, despite strong advice from policy makers
worldwide, increased tax rates in 1996 in a desperate
attempt to increase tax revenues. Consumer and investor
confidence, just about to stage a comeback, promptly
went into free-fall!
IS-LM Model

Biswa Swarup Misra

slide 44

Some IS Exercises
The IS curve in these circumstances experiences a
"double whammy" caused by increasing taxes at a time
when the economy is exceedingly vulnerable to adverse
macroeconomic policy. The intercept term falls as fragile
consumer and investor confidence plunges, and the
slope gets steeper due to the increase in the tax rate as
discussed, with IS shifting from ISo to IS1

The opposite may also hold true. The euphoria

generated by a perfectly timed tax-cut may cause the
confidence terms to soar, lifting up the intercept, and
causing the IS to flatten.

IS-LM Model

Biswa Swarup Misra

slide 45

The Slope of the IS Curve

The steepness of the IS curve depends on:
How sensitive investment spending is to changes in i
The multiplier, G
Suppose investment spending is very sensitive to i the
slope, b, is large
A given change in i produces a large change in AD
(large shift)
A large shift in AD produces a large change in Y
A large change in Y resulting from a given change in i
IS curve is relatively flat

If investment spending is not very sensitive to i, the IS

curve is relatively steep
IS-LM Model

Biswa Swarup Misra

slide 46

Factors Affecting Slope of IS Curve

Slope of IS curve
Value of f
Slope of IS curve
High
Flat
Low
Steep
Value of MPC
Slope of IS curve
High
Flat
Low
Steep
Value of t
Slope of IS curve
High
Steep
Low
Flat
Value of Multiplier Slope of IS curve
High
Flat
Low
Steep
IS-LM Model

Biswa Swarup Misra

slide 47

LM Curve

Equating real money supply with money

demand, we obtain the equilibrium

condition in the money market as:

M/P= kY -hi
Simplifying and solving for i, we obtain the LM
curve:
i = (k/h)Y - (l/h)M/P
Once again, this is an equation of a straight line
with slope (k/h), and negative intercept (l/h)M/P, as presented.
IS-LM Model

Biswa Swarup Misra

slide 48

LM Curve

All points on this line represent points in (i, Y)

space where the money market is in equilibrium.
The slope is positive, and will be held fixed here
since k and h are constants.

The negative intercept is an algebraic construct,

devoid of macroeconomic meaning per se but
vitally important in determining how the LM shifts
when the nominal money stock or prices
change.

IS-LM Model

Biswa Swarup Misra

slide 49

LM Curve
Interest Rates

LM

-(l/h)M/P

Y(GDP)

IS-LM Model

Biswa Swarup Misra

slide 50

Factors that Shift the LM

What will be the effect on the LM curve of an increase in
the nominal money stock, M?

The change in M by the central bank will affect the

intercept term. Since this is a negative term, the increase
in M would lead the intercept to become a larger
negative number (for example, from -40 to -48), thereby
decreasing the intercept. With no change in the slope
(there is no M in the slope term), the result of an
increase in M is a parallel downward, or rightward, shift
in LM from LMo to LM1.

A decrease in money growth (decrease in M) results in

an upward (leftward) shift in LM and, once again, will not
affect the slope.
IS-LM Model

Biswa Swarup Misra

slide 51

Factors that Shift the LM

What will be the effect in the LM curve of an increase in
the price level P (an increase in inflation)?

An increase in the price level will cause the ratio M/P to

fall, and given the minus sign that precedes the intercept
term, we now find the intercept to be "less negative"
(increasing from say, -40 to -30). Again, with no change
in the slope, an increase in P results in an upward, or
leftward, shift in LM from LMo to LM2

A decrease in P would cause the LM to incur a parallel

shift down (right) as the intercept term decreases
IS-LM Model

Biswa Swarup Misra

slide 52

Important "Rules" for Shifting LM

(1) If the ratio (M/P) decreases due to either a

decrease in M and/or an increase in P, the LM
shifts up (to the left).

(2) If the ratio (M/P) increases due to an

increase in M and/or a decrease in P, the LM
shifts down (to the right).
Basically, if the real money supply (M/P),
increases, the LM shifts right, and vice-versa.

(3) The slope does not change in either case.

IS-LM Model

Biswa Swarup Misra

slide 53

Applying the IS -LM Model

Equilibrium in the IS -LM model

The IS curve represents
equilibrium in the goods
market.

LM

Y C (Y T ) I (r ) G
The LM curve represents
money market equilibrium.

r1
IS

M P L (r ,Y )
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
IS-LM Model

Biswa Swarup Misra

slide 55

Policy analysis with the IS -LM model

Y C (Y T ) I (r ) G

LM

M P L (r ,Y )
We can use the IS-LM
model to analyze the
effects of

r1

fiscal policy: G and/or T

monetary policy: M

IS-LM Model

IS
Y1

Biswa Swarup Misra

slide 56

An increase in government purchases

r

1. IS curve shifts right

by

1
G
1 MPC

causing output &

income to rise.
2. This raises money
demand, causing the
interest rate to rise

2.

r2
r1

3. which reduces investment,

so the final increase in Y
1
is smaller than
G
1 MPC
IS-LM Model

LM

IS2

1.

IS1
Y1 Y2

3.

Biswa Swarup Misra

slide 57

A tax cut
Consumers save
r
(1MPC) of the tax cut,
so the initial boost in
spending is smaller for T
r2
than for an equal G
2.
r1
and the IS curve shifts by
1.

LM

1.

MPC
T
1 MPC

2. so the effects on r

and Y are smaller for T

than for an equal G.
IS-LM Model

IS2

IS1
Y1 Y2

2.

Biswa Swarup Misra

slide 58

Monetary policy: An increase in M

1. M > 0 shifts
the LM curve down
(or to the right)
2. causing the
interest rate to fall
3. which increases
investment, causing
output & income to
rise.
IS-LM Model

LM1
LM2

r1
r2
IS

Y1 Y2

Biswa Swarup Misra

slide 59

Why Increase in M shifts the LM Curve to the Right?

The increase in M causes the interest rate to fall. [People like to

keep optimal proportions of money and bonds in their portfolios; if
money is increased, then people try to re-attain their optimal
proportions by exchanging some of the money for bonds: they
use some of the extra money to buy bonds. This increase in the
demand for bonds drives up the price of bonds -- and causes interest
rates to fall (since interest rates are inversely related to bond prices).

The fall in the interest rate induces an increase in investment

demand, which causes output and income to increase.

The increase in income causes money demand to increase, which

increases the interest rate (though doesnt increase it all the way
back to its initial value; instead, this effect simply reduces the total
decrease in the interest rate).
IS-LM Model

Biswa Swarup Misra

slide 60

Interaction between
monetary & fiscal policy

Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.

Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.

Such interaction may alter the impact of the

original policy change.
IS-LM Model

Biswa Swarup Misra

slide 61

The Feds response to G > 0

Suppose Government increases G.

Possible RBI responses:
1. hold M constant
2. hold r constant
3. hold Y constant

In each case, the effects of the G

are different:

IS-LM Model

Biswa Swarup Misra

slide 62

Response 1: Hold M constant

If Government raises G,
the IS curve shifts right.

If RBI holds M constant,

then LM curve doesnt
shift.

r2
r1

LM1

IS2
IS1

Results:

Y Y 2 Y1

r r2 r1
IS-LM Model

Y1 Y2

Biswa Swarup Misra

slide 63

Response 2: Hold r constant

If Government raises G,
the IS curve shifts right.
To keep r constant,
RBI increases M
to shift LM curve right.

LM1

r2
r1
IS2
IS1

Results:

Y Y 3 Y1

LM2

Y1 Y2 Y3

r 0
IS-LM Model

Biswa Swarup Misra

slide 64

Response 3: Hold Y constant

If Government raises G,
the IS curve shifts right.
To keep Y constant,
RBI reduces M
to shift LM curve left.

LM2
LM1

r
r3
r2
r1

IS2
IS1

Results:

Y 0

Y1 Y2

r r3 r1
IS-LM Model

Biswa Swarup Misra

slide 65

What is the Feds policy instrument?

The news media commonly report the Feds

policy changes as interest rate changes, as if the
Fed has direct control over market interest rates.

In fact, the Fed targets the federal funds rate

the interest rate banks charge one another on
overnight loans.

The Fed changes the money supply and shifts

the LM curve to achieve its target.

Other short-term rates typically move with the

federal funds rate.

IS-LM Model

Biswa Swarup Misra

slide 66

What is the Feds policy instrument?

Why does the Fed target interest rates instead of
the money supply?
Answer: They are easier to measure than the
money supply.

IS-LM Model

Biswa Swarup Misra

slide 67

IS-LM and aggregate demand

So far, weve been using the IS-LM model to
analyze the short run, when the price level is
assumed fixed.

However, a change in P would

shift LM and therefore affect Y.

The aggregate demand curve

(introduced earlier) captures this
relationship between P and Y.
IS-LM Model

Biswa Swarup Misra

slide 68

Deriving the AD curve

r

Intuition for slope

of AD curve:

P (M/P )
LM shifts left
r

LM(P2)
LM(P1)

r2
r1

IS

Y2

Y1

P2

P1

AD
Y2
IS-LM Model

Y1

Biswa Swarup Misra

Y
slide 69

Deriving the AD curve

The position of the LM curve depends on the value of
M/P. M is an exogenous policy variable. So, if P is low
(like P1 in the lower panel of the diagram), then M/P is
relatively high, so the LM curve is over toward the right in
the upper diagram. If P is high, like P2, then M/P is
relatively low, so the LM curve is more toward the left.

Because the value of P affects the position of the LM

curve, we label the LM curves in the upper panel as
LM(P1) and LM(P2).

IS-LM Model

Biswa Swarup Misra

slide 70

Monetary policy and the AD curve

The Fed can increase
aggregate demand:

M LM shifts right

LM(M1/P1)
LM(M2/P1)

r1
r2

IS

r
I

Y at each
value of P

P1

Y1

Y1
IS-LM Model

Y2

Y2

Biswa Swarup Misra

AD2
AD1
Y
slide 71

Monetary Policy and the AD curve

To find out whether the AD curve shifts to the left or right,
we need to find out what happens to the value of Y
associated with any given value of P.

This is not to say that the equilibrium value of P will

remain fixed after the policy change (though, in fact, we
are assuming P is fixed in the short run). We just want to
see what happens to the AD curve.

Once we know how the AD curve shifts, we can then add

the AS curves (short- or long-run) to find out what, if
anything, happens to P (in the short- or long-run).
IS-LM Model

Biswa Swarup Misra

slide 72

Fiscal Policy and the AD curve

Expansionary fiscal
policy (G and/or T )
increases agg. demand:

LM

r2
r1

IS2

T C

IS1

IS shifts right

Y1

Y2

Y at each
value

P1

of P
Y1
IS-LM Model

Y2

Biswa Swarup Misra

AD2
AD1
Y
slide 73

Figure - From the IS-LM Diagram to the Aggregate

Demand Curve

IS-LM Model

Biswa Swarup Misra

slide 74

Session Summary
1. Keynesian cross

basic model of income determination

takes fiscal policy & investment as exogenous

fiscal policy has a multiplier effect on income.

2. IS curve

comes from Keynesian cross when planned

investment depends negatively on interest rate

shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services
slide 75

Session Summary
3. Theory of Liquidity Preference

basic model of interest rate determination

takes money supply & price level as exogenous

an increase in the money supply lowers the interest

rate
4. LM curve

comes from liquidity preference theory when

money demand depends positively on income

shows all combinations of r and Y that equate
demand for real money balances with supply
slide 76

Session Summary
5. IS-LM model
Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium in
both the goods and money markets.
6. Effectiveness of monetary and fiscal policy in the ISLM framework.
Factors governing slope of IS and LM curves

IS-LM Model

Biswa Swarup Misra

slide 77

Session Summary
7. AD curve

shows relation between P and the IS-LM models

equilibrium Y.
negative slope because
P (M/P ) r I Y
expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right.
expansionary monetary policy shifts LM curve right,
raises income, and shifts AD curve right.
IS or LM shocks shift the AD curve.
IS-LM Model

Biswa Swarup Misra

slide 78