IS and LM Curve
IS and LM Curve
Qazi Muhammad Adnan Hye
IS-LM Model IS-LM Model IS Curve IS Curve LM Curve LM Curve Keynesian cross Keynesian cross Governm
Government-purchases ent-purchases multipliermultiplier T
Long run
Long run
prices flexible
prices flexible
output determined by factors of production &
output determined by factors of production &
technology
technology
unemployment equals its natural rate
unemployment equals its natural rate
Short run
Short run
prices fixed
prices fixed
output determined by aggregate demand
output determined by aggregate demand
This chapter develops the IS -LM model,
the basis of the aggregate demand curve.
We focus on the short run and assume the
price level is fixed
(so,
SRAS curve is
Price Level, P Income, Output, Y SRAS AD Y* Y*' AD' AD'' Y*''
In the short run, when the price level is fixed, shifts in the aggregate demand curve lead to changes in national income, Y.
The IS-LM model = the leading interpretation of Keynes‟ work. The goal of the model: to show what determines national income for any given price level.
The Keynesian model - shows what causes the aggregate demand curve to shift.
1. The goods market and the IS curve
2. The money market and the LM curve
3. The short-run equilibrium
The basic textbook Keynesian model: an
The model of aggregate demand (AD) can be split into two parts:
- IS (“investment” and “saving”)model of the „goods market‟
The IS curve (which stands for investment and saving) plots the
relationship between the interest rate and the level of income that arises in the
market for goods and services.
The LM curve (which stands for liquidity and money) plots the relationship
between the interest rate and the level of income that arises in the money market.
The variable that links the two parts of the IS-LM model: the interest rate (it influences both investment and money demand).
In the General Theory of Money, Interest and Employment (1936), Keynes proposed: an economy‟s total income was, in the short run, determined largely by the desire to spend by households, firms and the government.
Thus, the problem during recessions and depressions , according to Keynes, was inadequate spending .
Planned expenditure is the amount
households, firms and government plan to
spend on goods and services.
Actual expenditure differs from planned
expenditure when firms are forced to make
inventory- that is when firms unexpectedly
rise or lower their stock of inventories in
The Keynesian Cross
A simple closed economy model in which
income is determined by expenditure.
(due to J.M. Keynes)
Notation:
I
= planned investment
PE
=
C + I + G= planned expenditure
Y= actual expenditure=GNP
Difference between actual & planned
expenditure = unplanned inventory
investment
Graphing planned expenditure
income, output, Y PE planned expenditure MPC 1 G I T Y C E ( )
Graphing the equilibrium condition
income, output, Y PE
planned expenditure
PE = Y
The equilibrium value of income
income, output, Y PE planned expenditure PE = Y Equilibrium income G I T Y C E ( ) A
An increase in government purchases
Y PE PE1 = Y 1 PE 2 = Y 2 Y At Y 1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium. G 1 ) (Y T I G C E G I T Y C E ( ) A BIf government spending were to increase by $1, then you might expect equilibrium output (Y) to also rise by $1.
But it doesn’t! The multiplier shows that the change in demand for
output (Y) will be larger than the initial change in spending. Here’s why:
When there is an increase in government spending (G), income rises by G as well. The increase in income will raise consumption by MPC G, where MPC is the marginal propensity to consume. The increase in
consumption raises expenditure and income again. The second increase in income of MPC G again raises consumption, this time by MPC
(MPC G), which again raises income and so on.
So, the multiplier process helps explain fluctuations in the demand for output. For example, if something in the economy decreases investment spending, then people whose incomes have decreased will spend less, thereby driving equilibrium demand down even further.
An increase in taxes
Y PE PE2 = Y 2 PE 1 = Y 1 YAt Y 1, there is now an unplanned
inventory buildup… …so firms
reduce output, and income falls toward a new equilibrium
C = MPC T Initially, the tax
increase reduces consumption, and therefore PE : G I T Y C E ( ) 1 I T Y C E ( *) 2
The tax multiplier
…is
negative :
A tax increase reduces C ,
which reduces income.
…is
greater than one
(in absolute value ):
A change in taxes has a
multiplier effect on income.
…is
smaller than the govt spending
multiplier :
Consumers save the fraction (1
–
MPC ) of a
tax cut,
so the initial boost in spending from a tax cut
is
Let‟s now relax the assumption that the level of planned investment is fixed.
- We write the level of planned investment as: I = I (r).
The investment function - downward-sloping (it shows the inverse relationship between investment and the interest rate) The IS curve summarizes the relationship between the interest rate and the level of income. It is downward-sloping.
The IS curve combines:
•the interaction between I and r expressed by the investment function
•the interaction between E and Y demonstrated by the Keynesian cross.
E Income, Output, Y Y=E Planned Expenditure, E = C + I + G r Income, Output, Y r Investment, I I(r) IS An increase in the
interest rate (in graph a), lowers planned
investment, which shifts planned expenditure
downward (in
graph b) and lowers income (in graph c).
(a)
(b)
E Income, Output, Y Y=E Planned Expenditure, E = C + I + G r Income, Output, Y IS1 An increase in government purchases or a decrease in taxes - IS curve shifts outward. A decrease in government purchases or an increase in taxes - IS curve shifts inward.
IS2
An increase in government purchases How fiscal policy
Summary
•The IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services.
•The IS curve is drawn for a given fiscal policy.
•Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right.
•Changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left.
r Supply
LM curve = the relationship between the interest rate and the level of income that arises in the market for money balances
The theory of liquidity preference
- how the interest rate is determined in the short run
The supply of real money balances - vertical
The demand for real money balances -downward sloping
Demand, L (r)
The supply and demand for real money balances determine the equilibrium interest rate.
Money Demand equals Real Money Balances
r
M/P M/P
Supply
Demand, L (r,Y)
Since the price level is fixed, a reduction in the money supply reduces the supply of real balances. Notice the equilibrium interest rate rose.
A Reduction in the
Money Supply: -
M/P
(M/P)
d= L (r,Y)
The quantity of real money balances demanded is negatively related to the interest rate (because r is the opportunity cost of holding money) and positively related to income (because of transactions demand).
r M/P M/P Supply L (r,Y)' L (r,Y) r1 r2 r Y LM
An increase in income raises money demand, which increases the interest rate; this is called an increase in transactions demand for money.
The LM curve summarizes these changes in the money market equilibrium.
r M/P L (r,Y) r Y LM M/P Supply
A contraction in the money supply raises the interest rate that equilibrates the money market. Why? Because a higher interest rate is needed to convince people to hold a smaller quantity of real balances.
As a result of the decrease in the money supply, the LM shifts
r1 r 1 M´ /P Supply' LM' r2 r2
Summary
•The LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances.
•The LM curve is drawn for a given supply of real money balances
•Decreases in the supply of real money balances shift the LM curve upward
•Increases in the supply of real money balances shift the LM curve downward
r Y LM(P0) IS r0 Y0
The IS curve/equation Y= C (Y-T) + I(r) + G The LM curve/equation M/P = L(r, Y)
The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.
The Big Picture
Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuationsChapter 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
Chapter 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
