The IS - LM Model
• Interest Rates and Rates of Return
– Assumption: Only 1 interest rate
– Functions of Interest Rates
The IS - LM Model
• Interest rates help allocate saving
– Return for investors
– Cost for borrowers
» Compare borrowing costs, investment returns
• Central to the role of monetary policy
– Types of Interest Rates
• Short-term versus long-term
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The IS - LM Model
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Figure 4-1
The Payoff to Investment for an Airline and the Economy
• The Relation of A(p) to the Interest Rate
– Rate of Return and Interest Rates
» Figure 4-1
• Business fixed investment
• Residential investment
• Consumer durable goods
– Business and Consumer Optimism
» Figure 4-2
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Figure 4-2 Effect on Autonomous Planned Spending of an Increase in Business and
Consumer Confidence
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The IS - LM Model
• The Relation of A(p) to the Interest Rate
– The Demand of A(p)
• Combining G, -cT, and NX
– which do not depend on r
• and I(p) and a
– which do depend on r
» Figure 4-3
• “Autonomous” A(p), i.e., when r = 0
– Shifts in the A(p) Demand Schedule
• Changes in G, T, NX, business or consumer
confidence
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Figure 4-3 Relation of the Various Components of Autonomous Planned Spending to
the Interest Rate
The IS - LM Model
• The IS Curve
– Introduction
• Y depends on A(p)
• A(p) depends on r
• Therefore Y depends on r
– This relationship is know as the IS curve
– Exogenous variables
» G, T, and NX
» Business and consumer confidence
» c and s
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Figure 4-4 Relation of the IS Curve to the Demand for Autonomous Spending and the
Amount of Induced Saving
The IS - LM Model
• The IS Curve (continued)
– How to Derive the IS Curve
• Start with A(p) demand curve
– Pick an initial interest rate and find the associated A(p)
• Find Y(e) via induced saving
– Y(e) = A(p) / s or A(p) * multiplier
– Establishes a Y(e), r point
• Repeat
» Figure 4-4
• IS curve plots the values of Y(e) and r
– IS curve = A(p) demand curve * multiplier
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Figure 4-5 Effect on the IS Curve of a Rightward Shift in the Demand for Autonomous
Planned Spending
The IS - LM Model
• The IS Curve (continued)
– What the IS Curve Shows
• Combinations of Y, r at which the economy’s
market for goods and services is in equilibrium.
– Where Y(e) = E(p)
• Disequilibrium adjustment
– What Changes the IS Curve?
• Changes in A(p) shift the IS curve
» Figure 4-5
• Changes in k and/or the interest sensitivity of A(p)
rotate the IS curve
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The IS - LM Model
The IS - LM Model
• Why People Use Money
• Income, r, and the Demand for Money (L)
– The Introduction of Money
– Income and the Demand for Money
• Definition
• Functions
• M(d)/P = dY
– The Interest Rate and the Demand for Money
– A Medium of Exchange
– A Store of Value
– A Unit of Account
• M(d)/P = dY - f * r
» Figure 4-6
– Change in the M(d)/P Curve
• Changes in r move along L
• Changes in Y shift L
» Figure 4-7
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Figure 4-6
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Figure 4-7 Effect on the Money Demand Schedule of a Decline in Real Income from
$4000 to $3000 Billion
The Demand for Money, the Interest Rate, and Real Income
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The IS - LM Model
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Figure 4-8
Derivation of the LM Curve
• The LM Curve
– Introduction
• M(s) is exogenous
• M(d)/P = f( Y, r )
• Equilibrium in the money markets requires
– M(s)/P = M(d)/P = f ( Y, r ) where f(1) > 0, f(2) < 0
» Figure 4-8 (left panel)
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The IS - LM Model
The IS - LM Model
• The LM Curve (continued)
• The LM Curve (continued)
– How to Derive the LM Curve
– What the LM Curve Shows
• Select a level for Y
• All combinations of Y and r where the money
market is in equilibrium
• Disequilibrium adjustment
– Find the M(d) curve associated with this level of Y
• Find r at the intersection of the M(s)/P and M(d)/P
• Plot Y, r in a separate graph
• Repeat with a new level for Y
• Connect all of the Y, r pairs into the LM curve
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–
–
–
Change in P
Change in r
Change in Y
Change in Y and r
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Figure 4-9 The Effect on the LM Curve of an Increase in the Real Money Supply from
$1000 Billion to $1500 Billion
The IS - LM Model
• The LM Curve (continued)
– What Makes the LM Curve Shift?
• Change in M(s)
• Changes in M(d)/P
– M(d)/P becomes more/less interest sensitive
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The IS - LM Model
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Figure 4-10
The IS and LM Schedules Cross at Last
• The IS Curve Meets the LM Curve
– General equilibrium requires both
• Equilibrium in the commodity market
• Equilibrium in the money market
» Figure 4-10
– Disequilibrium dynamics
– Endogenous variables
• Y, r
– Exogenous variables
• Business & consumer confidence, M(s), G, T & NX
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Figure 4-11
LM Curve
The IS - LM Model
The Effect of a $500 Billion Increase in the Money Supply with a Normal
• Monetary Policy in Action
– Expansionary Monetary Policy
» Figure 4-11
• Transmission effects
– Liquidity effect
– Income effect
• Results
– Higher Y
– Higher r
– Contractionary Monetary Policy
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Figure 4-12 The Effect on Real Income and the Interest Rate of a $250 Billion Increase
in Government Spending
The IS - LM Model
• Fiscal Policy in Action
– Expansionary Fiscal Policy
» Figure 4-12
• Effect on the multiplier
– and “crowding out”
• The crowding out effect
– Changes the composition of spending
• Can crowding out be avoided?
– Expansionary monetary policy
– Other possibilities
– Contractionary Fiscal Policy
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