GOODS AND FINANCIAL MARKETS: IS-LM MODEL
SHORT RUN IN A CLOSED ECONOMIC SYSTEM
THE GOOD MARKETS AND IS CURVE
 The Good markets assumption:
 The production Y is equal to the demand for goods Z;
 The demand is the sum of consumption, investments and
government spending. Z=C(Y-T)+I+G;
 The equilibrium condition is given by Y=Z such that Y=C(Y-
T)+I+G.
INVESTMENTS
 Before we assumed investment to be constant.
 Investment depends on two factors:
 Production: here we assume that the production to be equal to the level of sales. An increase in
the level of sales needs to increase the firm’s production. To do so, it need to improve its
endowment buying, i.e., additional machines. The firm need to invest.
 The interest rate: to buy new machines the firm should borrow. If the higher the interest rate, the
less attractive it is to borrow and buy other machineries. In fact the return of payments won’t
cover the interest payments and so the investment won’t be worth.
𝐼 = 𝐼(𝑌. 𝑖)
NEW OUTPUT FORMULA
𝐼𝑆: 𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺
DERIVING THE IS CURVE
Y ;Z
ZZ
Z >Y
ZZ’
A
𝒄𝟏
Z <Y
𝒄𝟎 + 𝑰+𝑮 − 𝒄𝟏 𝑻
45°
Y
For i’>i
DERIVING GRAPH OF IS CURVE
Z
Z
Z
Z >Y
A
Z <Y
Y
i
A’
A
DERIVING THE IS CURVE 2
S
S
45°
Y
I
i
i
IS
Y
I
SHIFTS OF THE IS CURVE
i
Government intervention on Taxation and
Government spending shifts the IS curve
for each interest rate and output. level
i
A
IS (for a given T)
ISY(for T’> T)
Y’
Y
FINANCIAL MARKETS EQUILIBRIUM AND LM CURVE
 Before starting to analyze the financial market equilibrium, it’s important to recall in mind the main assumption of
the short run.

1st fixed price level;

2nd fixed wage
𝑴
= 𝒀𝑳(𝒊)
𝑷
DERIVING THE LM CURVE
i
𝑀𝑠
An increase in output level leads an increase in
the demand for transaction money, it implies a
shift of the liquidity demand on the right hand
side. So people want to hold money and the
increase of the interest rate that leads to want
to hold less money.
A’
i’
A
i
𝑀𝑑
M
𝑀𝑑′
M
DERIVING LM CURVE 1
i
i
𝑀𝑠
A’
i’
i’
A
i
A
i
𝑀𝑑
M
A’
𝑀𝑑′
M
Y
Y’
Y
𝐿𝑇
𝐿𝑇
𝐿𝑆
Y
i
i
LM
Y
𝐿𝑆
IS-LM EQUILIBRIUM
 IS equilibrium: the supply of goods is equal to the
demand for goods.
 LM equilibrium: the supply of real money is equal to
the demand for money
𝐼𝑆: 𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺
𝑀
𝐿𝑀: = 𝑌𝐿(𝑖)
𝑃
IS-LM MODEL
i
IS
LM
A
i
Y
Y
IS curve: any point on the
downward-sloping curve
corresponds to equilibrium in
goods markets;
LM curve: any point on the
upward-sloping curve
corresponds to equilibrium in
financial markets:
Point A.: this point corresponds
to equilibrium conditions
satisfied
FISCAL POLICY AND INTEREST RATE
 Consider the Public Saving: G-T this is the budget equilibrium :

If (G-T) decreases: fiscal contraction or consolidation;

If (G-T) increases: fiscal expansion.
 Suppose the Government wants to increase the budget deficit: it reduces the taxes.
 What happens to the IS-LM equilibrium?
 How does the fiscal expansion affect the financial equilibrium?
 Describe the effects.
THE FISCAL EXPANSION
i
i’
IS
IS’
LM
A
i
Y
Y
Crowding out
of investments
1° the taxes 'reduction leads an increase in
disposable income and, as consequence, an increase
in consumption;
2° we assist to an increase both the aggregate
demand and, for the IS assumption, general output.
3° Consequently the IS curve shifts to the right, from
IS to IS’.
4° the fiscal expansion doesn’t affect the LM
equilibrium so the curve doesn’t shift.
5° the economy moves along the LM curve, in fact
the interest rates runs up to maintain the same level
of the real supply of money
EXPANSIONARY MONETARY POLICY
i
IS
LM
1st CB decides to implement the supply of
money in the economy. What happens? (remind
to expansionary open markets operations).
Why do the interest rate decrease?
2nd The interest rate’s decrease leads to an
increase of the demand for transactions, an
increase in investments and, in turn, o in
demand and output.
3rd the economy moves along the IS curve;
LM’
A
i
Y
Y
THE FISCAL POLICY MULTIPLIER
 Before deriving the fiscal policy multiplier, focus our attention on the IS equation
 Y= C(Y-T)+I(Y,i)+G
 The linear consumption equation is equal to : 𝐶 = 𝑐0 + 𝑐1 𝑌 − 𝑇 𝑐0 > 0 𝑎𝑛𝑑 < 𝑐1 < 1;
 The linear investment demand is : 𝐼 = 𝐼 + 𝑑1 𝑌 − 𝑑2 𝑖 𝑑1 , 𝑑2 > 0
 The IS linear equation is 𝑌 = 𝑐0 + 𝑐1 𝑌 − 𝑇
𝑌=
+ 𝐼 + 𝑑1 𝑌 − 𝑑2 𝑖 + 𝐺; solving the equation by Y
1
𝑑2
𝐴−
𝑖
1 − 𝑐1 − 𝑑1
1 − 𝑐1 − 𝑑1
1
1 − 𝑐1 − 𝑑1
𝑖 = 𝐴−
𝑌
𝑑2
𝑑2
THE MONETARY POLICY MULTIPLIER
 Considere the LM curve equation:
 The linear equation is :
𝑀
𝑃
𝑀
𝑃
= 𝑌𝐿(𝑖);
= 𝑓1 𝑌 − 𝑓2 𝑖 𝑓1 , 𝑓2 > 0
 The LM equilibrium equation
𝑌=
1 𝑀 𝑓2
+ 𝑖
𝑓1 𝑃 𝑓1
THE IS-LM EQUILIBRIUM IN FORMULA
IS: 𝑌 =
1
𝐴
1−𝑐1 −𝑑1
LM: 𝑌 =
1 𝑀
𝑓1 𝑃
+
−
𝑑2
𝑖
1−𝑐1 −𝑑1
𝑌=
1 − 𝑐1 − 𝑑1
𝑓2
𝑖
𝑓1
𝑖=
The
Monetary
Policy
Multiplier
1
𝑓2
+ 𝑓1
𝑑2
𝑀
+
𝑃
1
1 − 𝑐1 − 𝑑1
𝑓
+ 1 𝑑2
𝑓2
𝐴
1
𝑀
1
+
𝐴
𝑑2 𝑓1
𝑓2
𝑃
𝑓2 +
1 − 𝑐1 − 𝑑1
+ 𝑑2
1 − 𝑐1 − 𝑑1
𝑓1
The equations show us that both variables Y and i are in function of exogenous variables: the
money supply and the Autonomous spending. An increase of A leads an increase in Output
and in interest rate. An increase of M/P leads an increase in Y but a decrease of interest rate
The Fiscal
Policy
Multiplier
HOW DOES THE IS-LM MODEL FIT THE FACTS?
Introducing dynamics formally would be difficult, but we can describe the basic mechanisms
in words.

Consumers are likely to take some time to adjust their consumption following a
change in disposable income.

Firms are likely to take some time to adjust investment spending following a change
in their sales.

Firms are likely to take some time to adjust investment spending following a change
in the interest rate.

Firms are likely to take some time to adjust production following a change in their
sales.
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HOW DOES THE IS-LM MODEL FIT THE FACTS?
The Empirical Effects of an
Increase in the Federal Funds
Rate
In the short run, an increase in the federal
funds rate leads to a decrease in output
and to an increase in unemployment, but it
has little effect on the price level.
22 of 33
HOW DOES THE IS-LM MODEL FIT THE FACTS?
The two dashed lines and the tinted space between the dashed lines represents a
confidence band, a band within which the true value of the effect lies with 60% probability:

Figure 5-9(a) shows the effects of an increase in the federal funds rate of 1% on retail
sales over time. The percentage change in retail sales is plotted on the vertical axis;
time, measured in quarters, is on the horizontal axis.

Figure 5-9(b) shows how lower sales lead to lower output.

Figure 5-9(c) shows how lower output leads to lower employment: As firms cut
production, they also cut employment.

The decline in employment is reflected in an increase in the unemployment rate, shown
in Figure 5-9(d).

Figure 5-9(e) looks at the behavior of the price level.
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 ________ in taxes will decrease consumption spending, and ________ in transfer payments will increase
consumption spending.
A) An increase; a decrease B) An increase; an increase C) A decrease; a decrease D) A decrease; an increase;
Table 23-2
 Refer to Table below. Given the consumption schedule in the table above, the marginal
propensity to consume is
A) 0.1. B) 0.3. C) 0.6. D) 0.9.

________ describes the relationship between consumption spending and disposable income.
A) The liquidity trap B) Household wealth C) The consumption function D) The paradox of thrift
 If disposable income falls by $50 billion and consumption falls by $40 billion, then the slope of the consumption
function is
A) 1.20. B) 0.80. C) 0.70. D) 0.10.
 The marginal propensity to save is defined as
A) saving divided by disposable income. B) the change in saving divided by the change in disposable income.
C) disposable income divided by saving. D) the change in disposable income divided by the change in saving.
 Household spending on goods and services is known as
A) government purchases. B) net exports. C) consumption spending. D) planned investment spending.
 Refer to Figure. According to the figure above, at what point is aggregate expenditure greater than GDP?
A) J ; B)K; C) L; D) none of the above
 When aggregate expenditure = GDP,
A) net exports equal zero. B) the federal budget is balanced. C) saving equals zero. D) macroeconomic equilibrium
occurs.