IS-LM Model: Predictions are
Qualitative
• The IS-LM model shows how monetary and
fiscal policy influence the equilibrium level of
income.
• The predictions of the model are qualitative
not quantitative
– i.e. IS-LM model shows that increases in
government purchases raises GDP and that
increases in taxes lowers GDP. So the model tells
us the direction of the effect of a policy
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
1
IS-LM Model: Predictions are
Qualitative
• But it doesn’t tell us the size of the effect i.e.
the prediction of the model is qualitative not
quantitative
• Example: if the government increases taxes
by €100m, and monetary policy is not
affected how much will GDP fall by
• The IS-LM model tells us that GDP will fall but
it does not tell us by how much it will fall.
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
2
IS-LM Model: Predictions are
Qualitative
• A macroeconometric model: describes
the economy quantitatively
• A model is built using historical data and
economists simulate the affects of
different policies, using a computer
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
3
IS-LM Model: Shocks
• We can use the IS-LM model to examine how
various shocks (or economic disturbances)
can affect income.
– Shocks to the IS curve
– Shocks to the LM curve
• Shocks to the IS curve:
– Exogenous changes in the demand for goods and
services
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
4
IS-LM Model: Shocks
• Shocks to the IS curve (cont’d):
– Keynes emphasised: shocks can be as a
result of waves of pessimism or optimism
about the future of he economy
– Example: if firms become pessimistic about
the future of the economy: investment falls.
The fall in investment reduces expenditure
and the IS curve shifts to the left – reducing
income and employment.
– This fall in income partly validates the firms’
pessimism
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
5
IS-LM Model: Shocks
• Shocks to the IS curve (cont’d):
– May also arise from changes in the demand for
consumer goods.
– Example: an increase in consumer confidence in
the economy because of new government in
office. Consumers will save less for the future and
start to spend more. Consumption and thus
expenditure rise. Therefore, the IS curve shifts to
the right and this raises income in the economy.
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
6
IS-LM Model: Shocks
• Shocks to the LM curve:
– Arise from exogenous changes in the demand for
money
– Example: new restrictions on credit-card
availability. Therefore, people will want to hold
more money and there will be an increase in the
demand for money. In the money market, interest
rates rise. The LM curve shifts to the left, with
higher interest rates and lower income
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
7
IS-LM Model: Shocks
• Several kinds of events can cause shifts in
the IS and/or LM curves that result in
economic fluctuations.
• Policymakers can try to use the tools of
monetary and fiscal policy to offset
exogenous shocks.
• If policymakers are sufficiently quick and
skillful, shocks to the IS or LM curves may not
lead to changes in income or employment
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
8
IS-LM as a Theory of Aggregate
Demand
• The IS-LM model provides a theory to
explain the position and slope of the
aggregate demand curve.
• Recall: aggregate demand curve
describes the relationship between the
price level and the level of national
income. A higher price level implies
lower demand, lower level of income.
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
9
IS-LM Model as a Theory of
Aggregate Demand
• We use the IS-LM model to:
– Show why the aggregate demand curve is
downward sloping
– Examine what causes the aggregate
demand curve to shift
• In order to do this we have to relax the
assumption that prices are fixed.
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
10
IS-LM Model as a Theory of
Aggregate Demand
• To show why the aggregate demand curve
slopes downward:
– We examine what happens to the IS-LM
model when the price level changes
– For any given money supply, M, a higher price
level, P reduces the supply of real money
balances, M/P.
– A lower supply or real money balances shifts
the LM curve to the left with higher equilibrium
interest rate and lower income (see graph a
on next slide)
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
11
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
12
IS-LM Model as a Theory of
Aggregate Demand
• In graph b on the previous slide: the
aggregate demand curve plots this negative
relationship between national income and the
price level.
• In summary: the aggregate demand curve
shows the set of equilibrium points that arise
in the IS-LM model as we vary the price level
and see what happens to income.
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
13
IS-LM Model as a Theory of
Aggregate Demand
• To examine what causes the aggregate
demand curve to shift:
– At a given price, events that shift the IS curve and
LM curve cause the aggregate demand curve to
shift.
– Example: an increase in the money supply, with
prices fixed, causes interest rates to fall and
income to rise. The LM curve shifts to the right
(first slide of panel a on next slide).
– With constant prices and a rise in income this
must mean that the aggregate demand curve
shifts to the right (second graph of panel a on next
slide)
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
14
5th edition
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
15
IS-LM Model as a Theory of
Aggregate Demand
• To examine what causes the aggregate
demand curve to shift :
– Example: expansionary fiscal policy (i.e. an
increase in government purchases or a decrease
in taxes) shifts the IS curve to the right and raises
income in the IS-LM model.
– The price level has not changed but income has
increased, therefore, the aggregate demand curve
shifts to the right (see panel b in previous slide)
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
16
IS-LM Model as a Theory of
Aggregate Demand
• To examine what causes the aggregate
demand curve to shift :
– Contractionary fiscal or monetary policy will
cause the aggregate demand curve to shift
to the left
Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11:
5th edition
17