Goods & Financial Markets: The IS-LM Model
The IS-LM Model
The determination of output and
interest rates in the short-run
Econ 302 Macroeconomic Analysis IS-LM
Slide #1
Goods & Financial Markets: The IS-LM Model
The goods market and the IS relation
A Review
 Equilibrium in the goods market:
Production (Y) = Demand (Z)
 Demand (Z)= C+I+G
C=C(Y-T)
T, I, & G are given
Econ 302 Macroeconomic Analysis IS-LM
Slide #2
Goods & Financial Markets: The IS-LM Model
The goods market and the IS relation
A Review (Continued)
 Equilibrium: Y=C(Y-T)+I+G
 Changes in C, I, & G impact the
equilibrium Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #3
Goods & Financial Markets: The IS-LM Model
The goods market and the IS relation
Investment, sales, and the interest rate
Investment depends on:
The level of sales
The interest rate
Therefore:
I  I (Y , i )
(  , )
Econ 302 Macroeconomic Analysis IS-LM
Slide #4
Goods & Financial Markets: The IS-LM Model
The IS curve
Equilibrium:
Y  C (Y  T )  I  G
I  I (Y , i )
Y  C (Y  T )  I (Y , i )  G
Supply of
Goods
Econ 302 Macroeconomic Analysis IS-LM
Demand for
Goods (Z)
Slide #5
Goods & Financial Markets: The IS-LM Model
The IS curve
ZZ: Demand, a function of
Y for given i
equilibrium at a, Y
ZZ (i)
Demand, Z
a
ZZ´ (i´ > i)
b
ZZ´: Demand with higher i
equilibrium at b, Y´
45°
Y´
Y
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #6
Goods & Financial Markets: The IS-LM Model
ZZ (i)
A
ZZ´ (i´ > i)
A´
Interest Rate, i
Demand, Z
The IS curve
A´
i´
A
i
IS
45°
Y´
Y´
Y
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Y
Output, Y
Slide #7
Goods & Financial Markets: The IS-LM Model
Observation:
In the goods market, the higher
the interest rate, the lower the
equilibrium output.
Econ 302 Macroeconomic Analysis IS-LM
Slide #8
Goods & Financial Markets: The IS-LM Model
Interest Rate, i
The IS curve
Shifts in the IS Curve:
An increase in taxes shifts the IS curve to the left
i
IS (T)
IS´ (T´ > T)
Y´
Y
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #9
Goods & Financial Markets: The IS-LM Model
Interest Rate, i
The IS curve
Shifts in the IS Curve:
An increase in G shifts the IS curve to the right
i
IS´ (G´ > G)
IS (G)
Y´
Y
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #10
Goods & Financial Markets: The IS Curve
Shifts in the IS curve
What do you think:
How would a decrease in consumer
confidence shift the IS curve?
Econ 302 Macroeconomic Analysis IS-LM
Slide #11
Financial Markets and the LM Relation
Money market equilibrium revisited
M=
nominal money supply (controlled by
the Central Bank)
$YL(i) = Demand for money (function of
nominal income and the interest rate)
Equilibrium Interest Rate:
M=$YL(i)
Econ 302 Macroeconomic Analysis IS-LM
Slide #12
Financial Markets and the LM Relation
Real money, real income, and the interest rate
Real Income (Y ) 
$Y
P
M 
Real Money Supply 
 =Real Money Demand: Y(L)i
 P 
LM relation:
M
 Y ( L )i
P
Econ 302 Macroeconomic Analysis IS-LM
Slide #13
Financial Markets and the LM Relation
The LM curve
Interest Rate, i
Ms
Increase in Y => increases Md which increases i
A´
i´
A
i
Md´ (for Y´ > Y)
Md (for Y)
M/P
(Real) Money, M/P
Econ 302 Macroeconomic Analysis IS-LM
Slide #14
Financial Markets and the LM Relation
The LM curve
Interest Rate, i
Interest Rate, i
Ms
A´
i´
A
i
i´
i
LM (M/P)
A´
A
Md´ (for Y´ > Y)
Md (for Y)
M/P
(Real) Money, M/P
Econ 302 Macroeconomic Analysis IS-LM
Y
Y´
Income, Y
Slide #15
Financial Markets and the LM Relation
Shifts in the LM Curve:
Showing changes in M & P
The LM curve
Interest Rate, i
Ms
i
LM´
(M´/P > M/P)
b
i´2
b´
a
i
a´
i2
LM (M/P)
i´
b
i´
i´2
Interest Rate, i
Ms´
Md´ (for Y´ > Y)
b´
a
i2
a´
Md
M/P
(for Y)
M´/P
(Real) Money, M/P
Econ 302 Macroeconomic Analysis IS-LM
Y
Y´
Income, Y
Slide #16
The IS-LM Model Exercises
Equilibrium Requires:
IS : Y  C (Y  T )  I (Y , i )  G
LM :
M
 YL ( i )
P
or IS  LM
Econ 302 Macroeconomic Analysis IS-LM
Slide #17
The IS-LM Model Exercises
The IS-LM Equilibrium Graphically
Interest Rate, i
LM
i & Y is the only interest rate,
output combination that
yields a simultaneous
equilibrium in the goods and
financial markets
i
IS
Y
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #18
Fiscal Policy, Activity, and the Interest Rate
Monetary Policy, Activity, and the Interest Rate
A Scenario:
The Fed engages in monetary
expansion, i.e., it increases the
money supply through open
market operations
Question:
What impact will the monetary
expansion have on output and
interest rate?
Econ 302 Macroeconomic Analysis IS-LM
Slide #19
Fiscal Policy, Activity, and the Interest Rate
The IS-LM Equilibrium Graphically
LM (M/P)
Interest Rate, i
LM´ (M´/P > M/P)
• IS & LM: Before increasing M
Equilibrium A: i & Y
i
• LM´: After increasing M
B
A
• Disequilibrium at i (A, B)
A´
• New equilibrium A´: i´ & Y´
i´
• Monetary expansion
lowered i & increased Y
IS
Y Y´
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #20
Fiscal Policy, Activity, and the Interest Rate
The effects of fiscal and monetary policy
Shift in IS
Shift in LM
Movement in
Output
Movement in
Interest Rate
Increase in taxes
left
none
down
down
Decrease in taxes
right
none
up
up
Increase in spending
right
none
up
up
Decrease in
spending
left
none
down
down
Increase in money
none
down
up
down
Decrease in money
none
up
down
up
Econ 302 Macroeconomic Analysis IS-LM
Slide #21
Using a Policy Mix
The Clinton-Greenspan Policy Mix
The policy
dilemma of
1992:
Recall:
Record high federal budget deficit
(4.5% of GNP)
High unemployment and slow
growth
Deficit reduction reduces output
Expansionary fiscal policy increases the
deficit
Solution:
Policy Mix
Deficit reduction and expansionary
monetary policy
Econ 302 Macroeconomic Analysis IS-LM
Slide #22
Using a Policy Mix
The Clinton-Greenspan Policy Mix
LM
Interest Rate, i
LM´
• IS & LM: Before policy changes
Equilibrium A: i & Y
• IS´: After deficit reduced
A
i
• B equilibrium without monetary
expansion
B
• LM´ after monetary expansion
A´
i´
IS
• New equilibrium i´, Y´
IS´
Y Y´
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #23
Using a Policy Mix
German Unification & the German Monetary Fiscal
Tug-of-War
The Scenario:
• Prior to unification, West Germany was
exhibiting strong growth, investment
• After unification, strong fiscal stimulus
from increased governmental
spending on infrastructure and slow
investment growth.
Econ 302 Macroeconomic Analysis IS-LM
Slide #24
Using a Policy Mix
Interest Rate, i
German Unification & the German Monetary Fiscal
Tug-of-War
LM´
LM
• A (i, Y) pre-unification
equilibrium
A´
i´
• IS´: Post-unification IS
• LM´: Post-unification LM:
Reduction in M to offset
IS expansion
A
i
IS´
• A´(i´, Y´) post-unification
equilibrium
IS
Y Y´
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #25
Using a Policy Mix
German Unification & the German Monetary Fiscal
Tug-of-War
The West German Economy, 1998-1991
BDGP growth (%)
Investment*growth (%)
Budget surplus (% of GDP)
(minus sign: deficit)
Interest rate (short term)
Econ 302 Macroeconomic Analysis IS-LM
1988
1989
1990
1991
3.7
5.9
-2.1
3.8
8.5
0.2
4.5
10.5
-1.8
3.1
6.7
-2.9
4.3
7.1
8.5
9.2
Slide #26
Adding Dynamics
Observations:
•Changes in output adjust slowly to changes
in the goods market (IS)
•Interest rates adjust instantaneously to
changes in the financial markets (LM)
Econ 302 Macroeconomic Analysis IS-LM
Slide #27
Adding Dynamics
Dynamics Graphically
Adjusting to a
monetary contraction
B
A´
iA
Output
decreases
slowly
IS
B
iB
iA
A
IS´
Yb
LM´
LM
Interest Rate, i
Interest Rate, i
Adjusting to a
tax increase
Ya
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Interest rates
adjust
instantaneously
Ya
Output, Y
Slide #28
Adding Dynamics
The Dynamics of Monetary Contraction with IS-LM
LM´
Interest Rate, i
LM
• A: Initial equilibrium (i & Y)
A´´
i´´
• LM´: After reducing money
supply
A´
i´
• i rises to i´´
• Higher i reduces demand and
output slowly A´´ to A´
A
i
• Equilibrium restored at A´: i´, Y´
IS
Y´
Y
Output, Y
Econ 302 Macroeconomic Analysis IS-LM
Slide #29
Adding Dynamics
A Summary
•Monetary policy changes interest rates
rapidly and output slowly
•The Central Bank must consider the output
lag when implementing monetary policy
Econ 302 Macroeconomic Analysis IS-LM
Slide #30
Does the IS-LM Model Actually Capture What
Happens in the Economy?
Does the IS-LM model pass two tests?
Are the assumptions of IS-LM reasonable?
Are the implications of IS-LM consistent
with real-world observations?
Econ 302 Macroeconomic Analysis IS-LM
Slide #31
Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the Federal
Funds Rate
Are the assumptions of IS-LM reasonable?
Are the implications of IS-LM consistent
with real-world observations?
Econ 302 Macroeconomic Analysis IS-LM
Slide #32
Does the IS-LM Model Actually Capture What
Happens in the Economy?
Summary
The IS-LM model is consistent with
economic observations
The IS-LM model explains movements in
economic activity over the short-run
Econ 302 Macroeconomic Analysis IS-LM
Slide #33