Chapter 7
Joint Determination of Income and
Interest Rates: The IS/LM
Diagram
The IS/LM Diagram
• When the economy is in a prolonged slump, the
standard remedy is to use stimulative fiscal and
monetary policy. However, that might not work for
several reasons.
• An increased demand for funds could boost interest
rates.
• Inflationary expectations might rise, boosting interest
rates even if funds remained plentiful.
• Expectations, especially in the stock market and for
capital spending, might decline as the deficit increased.
• An increase in demand might be partially or even totally
offset by a rise in imports.
The IS/LM Diagram (Slide 2)
• Current economic theory and analysis takes all
these factors into consideration.
• The original IS/LM diagram only considers the
first of these factors – the possible rise in
interest rates. Other factors will be added after
the chapters on inflation and foreign trade are
presented.
• Even this simple case, however, accurately
portrays the interrelationship between output
and interest rates. Demand cannot be
expanded indefinitely without taking into account
the impact on financial markets.
The IS/LM Diagram (Slide 3)
• This diagram consists of two curves. The IS
curve represents all the points of equilibrium in
the goods market, and indicates the level of
aggregate demand that would occur for each
level of interest rates.
• The LM curve represents equilibrium in the
assets market, and indicates the level of interest
rates (and credit availability) that would occur for
each level of aggregate demand.
• The intersection of these two curves jointly
determines output and interest rates.
Equilibrium in the Goods Market
• Saving must equal investment ex post. That is
an accounting identity, and is the same thing as
saying GDP must equal gross national income.
But what does that mean in an economic sense?
• Suppose there is a negative exogenous shock in
the economy, so consumers decide to save
more but businesses decide to invest less. Yet
we know that on an ex ante basis, the changes
must be the same. How is the difference
reconciled?
How I = S ex post
• Sometimes interest rates will decline, hence reducing
consumer saving and boosting investment.
• To a certain extent, weakened business conditions mean
government and foreign saving will decline.
• But often, these are not sufficient to reach equilibrium.
We must also take into account the change in income
that influences saving.
• In particular, a drop in income reduces all four
components of saving.
• If lower interest rates and fiscal stimulus do not achieve
equilibrium, then income must fall until saving is reduced
enough to offset the initial planned increase.
The IS Curve
• At each level of income, I must equal S on an ex
post basis. At high interest rates, I and S will
both be low. I will be low because of the
negative impact of high interest rates, and S will
be low because of the low level of income
caused by reduced investment. As interest rates
decline, both I and S will increase. Thus the
relationship between all the equilibrium points
where I = S and the rate of interest will have a
negative slope. That line is known as the IS
curve.
Shifts in the IS Curve
• A change in interest rates will cause a
movement along the curve, but it does not shift.
• Any exogenous change in the components of
aggregate demand will cause the curve to shift.
• Change in fiscal policy: government purchases or tax rates
• Change in value of the currency of growth in income in
foreign countries
• Change in monetary policy
• Change in consumer or business attitudes
• Rate of growth in technology
Equilibrium in the Assets Market
• Of course everyone would like more
money rather than less. The “demand for
money” does not refer to this
phenomenon, but to asset allocation
between money and bonds, which in this
case represents assets whose market
value fluctuates. While there are many
other types of assets, only these two
classes are used here.
Equilibrium in the Assets Market,
Slide 2
• For any given level of income, consumers
will allocate their assets between money
and bonds. As income rises, they will hold
more money for transactions purposes.
More important, as interest rates rise, they
will hold more of their assets in bonds.
That means there will be less money
available for loans, which will reduce the
availability of credit and hence GDP.
The LM Curve
• The LM curve represents all the points of
equilibrium in the assets market. It shows the
allocation between money and bonds at each
different level of income and interest rates.
• As income rises, the demand for money will also
rise, which means for a given money supply,
fewer assets are available to be invested in
bonds, hence boosting interest rates.
• Thus higher levels of income are associated with
higher levels of interest rates in the assets
market, and the LM curve has an upward slope.
The IS/LM diagram
• The intersection of the IS and LM curves
jointly determine interest rates and
income.
• If an exogenous increase in income
occurs, the IS curve moves out. However,
that means interest rates will rise. Thus
some of the initial increase in demand is
offset by higher interest rates.
IS/LM Diagram, Slide 2
• If it desired, the central bank could ease
monetary policy and move the LM curve
out when the IS curve moves out, thereby
holding interest rates constant. During
periods of economic slack and stable
inflationary expectations, that would boost
the level of income substantially. The risk
is that by raising inflationary expectations,
interest rates would rise in spite of central
bank accommodation.
IS/LM Diagram, Slide 3
• Inflation is not included in this simple diagram,
yet the lesson is well worth learning. Fiscal
expansion is no “free lunch”; if carried to excess,
it will generate a negative reaction in financial
markets, and the initial gains will be offset.
• If that were not the case, all countries could
remain at full employment all the time simply by
having the government spend more and more.
Of course that is nonsense. So in spite of its
limitation of holding inflation constant, the IS/LM
diagram illustrates this important relationship.
Asymmetries in the IS/LM Diagram
• During periods of economic slack
• Cutbacks in government spending have a
larger negative impact than the positive
impact from a rise in spending
• Monetary easing has only a modest
expansionary effect, but further tightening
would have a much larger contractionary
effect
• Tax increases have a larger negative
impact than the positive impact of tax cuts.
Asymmetries in the IS/LM Diagram,
Slide 2
• During periods of full or overfull employment:
• Monetary easing is more likely to boost inflation than real
growth, while monetary tightening will have a much greater
effect
• A rise in government spending will boost inflation rather than
real growth, while a cutback in spending will have little
negative impact
• The case for a change in tax rates is more complicated
because it depends on whether it is temporary or permanent.
In general, a temporary tax increase would be ignored, while
a permanent tax increase would reduce real growth but might
also raise inflation because taxes are a cost that has
increased. The IS/LM diagram does not provide a complete
answer in this case.
Factors That Shift the IS and LM
Curves
•
•
•
•
•
•
•
•
•
•
Increase in fiscal stimulus (rise in
government spending or tax cut)
Increase in value of the dollar
Increase in inflationary expectations
Drop in propensity for personal saving
Exogenous rise in stock market
Change in sentiment boosts investment
Change in tax rates that reduces the
cost of capital
shifts out
shifts in
shifts in
shifts out
variable
shifts in
shifts out
neutral*
shifts out
neutral*
shifts out
neutral*
shifts out prices -- shifts out
deficit – shifts in
•
Exogenous boost in productivity
shifts out
IS curve
LM curve
shifts out
* Movement along the LM curve, assuming no exogenous change in monetary policy
Summary
• The IS/LM curve is a very useful first step in
showing the joint determination of output and
interest rates, and explaining how continued
increases in fiscal policy will not necessarily
boost output.
• Its major drawback is that it assumes inflation,
and inflationary expectations, remain constant.
That is not the case when fiscal and monetary
policy are overly accommodative, so the model
is modified to take these into consideration.