Chapter 3: The IS-LM Model Kornkarun Kungpanidchakul, Ph.D. Macroeconomics MS Finance Chulalongkorn University, Spring 2008 Introduction • The IS-LM model is developed by Sir John Hicks and Alvin Hansen. It is widely used to analyze the impact of the money market and the interest rate on output. The IS Curve • The IS curve represents the locus of all equilibriums in the output market. It is determined by the following equations: Q=C+I+G (1) C = C0+c(1-t)Q (2) I = I0 – br (3) G = G0 (4) With t>0 is a tax rate, r>0 is the interest rate, c>0 is consumption propensity, C0,I0 and G0 are constant. The IS Curve From (1) – (4), we have 1 1 c(1 t ) r (C0 I 0 G0 ) Q b b (5) (5) defines the relationship between output and interest rate in the equilibrium in the output market. The IS Curve From (5), we have the IS curve as follows: r AS > AD AS < AD Q The LM Curve • The LM curve represents the locus of all equilibriums in the money market. It can be defined by: Ms/P = MD/P MD /P=kQ - hr Ms = M0 with k,h >0, M0 is constant. (6) (7) (8) The LM Curve From (6)-(8) we have: 1 M 0 kQ r h P h (9) The LM Curve • From (9), we have the LM curve as follows: r Ms >MD Ms < MD Q The equilibrium when price is fixed r LM IS Q Qo Qf The equilibrium when price is fixed r • Suppose that the central bank increases the money supply. LM1 • The immediate effect is that the interest rate drops to r1 at point B. • At r1, there is excess demand in the output market. The economy IS gradually adjusts to Q point C with the higher interest rate. LM0 r0 A C r2 r1 B Qo Q1 The equilibrium when price is flexible • Price is rigid only in the short run. • In the long run, price is flexible and output is at the full employment level (QF). • From (5), the interest rate is constant, r=rF as well. • Consider the equilibrium in the money market: M0/P = kQF-hrF. An increase in the money stock leads to price increase only. There is no effect on real variables. Liquidity Trap • It is the situation in which the money demand is perfectly elastic. Usually, liquidity trap occurs at very low interest rate. • An increase in money supply cannot change the interest rate when there is a liquidity trap. • When there is a liquidity trap, the fiscal policy is more effective since there is no crowding out effect.