Lecture 6

Section 5.6 from

Fundamental methods of Mathematical Economics, McGraw
Hill 2005, 4th Edition.
By A. C. Chiang & Kevin Wainwright is covered.
Application to market and National-Income models
III. IS-LM Models

The IS schedule is a locus of points representing all the different

combinations of interest rates and income levels consistent with
equilibrium in the goods (commodity) market. The LM schedule is a
locus of points representing all the different combinations of interest
rates and income levels consistent with equilibrium in the money
market. IS-LM analysis seeks to find the level of income and the rate
of interest at which both the commodity market and the money market
will be in equilibrium. This can be accomplished with the techniques
used for solving simultaneous equations.

Example 1: (IS-LM model)

Let IS equation be

A g
Y= − i
1−b 1−b

Where 1-b is the marginal propensity to save, g is the investment

sensitivity to interest rates, and A is an aggregate of exogenous
variables. Let the LM equation be
 M0 l
Y= + i
k k

Where k and l are income and interest sensitivity of money demand,

respectively, and M 0 is real money balances.

(a)Write the IS-LM system in matrix form.

(b) Solve for Y and i by matrix inversion.
Solution: The IS-LM model can be rewritten as

( 1−b ) Y + gi= A

kY −li=M 0

[ 1−bk −lg ][ Yi ]=[ MA ]

0

For this model, we have

A= 1−b g , X = Y , B= A
k[ −l ] [] [ ]
i M0

| A|=−l (1−b)−gk ≠0 , therefore matrix is invertible and

1 −l −g ,
A−1= [
−l(1−b)−gk −k 1−b ]
By inverse matrix method

X =A −1 B

Y = 1 −l −g A = 1 Al + g M 0
[] [ ][ ]
i −l(1−b)−gk −k 1−b M 0 l ( 1−b )+ gk kA−(1−b) M 0 [ ]
 Therefore
Al + g M 0
Y=
l ( 1−b )+ gk
kA−(1−b) M 0
i=
l (1−b ) + gk

Example 2: (IS-LM model)

Take IS and LM equations from example 1 and

(a)Write the IS-LM system in matrix form if

b=0.7 , g=100 , A=252, k =0.25 , l=200 , M 0=176

(b) Solve model obtained in (a) for Y and i by matrix

inversion.
Solution: The IS-LM model can be rewritten as

( 1−b ) Y + gi= A

kY −li=M 0

0.3 Y +100 i=252

0.25 Y −200 i=176

0.3 100 Y 252

[ 0.25 ][ ] [ ]
−200 i
=
176

For this model, we have

A= 0.3 100 , X= Y , B= 252

[
0.25 −200 i ] [] [ ]
176

| A|=−85 ≠ 0, therefore matrix is invertible and

 1 −200 −100
−1
A = [
−85 −0.25 0.3
, ]
By inverse matrix method

X =A −1 B

Y 1 −200 −100 252 800

[]= [
i −85 −0.25 0.3 176
= ][ ] [ ]
0.12

Therefore
Y =800 ,i=0.12

Note that by further substitution the system could be further reduced

to a 3 ×3 system of equations or may be further reduced to a 2 ×2
system of equations.

Example 3: Suppose economy is made up of two sectors: the real

goods sector and the monetary sector:
 Together, the two sectors give us the following IS-LM model:

Y =C + I + G 0 ,

C=a+ b(1−t )Y

I =d −ei

M 0=kY −li

Solve this system for Y , C , I and i after convertingit to a system of two

equations in terms of any two variables.

Solution:

Substitute from equations ii and iii into equation i :

Y =C + I + G 0 ,

Y =a+b ( 1−t ) Y +d−ei+G 0

On simplifying we get

Y −b ( 1−t ) Y + ei=a+ d+G 0

kY −li ¿ M 0

Solving by Cramers Rule:

Example 4: Suppose economy is made up of two sectors: the real
goods sector and the monetary sector:

The goods market involves the following equations:

Y =C + I + G
C=30+0.2 Y
I =10−20i
G=10

The endogenous variables are Y, C, I and i (where i is the rate

of interest).
In the newly introduced money market, we have:
Equilibrium condition: M d =M s

Money demand: M d =5+0.1 Y −10 i

Money supply: M s=10

(a)Write IS-LM model for the two sectors economy.

(b) Solve this system for Y , C , I and i after convertingIS-LM
model obtained in part (a) to system of two equations in
terms of any two variables.
¿ and i=0.1 . ¿
Solution:
(a)The three equations for money market can be condensed
into:
0.1 Y −10 i=5
Together, the two sectors give us the following IS-LM model:
Y =C + I + 10
C=30+0.2 Y
I =10−20i
0.1 Y −10 i=5.

(b)
Substituting G and C into the equation for Y;
Y= 30+ 0.2Y +I +10
0.8 Y – I = 40
I + 20i = 10
0.1 Y – 10i = 5

Substituting I into equation for Y;

Y = 30+ 0.2 Y + 10 – 20 i + 10
0.8 Y + 20 i = 50
0.1 Y – 10 i = 5

Forming a 2x2 Matrix;

A= [ 0.8
0.1
20
−10 ] [ Yi ] = [ 505]
Finding determinant of A;
= -8 -2
= -10

For Y;

A1 = [ 505 20
−10 ]
Determinant of A1;
= -500 – 100
= - 600
Y = -600 / -10
Y = 60

For i;

A2 = [ 0.8 50
0.1 5 ]

Determinant of A2;
=4–5
=-1
i = -1 / -10
i = 0.1

For C;
C = 30 + 0.2 Y
C = 30 + 0.2 (60)
C = 42

For I;
I = 10 – 20i
I = 10 – 20 (0.1)
I=8

c) Solve the given IS-LM Model by susbstitution:

Y =C + I + 10
C=30+0.2 Y
I =10−20i
0.1 Y −10 i=5.

Solution:

The first 3 equations can be reduced to

Y =C + I + 10=30+ 0.2Y +10−20 i+10
Y =0.2Y −20 i+50
¿ 0.8 Y +20 i=50 and equation iv is 0.1 Y −10 i=5.

Which implies 0.1 Y −5=10 i∨i=0.01 Y −0.5

0.8 Y +20 ( 0.01 Y −0.5 ) =50 so Y =60

¿ i=0.01 Y −0.5=0.01 ( 60 )−0.5=0.1

By further substitution:
C=30+0.2 Y =30+ 0.2 ( 60 )=42
I =10−20i=10−20 ( 0.1 )=8

Solution Outcomes for a system of Linear Equations

Consider a system of n x n linear equations given by
AX = d

Determinant of A d ≠0 d=0
Non-homogeneous Homogeneous
system system
| A|≠ 0 A unique nontrivial A unique trivial
A is nonsingular solution exists solution exists
x¿ ≠ 0 x ¿=0 ¿

| A|=0
A is singular
Equations Infinitely many Infinitely many
dependent solutions exist not solutions exist
including the zero including the zero
solution solution
Equations No solution exists (Not possible as
inconsistent the zero solution
always exists)