IS-LM

Module VI
Vanita Agarwal Chapter 16-17
B. Chatterjee
NMIMS- SOC
 r
IS curve
Locus of combinations of interest rate (r) and
GDP (Y) that keeps the goods and services
market in equilibrium

IS

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 r
LM curve LM
Locus of combinations of interest rate (r) and
GDP (Y) that keeps the money market in
equilibrium

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IS-LM Equilibrium
At the interest rate Md=Ms. Lets say r=6
percent, and 1000 amount of liquidity is
demanded and supplied in the economy.
Out of this 1000, 600 are for Transactions r
purpose and 400 for speculative. LM
Money market is in equilibrium.
By saying Goods and services market is also in
equilibrium we mean that with this 600
transactions demand for money, the aggregate E
demand that is generated is exactly equal to
AS, ie, production. That means, all goods and
services are sold. AD=AS.
IS

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IS-LM Equilibrium
If money market is in equilibrium,
does that mean overall economy is in
equilibrium?
r
If goods market is in equilibrium, LM
does that mean overall economy is in
equilibrium?

Money supply  r  I  AD  Y E

Price  Money Demand  r I  AD  Y

IS

Y
E is the point where both goods and services
market and money market is in equilibrium.

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The ailing Indian economy may just get a lifeline from the government. A day after Finance
Minister Arun Jaitley hinted that the government may look at pump-priming the economy with a
whopping 65,000 cr rupee stimulus. This could mean Asia's third largest economy may have to
again take leave from its fiscal targets.

New Delhi seems convinced that steroids are needed to lift economic growth, which slipped to a
three year low of 5.7 percent in the quarter ending June 2017. This time the focus of the stimulus
is likely to be MSMEs, Bank Recap and Expenditure in capital guzzlers like roads and railways.
At a time when the economy is firing on only one engine that is public investments, PM Modi and
his chief lieutenant Arun Jaitley have their task cut out. Sources indicate that the first lifeline will
be given to the public sector banks caught in the middle of the NPA crisis. The government may
pump additional 25,000 cr rupees in PSU banks in FY18 over and above the budgeted amount of
10,000 cr rupees. The move is aimed at boosting credit offtake in the economy.
MSMEs that have been hit hard by demonetisation have will also be given a booster shot. The
bulk of economic activity in India is done by MSMEs and interest subvention and relaxation in
working capital norms will go a long way in providing comfort to the sector that has been
struggling to keep its head above water post a series of economic disruptions. According to
economic times report, working capital requirement norm could be doubled from the current 90
days to 180 days.
Rail and Road, the two big capital guzzlers will see major thrust. The government plans to give a
massive infra push by injecting close to 40,000 cr in the sector in a hope that this will have a
multiplier effect, generate employment and boost economic activity.
In light of the fiscal stimulus by the government, Reserve Bank of India governor Urjit Patel in the
monetary policy committee meeting said that there are several signs of growth impulses
strengthening. He has cautioned about the high fiscal deficit ‘crowding out’ private investment.
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Questions
• Explain using the IS-LM framework the impact of fiscal stimulus on
interest rate and GDP of the economy.
• RBI has cautioned about “crowding out” of private investment.
Explain the crowding out phenomenon with a suitable diagram.
• How can crowding out be avoided?

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IS-LM: Monetary and Fiscal Policies
The Reserve Bank of India (RBI) purchased Rs 6,156.74 crore of government bonds
through an open market operation (OMO) auction on Monday.
NDTV profit November 19, 2013

The Reserve Bank of India sold Rs 2,255 crore of government bonds between June
2 and 6 to suck out excess rupee it has injected into the system. Bond prices may
fall if the RBI extends the practice.
ET Bureau June 17, 2014

In a big boost for the markets and economy, RBI governor Raghuram Rajan cut repo
rate by 50 basis points to 6.75%. The repo rate now stands at a 4-1/2 year low.
Rajan kept the Cash Reserve Ratio (CRR) unchanged at 4%.
ET Bureau Sep 29, 2015

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Expansionary
Monetary Policy
(i) increase in Money Supply
(ii) increase in supply of real
balances
(iii) i decreases
(iv) increase in investment spending
(v) excess demand in the goods
market
(vi) Y increases
(vii) demand for money increases
(viii) i increases
(ix) decrease in i is partially
reversed

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A fiscal stimulus package was unveiled by the government to contain
the impact of global financial crisis on the Indian economy. The Union
government over the weekend announced a Rs 30,000 crore package
combining additional spend with tax cuts.

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Expansionary Fiscal
Policy
(i) increase in government
expenditure
(ii) excess demand in the goods
market
(iii) Y increases
(iv) demand for money increases
(v) i increases
(vi) investment spending declines
(vii) Y declines
(viii) net increase in Y is moderated
due to the decline in investment
spending

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1970 recession and recovery
During the 1970s, the U.S. economy was going through a tough phase.
In 1973, United States and the rest of the world were hit by the first oil
price shock. At the same time, the unemployment rate in the U.S. was
at record high level of 8.9 percent. As a policymaker, what intervention
would you suggest to tackle this issue? Explain in terms of the IS-LM
framework.

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In 2001, the U.S. economy experienced a pronounced slowdown in economic
activity. The unemployment rate rose from 3.9 percent in September 2000 to 4.9
percent in August 2001, and then to 6.3 percent in June 2003. In many ways, the
slowdown looked like a typical recession driven by a fall in aggregated demand.
Three notable shocks explain this event. The first was a decline in the stock market.
During the 1990s, the stock market experienced a boom of historic proportions, as
investors became optimistic about the prospects of the new information
technology. Some economists viewed the optimism as excessive at the time, and in
hindsight this proved to be the case. When the optimism faded, average stock
prices fell by about 25 percent from August 2000 to August 2001. The fall in the
market reduced household wealth and thus consumer spending. In addition, the
declining perceptions of the profitability of the new technologies led to a fall in
investment spending.
The second shock was the terrorist attacks, the stock market fell another 12
percent, its biggest weekly loss since the Great depression of the 1930s. The attacks
increased uncertainty about what the future would hold. Uncertainty can reduce
spending because households and firms postpone some of their plans until the
uncertainty is resolved.
The third shock was a series of accounting scandals at some of the nation’s most
prominent corporations, including Enron and WorldCom. The result of these
scandals was bankruptcy of some companies that had fraudulently represented
themselves as more profitable than they truly were. These events further
depressed stock prices and discouraged business investment.
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Use the IS-LM framework to understand the Economic situation.

As a policymaker what policy would you use to stimulate the economy?

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