Chapter 2

IS – LM model and AD in a closed

economy

Hồ Thị Hoài Thương

Email: thuonght@ftu.edu.vn

slide 1
 In this chapter, you will learn
▪ the IS curve & the LM curve
▪ how the IS-LM model determines income and
the interest rate in the short run when P is fixed
▪ how to use the IS-LM model to analyze the
effects of fiscal policy and monetary policy
▪ how to derive the aggregate demand curve from
the IS-LM model

slide 2
 1. Introduction to IS –LM model
▪ The IS-LM model was developed in 1937 by John Hicks
▪ The model IS-LM shows the interest rate and income
that satisfy equilibrium in the goods market and money
market for a given price level in the short run

slide 3
 2. The goods market and the IS
curve
2.1 The Keynesian Cross
A simple closed economy model in which income
is determined by expenditure.
▪ Notation:
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
▪ Difference between actual & planned expenditure
= unplanned inventory investment (UI)

slide 4
 2.1 The Keynesian Cross
▪ Determinants of planned expenditure (PE)
▪ Consumption (C)

▪ Investment (I)

▪ Government spending (G)

slide 5
Figure 1: Planned expenditure
PE
planned
expenditure
PE =C +I +G

MPC

income, output, Y

slide 6
 2.1 The Keynesian Cross

▪ Equilibrium condition:

actual expenditure = planned expenditure

slide 7
Figure 2: The equilibrium value
of income
PE
planned PE =Y
expenditure
PE =C +I +G

income, output, Y
Equilibrium
income
slide 8
 2.1 The Keynesian Cross
▪ Fiscal policy and the Keynesian Cross

An increase in PE PE =Y
government
spending
shifts...
PE
....Which......
Y

Y
slide 9
 Solving for Y
Y = C + I + G equilibrium condition

Y = C + I + G in changes

= C + G because I exogenous

= MPC  Y + G because C = MPC Y

Collect terms with Y Solving for Y :

on the left side of the
equals sign:  1 
Y =    G
(1 − MPC)  Y = G  1 − MPC 

slide 10
 2.1 The Keynesian Cross
▪ Fiscal policy and the Keynesian Cross

A decrease in PE PE =Y
taxes shifts
PE.....

PE
…Which.....
Y

Y
slide 11
 Solving for Y
eq’m condition in
Y = C + I + G
changes
= C I and G exogenous

= MPC  ( Y − T )
Solving for Y : (1 − MPC)  Y = − MPC  T

 − MPC 
Final result: Y =    T
 1 − MPC 

slide 12
NOW YOU TRY:
Practice with the Keynesian Cross
▪ Use a graph of the Keynesian cross
to show the effects of an increase in planned
investment on the equilibrium level of
income/output.

slide 13
 2.2 The IS curve

a. Definition: a graph of all combinations of r and Y

that result in goods market equilibrium
i.e. actual expenditure = planned expenditure
The equation for the IS curve is:

slide 14
Deriving the IS curve
PE

Y
r

slide 15
 Fiscal Policy and the IS curve

▪ Let’s start by using the Keynesian cross

to see how fiscal policy shifts the IS curve…

slide 16
 Shifting the IS curve: G
PE
At any value of r, G
 APE  Y
…so the IS curve
shifts to...

The horizontal Y
r
distance of the
IS shift equals...

slide 17
NOW YOU TRY:
Shifting the IS curve: T
▪ Use the diagram of the Keynesian cross to
show how an increase in taxes shifts the IS
curve.

slide 18
 3. The money market and the LM curve
3.1 The theory of liquidity preference

The interest rate adjusts r

to equate the supply and interest
demand for real money rate
balances :

M/P
real money
balances
slide 19
 3.2 The LM curve
The LM curve is a graph of all combinations of
r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:

slide 20
 Deriving the LM curve
(a) The money market
(b) The LM curve
r r

M/P Y

slide 21
 How M shifts the LM curve
(a) The money market
(b) The LM curve
r r

M/P Y

slide 22
NOW YOU TRY:
Shifting the LM curve
▪ Suppose a wave of credit card fraud causes
consumers to use cash more frequently in
transactions.
▪ Use the liquidity preference model
to show how these events shift the
LM curve.

slide 23
 The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y
LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:

IS
Y
Equilibrium
interest Equilibrium
rate level of
income

slide 24
 Exercise 1

C = 200 + 0.75(Y – T); I = 225 – 25r; G = 75

T = 100; M = 1000; P = 2; MD = Y – 100r
a) Find the equilibrium value of r and Y
b) G = ? so that Y = 1500
c) M=? so that Y =1300

slide 25
 The Big Picture

Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve

slide 26
 4. Policy analysis with the IS -LM
model
r
We can use the IS-LM LM
model to analyze the
effects of
• fiscal policy: G and/or T r1
• monetary policy: M
IS
Y
Y1

slide 27
 Fiscal policy: An increase in G
1. IS curve shifts ...... r
causing output & LM
income to....
2. This raises....., r2
causing the interest 2.
r1
rate to ….
1. IS2
3. …which reduces........, so the
IS1
final increase in Y
Y
Y1 Y2
3.

slide 28
 Monetary policy: An increase in M

1. M > 0 shifts
r
LM1
the LM curve ....
LM2

2. …causing the r1
interest rate to... r2

3. …which IS
increases....., Y
Y1 Y2
causing output &
income to .....

slide 29
 5. IS-LM and aggregate demand
▪ So far, we’ve been using the IS-LM model to
analyze the short run, when the price level is
assumed fixed.
▪ However, a change in P would shift LM and
therefore affect Y.
▪ The aggregate demand curve captures this
relationship between P and Y.

slide 30
 Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y

slide 31
 Exercise 2
C = 150 + 0.75(Y – T), T = 100, G = 70, I = 220 – 25r
M = 1000, MD = Y – 100r
Find the equation of AD

slide 32
 Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
P
 I
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y

slide 33
 Fiscal policy and the AD curve
r LM
Expansionary fiscal
policy (G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
Y1 Y2 Y
 IS shifts right P
 Y at each
value of P P1

AD2
AD1
Y1 Y2 Y

slide 34
 CASE STUDY:
The Liquidity Trap
▪ Interest rates hit 0 and the monetary
transmission mechanism breaks down
▪ Monetary policy becomes ineffective at low
interest rates

M r I Y

slide 35
 Ways out of the Liquidity Trap

▪ Central bank raises expectations of inflations

that reduces the real interest rate, which
increases I and increases Y
▪ Increasing money lowers the exchange rate
value of the domestic currency and increases
export and increases Y
▪ Central bank conducts open market operations
in other securities- mortgages, corporates– to
lowers interest rates and increase I and Y
slide 36