CHAPTER 2 The IS LM Model

IS – LM model and
Aggregate Demand (AD) in

close economy
Lecture 2
Lecturer: Le Phuong Thao Quynh
CHAPTER 10 Aggregate Demand I 0

In this chapter, you will learn:
● the IS curve, and its relation to:
● the Keynesian cross
● the loanable funds model
● the LM curve, and its relation to:
● the theory of liquidity preference
● how the IS-LM model determines income and
the interest rate in the short run when P is
fixed
Context
● Refer to the model of aggregate demand and
aggregate supply.
● Long run
● prices flexible
● output determined by factors of production &
technology
● unemployment equals its natural rate
● Short run
● prices fixed
● output determined by aggregate demand
CHAPTER 10 Aggregate Demand I
● unemployment negatively related to output 0
Context
● This chapter develops the IS-LM model,

the basis of the aggregate demand curve.
● We focus on the short run and assume the price
level is fixed (so, SRAS curve is horizontal).
● This chapter focus on the closed-economy case.

The Keynesian Cross
● A simple closed economy model in which income

is determined by expenditure.
(due to J.M. Keynes)
● Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
● Difference between actual & planned expenditure
= unplanned inventory investment
Elements of the Keynesian Cross
consumption function:
govt policy variables:
for now, planned

investment is exogenous:
planned expenditure:
equilibrium condition:
actual expenditure = planned expenditure

Graphing planned expenditure
PE
planned
expenditure PE =C +I +G
MPC
1
income, output, Y

Graphing the equilibrium condition
PE
planned PE =Y
expenditure
45º
income, output, Y

The equilibrium value of income
PE
planned PE =Y
expenditure PE =C +I +G
income, output, Y
Equilibrium
income
An increase in government purchases
P
PE E
=
At Y1,
YPE =C +I +G2
there is now an
unplanned drop PE =C +I +G1
in inventory…
G
…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y1 Y PE2 = Y2

Solving for Y
equilibrium condition
in changes
because I exogenous
because C = MPC Y
Collect terms with Y Solve for Y :

on the left side of the
equals sign:

The government purchases multiplier
Definition: the increase in income resulting from a

$1 increase in G.
In this model, the govt
purchases multiplier equals
Example: If MPC = 0.8, then

An increase in G
causes income to
increase 5 times
as much!

Why the multiplier is greater than 1
● Initially, the increase in G causes an equal increase
in Y: Y = G.
● But Y C
further Y
further C
further Y
● So the final impact on income is much bigger than

the initial G.

An increase in taxes
P
PE E
Initially, the tax = PE =C1 +I +G
increase reduces Y
consumption, and PE =C2 +I +G
therefore PE:
C = MPC T At Y1, there is now

an unplanned
inventory buildup…
…so firms
reduce output,
and income falls Y
toward a new PE2 = Y2 Y PE1 = Y1
equilibrium

Solving for Y
eq’m condition in
changes
I and G exogenous
Solving for Y :
Final result:

The tax multiplier
def: the change in income resulting from

a $1 increase in T :
If MPC = 0.8, then the tax multiplier equals

The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.

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.
The IS curve
def: a graph of all combinations of r and Y that

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

Deriving the IS curve
PE PE =Y
PE =C +I (r2 )+G
r I PE =C +I (r1 )+G
PE I
Y Y1 Y2 Y
r
r1
r2
IS
Y1 Y2 Y

Why the IS curve is negatively sloped
● A fall in the interest rate motivates firms to

increase investment spending, which drives up
total planned spending (PE ).
● To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.

Fiscal Policy and the IS curve
● We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
● Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…

Shifting the IS curve: G
PE PE =Y PE =C +I (r1 )+G2
At any value of r,
G PE Y PE =C +I (r1 )+G1
…so the IS curve
shifts to the right.
The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
Y
IS1 IS2
Y1 Y2 Y

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.
The Theory of Liquidity Preference
● Due to John Maynard Keynes.

● A simple theory in which the interest rate
is determined by money supply and
money demand.

Money supply
r
The supply of
real money interest
rate
balances
is fixed:
M/P
real money
balances

Money demand
r
Demand for
real money interest
rate
balances:
L (r )
M/P
real money
balances

Equilibrium
r
The interest
rate adjusts interest
to equate the rate
supply and
demand for
money: r1
L (r )
M/P
real money
balances

How the Fed raises the interest rate
To increase r, interest
Fed reduces M rate
r2
r1
L (r )
M/P
real money
balances

The LM curve
Now let’s put Y back into the money demand

function:
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:

Deriving the LM curve
(a) The market for

(b) The LM curve
real money balances
r r
LM
r2 r
2
L (r , Y2 )
r1 r
L (r , Y1 ) 1
M/P Y1 Y2 Y

Why the LM curve is upward sloping
● An increase in income raises money demand.

● Since the supply of real balances is fixed, there
is now excess demand in the money market at
the initial interest rate.
● The interest rate must rise to restore equilibrium
in the money market.

How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r LM
2
LM1
r2 r2
r1 r1
L (r , Y1 )
M/P Y1 Y

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.
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

Equilibrium of IS – LM model and its
implications
Equilibrium of IS – LM model
Finding the equilibrium value of r and Y
Step 1: Formulating IS equation and LM equation
Step 2: Solving the simultaneous equations with two variables r
and Y
Problem example
C = 200 + 0.75(Y – T) I = 225 – 25r G = 75 T = 100
M = 1000 P = 2 MD = Y – 100r
i) Find the equilibrium value of r and Y
ii) G = ? so that Y = 1500
Equilibrium of IS – LM model and its
implications
Equilibrium of IS – LM model
Problem example (continue)
C = 60 + 0.8 (Y – T), T = 100, G = 500, I = 300 – 20r
MS = 1080, P = 2, MD = Y – 40r
i) Find the equilibrium value of r and Y
ii) M = ? so that Y = 1300

Policy analysis with the IS -LM model
r
LM
We can use the IS-LM

model to analyze the r1
effects of
• fiscal policy: G and/or T IS
• monetary policy: M Y
Y1

1. IS curve shifts right r
LM
causing output & r2

income to rise. 2.
r1
2. This raises money
demand, causing the 1. IS2
interest rate to rise… IS1
3. …which reduces investment, Y
Y1 Y2
so the final increase in Y
3.

Crowding-out effect
IS shifts to the right. Ideally, economy

will move from E1 to E’1. However,
due to increase of interest rate that
mitigates investment, economy
eventually moves to E2. The gap in
terms of output between E’1 and E2 is
the degree of crowding out investment
effect (in terms of output this gap is the
distance between Y’1 and Y2)

III Equilibrium of IS – LM model and its
implications
3 Applying IS – LM model to explain economic fluctuations in

short run
Crowding-out effect
How to calculate the degree of crowding-out effect
Step 1: Find the new equation of IS curve as government spending or/and tax
changes and combine with unchanged LM to find new equilibrium output.
Step 2: Replace the old equilibrium interest rate to the new equation of IS
curve to find without – crowding out effect supposed output
Step 3: Compare this supposed output with the new equilibrium one in step 1.
(Another way: calculate expenditure multiplier, compare old and equilibrium
of interest rate, estimate change of investment based on investment function
and then change of output based on expenditure multiplier)
Crowding-out effect
C = 40 + 0.8(Y-T) T = 100 I =100 – 20r G =200
M = 1200 P = 2 MD = 2Y – 50r
i) Find the output and interest rate at equilibrium
ii) If G = 300 find the new equilibrium
iii) Estimate the degree of crowding-out effect

A tax cut
Consumers save (1 r
MPC) of the tax cut, so LM
the initial boost in
spending is smaller for T
r2
than for an equal G… 2.
r1
and the IS curve shifts by
1. IS2
1.
IS1
Y
Y1 Y2
2. …so the effects on r
2.
and Y are smaller for T
than for an equal G.
Monetary policy: An increase in M
r
1. M > 0 shifts LM1
the LM curve down
LM2
(or to the right)
r1
2. …causing the
interest rate to fall r2
3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

Interaction between
monetary & fiscal policy
● Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
● Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
● Such interaction may alter the impact of the
original policy change.
IV Coordinate Fiscal policy and Monetary policy
1 Expansionary fiscal policy and expansionary
monetary policy
Results: Y increases, r unchanged (used when government

wants to stimulate economy but creates no effect to
investment by keeping interest rate unchanged)
2 Contractionary fiscal policy and contractionary monetary policy
Results: Y decreases, r unchanged (used when government wants to reduce

great amount of aggregate demand in order to curb inflation, whereas
creating no effect on investment by keeping interest rate unchanged )
3 Contractionary fiscal policy and expansionary monetary policy
Results: Y unchanged, r decreases (used when government wants to

change structure of Y by decreasing government spending and
increasing investment = enhance efficiency of economy and constraint
public debt)
4 Expansionary fiscal policy and contraction monetary policy
Results: Y unchanged, r increases (used when government wants to change

structure of Y by increasing government spending and decreasing investment =
stimulate economy in downturn period but caution about high inflation)

NOW YOU TRY:
Analyze shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of
1. a boom in the stock market that makes
consumers wealthier.
2. after a wave of credit card fraud, consumers
using cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects of the
shock on Y and r.
b. determine what happens to C, I, and the
unemployment rate.

CASE STUDY:
The U.S. recession of 2001
● During 2001,
● 2.1 million jobs lost,
unemployment rose from 3.9% to 5.8%.
● GDP growth slowed to 0.8%
(compared to 3.9% average annual growth
during 1994-2000).

CASE STUDY:
Causes: 1) Stock market decline C
In 1500 Standard & Poor’s

d 500
e 1200
x
( 900
1
9 600
4
2 300
=
1995 1996 1997 1998 1999 2000 2001 2002 2003
1
CHAPTER
0 10 Aggregate Demand I 0
0
CASE STUDY:
Causes: 2) 9/11
● increased uncertainty
● fall in consumer & business confidence
● result: lower spending, IS curve shifted left
Causes: 3) Corporate accounting scandals
● Enron, WorldCom, etc.
● reduced stock prices, discouraged investment

CASE STUDY:
● Fiscal policy response: shifted IS curve right
● tax cuts in 2001 and 2003
● spending increases
● airline industry bailout
● NYC reconstruction
● Afghanistan war

CASE STUDY:
● Monetary policy response: shifted LM curve right
7
6
Three-month
T-Bill Rate
5
4
3
2
1
0
01 04 07 10 01 04 07 10 01 04 07 10 01 04
/0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /1
1/ 2/ 3/ 3/ 3/ 5/ 6/ 6/ 6/ 8/ 9/ 9/ 9/ 1/
20 20 20 20 20 20 20 20 20 20 20 20 20 20
CHAPTER00
10 00 00 00 Demand
Aggregate 01 01 I01 01 02 02 02 02 03 03 0
What is the Fed’s policy instrument?
● The news media commonly report the Fed’s policy

changes as interest rate changes, as if the Fed
has direct control over market interest rates.
● In fact, the Fed targets the federal funds rate –
the interest rate banks charge one another on
overnight loans.
● The Fed changes the money supply and shifts the
LM curve to achieve its target.
● Other short-term rates typically move with the
federal funds rate.
What is the Fed’s policy instrument?
Why does the Fed target interest rates instead of

the money supply?
1) They are easier to measure than the money
supply.
2) The Fed might believe that LM shocks are
more prevalent than IS shocks. If so, then
targeting the interest rate stabilizes income
better than targeting the money supply.
(See end-of-chapter Problem 7 on p.337.)

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
(introduced in Chap. 9) captures this
relationship between P and Y.

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

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

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
P1
value of P
AD2
AD1
Y1 Y2 Y

The SR and LR effects of an IS shock
r LRAS LM(P1
A negative IS shock )
shifts IS and AD left,
causing Y to fall. IS1
IS2
Y
P LRAS
P1 SRAS1
AD1
AD2
Y
r LRAS LM(P1
)
In the new short-run
equilibrium, IS1
IS2
Y
P LRAS
P1 SRAS1
AD1
AD2
Y
r LRAS LM(P1
)
In the new short-run
equilibrium, IS1
IS2
Y
Over time, P gradually
falls, causing P LRAS
• SRAS to move down P1 SRAS1
• M/P to increase,
which causes LM AD1
AD2
to move down
Y
r LRAS LM(P1
) LM(P2
)
IS1
IS2
Y
Over time, P gradually
falls, causing P LRAS
• SRAS to move down P1 SRAS1
• M/P to increase, P2 SRAS2

which causes LM AD1
AD2
to move down
Y
r LRAS LM(P1
) LM(P2
)
This process continues IS1
until economy reaches a IS2
long-run equilibrium with Y
P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y
NOW YOU TRY:
Analyze SR & LR effects of M
• Draw the IS-LM and AD- r LRAS LM(M1/P1)
AS diagrams as shown here.
• Suppose Fed increases M. IS

Show the short-run effects
on your graphs. Y
• Show what happens in the
transition from the short run P LRAS
to the long run.
• How do the new long-run P1 SRAS1
equilibrium values of the
endogenous variables AD1
compare to their initial Y
values?
Monetary Policy Transmission Mechanism
M r I Y

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

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

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

Chapter Summary
1. IS-LM model
● a theory of aggregate demand
● exogenous: M, G, T,
P exogenous in short run, Y in long run
● endogenous: r,
Y endogenous in short run, P in long run
● IS curve: goods market equilibrium
● LM curve: money market equilibrium

Chapter Summary
2. AD curve
● shows relation between P and the IS-LM model’s
equilibrium Y.
● negative slope because
P (M/P ) r I Y
● expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right.
● expansionary monetary policy shifts LM curve
right, raises income, and shifts AD curve right.
● IS or LM shocks shift the AD curve.

CHAPTER 2 The IS LM Model

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CHAPTER 2 The IS LM Model

Uploaded by

Copyright:

Available Formats

IS – LM model and

Aggregate Demand (AD) in

Lecturer: Le Phuong Thao Quynh

CHAPTER 10 Aggregate Demand I 0

● This chapter develops the IS-LM model,

CHAPTER 10 Aggregate Demand I 0

● A simple closed economy model in which income

govt policy variables:

for now, planned

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

Collect terms with Y Solve for Y :

CHAPTER 10 Aggregate Demand I 0

Definition: the increase in income resulting from a

Example: If MPC = 0.8, then

CHAPTER 10 Aggregate Demand I 0

● So the final impact on income is much bigger than

CHAPTER 10 Aggregate Demand I 0

C = MPC T At Y1, there is now

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

def: the change in income resulting from

If MPC = 0.8, then the tax multiplier equals

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

● Use a graph of the Keynesian cross

def: a graph of all combinations of r and Y that

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

● A fall in the interest rate motivates firms to

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

● Use the diagram of the Keynesian cross to

● Due to John Maynard Keynes.

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

Now let’s put Y back into the money demand

The LM curve is a graph of all combinations of r

CHAPTER 10 Aggregate Demand I 0

(a) The market for

CHAPTER 10 Aggregate Demand I 0

● An increase in income raises money demand.

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

● Suppose a wave of credit card fraud causes

The short-run equilibrium is r

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0

We can use the IS-LM

CHAPTER 10 Aggregate Demand I 0

causing output & r2

CHAPTER 10 Aggregate Demand I 0

IS shifts to the right. Ideally, economy

CHAPTER 10 Aggregate Demand I 0

3 Applying IS – LM model to explain economic fluctuations in

CHAPTER 10 Aggregate Demand I 0

CHAPTER 10 Aggregate Demand I 0