Lecture 1: IS-LM Closed Economy

B. A. (P) Economics 2nd Year Principles of Macroeconomics II

IS–LM Model in Closed Economy

Let’s consider following two sectors IS –LM model.

Goods Market

The IS equation is

Y = C(Y – t(Y)) + I(r) + G 0 < c’, t’ < 1 I’< 0 (1)

Here

Y is output

t(Y) is tax function which is depends on Y

Y – t(Y) is disposable income

C is consumption which is a function of disposable income (Y – t(Y)).

I is investment which is now a function of rate of interest(r).

G is government expenditure

c’ (dC/dY) is a marginal propensity to consume out of disposable income and as we know its lie between
0 and 1.

t’ (dt/dY) is tax rate and it’s also lie between 0 and 1 because people pay fraction of their income to
government in the form of tax.

I' (dI/dr) is interest sensitivity to r

Let’s find out slope of IS curve

After taking total differentiation of IS Equation (1), we get

dY = c’( dY – t’dY) + I’dr + dG

After taking dY common form consumption function we get

dY = c’( 1 – t’) dY + I’dr + dG

After taking dY term on the left side

dY -c’( 1 – t’) dY = I’dr + dG

After taking dY common, we get

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

[1 - c’( 1 – t’)]dY = I’dr + dG

After putting dG = 0 , we get

dY/dr = I’/ [1 - c’( 1 – t’)] < 0 since 0 < c’< 1 I’< 0

dY/dr is the slope of IS curve and which is negative in Y and r space. in other words we have downward
sloping IS curve in Y and r space.

IS

Money market

The LM equation is

M/P = K(Y) + L(r) K’ (dK/dY) > 0 L’(dL/dY) < 0

M is nominal money supply

P is price

M/P is real money supply

K(Y) is transaction demand for money and it’s positively related to Income(Y).

L(r) is speculating demand for money and it’s negatively related to rate of interest.

Let P = 1

The LM equation become

M = K(Y) + L(r) (2)

Let’s find out slope of LM curve

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

After taking total differentiation of LM Equation (2), we get

dM = K’dY + L’dr

After putting dM = 0, we get

dr/dY = -K’/L’ > 0 since K’ > 0 L’ < 0

dY/dr is the slope of LM curve and which is positive in Y and r space. In other words we have upward
sloping LM curve in Y and r space.

r LM

Now let’s find out fiscal and monetary multiplier of closed economy.

Fiscal multiplier

After taking total differentiation of IS Equation (1), we get

dY = C’( dY – t’dY) + I’dr + dG

After taking dY common form consumption function we get

dY = C’( 1 – t’) dY + I’dr + dG

After taking dY term on the left side

dY - C’( 1 – t’) dY = I’dr + dG

After taking dY common, we get

[1 - C’( 1 – t’) ]dY = I’dr + dG (3)

After taking total differentiation of LM Equation (2), we get

dM = K’dY + L’dr

After putting dM = 0, we get

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

dr = -K’/L’dY (4)

After putting the value of dr from equation (4) into (3) we get

[1 - C’( 1 – t’) ]dY = I’-K’/L’dY + dG

After taking dY term in left hand side , we get

[1 - C’( 1 – t’) ]dY + I’K’/L’dY = dG

After taking dY common, we get

[1 - C’( 1 – t’) + I’K’/L’]dY = dG

dY/dG = 1/[1 - C’( 1 – t’) + I’K’/L’] > 0 since 0 < c’, t’ < 1 K’ > 0 L’ < 0

Now let’s see it by theoretically and diagrammatically.

r LM0

r2

r0 A B C G1 > G0

IS(G0) IS(G1)

Y0 Y2 Y1 Y

G↑→Y↑( G is adding in Y) →C↑( 0< C <1’) → Y1↑( C is adding in Y) →MdT↑( K’ > 0) →r1↑(
Ms is constant) → MdSP↓( L’ < 0) → r2↓( Ms is constant) → (but all over r has increased) I↓( I’ <
0) →Y2↓( I is adding in Y)

Y1↑ > Y2 ↓

r1↑ > r2 ↓

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

Red color is Goods market effect and Green color is Money market effect.

AB = dY = {1/[1 - C’( 1 – t’)]} dG

AC = dY = {1/[1 - C’( 1 – t’) + I’K’/L’]} dG

I’K’/L’ is the money market effect which is reducing fiscal policy multiplier value.

BC is called crowding out. Crowding out refers as a reduction in private investment due to increase in
government expenditure. I’K’/L’ is crowding out part in Fiscal multiplier but we cannot separate it
because it is in denominator.

Monetary multiplier

After taking total differentiation of IS Equation (1), we get

dY = C’( dY – t’dY) + I’dr + dG

After taking dY common form consumption function we get

dY = C’( 1 – t’) dY + I’dr + dG

After taking dY term on the left side

dY - C’( 1 – t’) dY = I’dr + dG

After taking dY common, we get

[1 - C’( 1 – t’) ]dY = I’dr + dG (3)

Put dG = 0

After taking total differentiation of LM Equation (2), we get

dM = K’dY + L’dr

dr = dM/L’ -K’/L’dY
(4)

After putting the value of dr from equation (4) into (3) we get

[1 - C’( 1 – t’) ]dY = I’-K’/L’dY + I’/L’dM)

After taking dY term in left hand side , we get

[1 - C’( 1 – t’) ]dY + I’K’/L’dY = I’/L’dM

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

After taking dY common, we get

[1 - C’( 1 – t’) + I’K’/L’]dY = I’/L’dM

dY/dM = (I’/L’)/[1 - C’( 1 – t’) + I’K’/L’] > 0 since 0 < c’, t’ < 1 I’< 0 K’ > 0 L’ < 0

Now let’s see it by theoretically and diagrammatically.

r LM(M0)

LM(M1)

r0

r1 M 1 > M0

IS0

Y0 Y1 Y

M↑→ r1↓( Md is constant) → I↑ ( I’ < 0) →Y1↑ ( I is adding in Y)

Now let’s study IS-LM in extreme cases

Case-I

Speculative demand for money is completely inelastic with rate of interest. In the other word

L 0. Recall Speculating demand for money chapter where we studied that there exist a maximum
rmax where speculative demand for money is equal to zero. Suppose this maximum rmax exist in the
economy. IS equation and shape of IS curve are in this case is same as in normal case but LM
equation and shape of LM curve will change. LM equation is this case is

Ms = K(Y) or Y = A where A is some positive No.

LM curve will become a vertical line in Y and r space. You can see it by looking LM equation because Y
= A is a vertical line in Y and r space.

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

r LM

IS

A Y

Now let’s find out fiscal and monetary multiplier of closed economy in this extreme case-I.

Fiscal Multiplier

dY/dG = 1/[1 - C’( 1 – t’) + I’K’/L’] = o

LimL’ 0

This show that fiscal policy is completely ineffective if there is no speculative demand for money.

Now let’s see it by theoretically and diagrammatically.

r LM

r1

r0

IS0 IS1

A Y

G↑→Y↑( G is adding in Y) →C↑( 0< C <1’) → Y1↑( C is adding in Y) →MdT↑( K’ > 0) →r1↑ →
I↓( I’ < 0) →Y2↓( I is adding in Y)

Y1↑ = Y2 ↓

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

Increase in G will shift IS curve right from IS0 to IS1 and output didn’t change only interest rate goes
up from r0 to r1.

Monetary Multiplier

dY/dM = I’K’/L’/[1 - C’( 1 – t’) + I’K’/L’] = 1/ K’ (using L-hospital rule) > 0 because K’ > 0

Lim L’ 0

Increase in Ms by dMs will increase Y* by dY*. Increase in Ms will increase the value of A because A =
Y* = Ms/k. we can say that monetary policy is effecting in case-I

Now let’s see it by theoretically and diagrammatically.

r LM0 LM1

IS

A A* Y

M↑→ r1↓( Md is constant) → I↑ ( I’ < 0) →Y1↑ ( I is adding in Y)

Increase in Ms will shift LM curve right from LM0 to LM1 and output increase from A to A*.

Case-II

Speculative demand for money is infinitely elastic with rate of interest. In the other word

L’ ∞. Recall Speculating demand for money chapter where we studied that there exist a
minimum rmin where speculative demand for money is infinite. Suppose this minimum rmin exist in the
economy. IS equation and shape of IS curve are in this case is same as in normal case but shape of
LM curve will change.

LM curve will become a horizontal line at rmin in Y and r space.

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

rmin LM

Now let’s find out fiscal and monetary multiplier of closed economy in this extreme case-II.

Fiscal Multiplier

dY*/dG = 1/[1 - C’( 1 – t’) + I’K’/L’] = 1/[1 - C’( 1 – t’)] > 0 because 0 < C1 < 1

Lim L’ ∞

This shows that fiscal policy is effective. Increase in G by dG will increase Y0 by Y1.

Now let’s see it by theoretically and diagrammatically.

G1 > G0

rmin LM

IS(G0) IS(G1)

Y0* Y1 * Y

G↑→Y↑( G is adding in Y) →C↑( 0< C <1’) → Y1↑( C is adding in Y)

Increase in G will shift IS curve right from IS0 to IS1 and output increase from Y0* to Y1*.

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 Lecture 1: IS-LM Closed Economy
B. A. (P) Economics 2nd Year Principles of Macroeconomics II

Monetary multiplier

dY*/dMs = (I’/L’)/[1 - C’( 1 – t’) + I’K’/L’] = 0

Lim l ∞

This shows that monetary policy is completely ineffective.

Now let’s see it by diagrammatically.

rmin LM

IS

M↑, r will not change

Increase in Ms will not shift LM curve because it fixed at rmin and output an interest rate will not
change.

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