CHAPTER FOUR

TWO-MARKET EQUILIBRIUM: THE IS-LM APPROACH TO

AGGREGATE DEMAND

Introduction

 This chapter aims to integrate the money and commodities market, with primary emphasis on
the mechanics of their interaction. We also show how possible alternative interactions between
money and commodities may affect crucial macroeconomics variables such as income (and
implicitly, employment) and interest rate. We consider the possible effects of fiscal and
monetary policy, the fundamental tools of economic stabilization.

Objectives

By the end of this lesson, you should be able to:

 Understand the conditions for equilibrium in the goods and

money markets.
 Describe the general equilibrium
 Explain the effects of monetary and fiscal policies on real
macro vaariables.

EQUILIBRIUM IN THE REAL SECTOR-THE IS CURVE

 We develop a commodities market equilibrium function called the IS or investment-saving

function. In developing the IS model, the interest rate is allowed to vary and affect investment.
I  I i 
I
Where 0
i
 This condition means that investment will increase as the interest rate fall and vice versa.
 Initially, we assume that the economy is closed, excluding the foreign trade sector.
 In the later section, however, this assumption will be relaxed, and the effect of the foreign trade
sector on the IS-LM model be examined.
 The fiscal sector- government expenditure and taxation are included in the model when
deriving the IS model.

Constructing the IS function

 Recall that in the previous chapter, equilibrium in the goods market comprising consumer,
investor, and government sector required that
S

T
IG
leakages injections

 In figure 8.1 we derived the IS curve

Figure 8.1: Equilibrium in the goods market

S T i
I G

S T

R
I i1   G i2
I i0   G i0
U
I i2   G i1
IS

0 Y1 Y0 Y1 Y1 Y0 Y1

 In panel a, with interest rate i0 equilibrium, income is at level Y0 since leakages equal injection

at that income level S  T  I i0   G .

 However, a lower interest rate i1 will increase investment spending and shift I i0   G to

I i1   G . Income will rise from Y0 to Y1 .

 Similarly, a higher interest rate i 2 will cause I i0   G to shift downwards to I i2   G ,

resulting in a lower income level Y2 .

 The inverse relationship between the interest rate and income is plotted on the IS curve in
panel (b), which shows the various combination of i and Y that produce equilibrium in the
real sector.
 If the economy is situated to the right of the IS curve (such as at point R in panel b), then
disequilibrium exists because S  T  I  G . The income level is “too high” for the associated
interest rate, and the high-income level “too much” saving and tax. Alternatively, the interest
rate is too high for the income level associated with R, choking off investment.
 Income will fall until the IS curve is reached through cutbacks of production because of
unintended inventory accumulation at the higher income level.
 To the left of the IS curve, such as at point U, S  T  I  G and there is upward pressure on
the income level.

What causes a shift in the IS curve?

Any change in autonomous investment, government expenditure, taxes, and savings will do so.
An increase in autonomous investment (due to something other than a fall in the interest rate) and
government expenditure or an autonomous decrease in savings and taxes will shift the IS curve to
the right.
On the other hand, an autonomous decrease in I or G or an autonomous increase in S and T will
shift the IS curve to the left.
EQUILIBRIUM IN THE MONEY MARKET: THE LM CURVE.
In the earlier chapters, we derived the Keynesian money demand and equilibrium in the money
market by the equation of money demand to the money supply.

Figure 8.2: Equilibrium in the money market

Interest
rate
MS

Keynesian liquidity trap

e 
ie LD  LT  LSP

Money

 The fixed money supply is indicated by the vertical line M S . The demand for money is

represented by the LD curve and is the summation of speculative money demand LSP and

money demand for transaction motives LT . Equilibrium interest rate is ie

 It is worth noting, however that the above analysis focuses on the interest rate and equilibrium
between the demand and supply of money. But this is only a partial analysis because it has
neglected the other main determinant of money – the level of income in the economy. We now
introduce the role of income in money market equilibrium. The level of income is positively
associated with the demand for money.

Construction of LM curve

Figure 8.3: The LM curve

 In panel (a), an increase in income from Y0 to Y1 will increase the demand for money from

LY0  to LY1  and will result in a rise in the interest rate from i0 to i1

 A decrease in income from Y0 to Y2 will decrease the demand for money from LY0  to LY2 

and lead to a fall in the interest rate from i0 to i 2 .

 This positive relationship between Y and i is portrayed by the LM curve in panel (b). The LM
curve shows the various combinations of income and the interest rate that yield equilibrium in
the money market.
 Note that at the lowest interest rate LM curve is horizontal. The horizontal portion illustrates
the liquidity trap.

i
Interest LY1 
i 
LY0 
MS

LY2  LM
i1 i1

i0 i0
i2 i2

   
Liquidity trap Liquidity trap
Y2 Y0 Y1 IncomeY 
Money

Panel A
Panel B

 Any point to the right of LM curve, such as point T, is associated with an excess demand for
money LD  M S . At such a point, the interest rate is too low for the income level. Equilibrium
in the money market requires a higher i .
 Similarly any point to the left of the LM curve, such as point V, involves an excess money
supply LD  M S . For the income level associated with V, the interest rate needs to be lower in
order to have equilibrium in the money market.
What causes shift in LM?
 Increases in the demand for money (due to other things besides a rise in income) or decreases
in the supply of money will shift the LM curve to the left. In either situation, the interest rate
rises for any given income level, which is analogous to saying that the income level must fall
in order to maintain the same interest rate, thus each interest rate is plotted against a lower
 income level than before the increase in the demand for money or the decrease in the supply
of money.
 By reverse reasoning decrease in the demand for money (due to other things besides a fall in
income) and increase in the supply of money will shift the LM curve to the right.

Figure 8.4
i

LM 0 LM 2
LM 1

deacrease in M S
or increase in M D increase in M S
or decrease in M D

SIMULATANIUS EQUILIBRIUM IN THE MONETARY AND REAL (GOOD) SECTOR

 Equilibrium occurs where the LM and the IS curves intersect at point e, giving the income
level Ye and the interest rate i.e. as shown in figure 8.5.

Figure 8.5: Equilibrium in the Real and Monetary Sector

i

LM

e
ie F

IS
Ye

 If the economy is situated away from point F, since we are to the right of the IS curve, then
S  T  I  G , there will be contractionary pressure on the level of income. But since we are
 also to the right of the LM curve, the demand for money exceeds the supply of money and
therefore the interest rate will rise. These forces will eventually move the economy to point e.
 Figure 8.6 summarizes the adjustments or directional changes in interest rates and income
resulting from disequilibrium forces in both products and money market.

Figure 8.6: Adjustment Mechanism

i

S T  I G
LD  M S

S T  I G S T  I G
LD  M S
E LD  M S

S T  I G
LD  M S
0 Y

FISCAL AND MONETARY POLICY IN THE IS-LM FRAMEWORK

 Using the IS-LM framework, we will be comparing the effect of fiscal and monetary policy on
the income level and the interest rate under the three ranges of the LM function.
 With a fixed money supply, the LM functions as derived in figure 8.3 slopes upwards to the
right.
 However at one extreme the function may become perfectly elastic, and at the other extreme it
may become perfectly inelastic. With a range of varying elasticities in between. These three
ranges are defined in figure 8.7 in which the perfectly elastic section is the “Keynesian range”
the perfectly inelastic section is the “classical range” and the section between is the
intermediate range.
Figure 8.7: LM function’s three ranges
LM
i


 Classical range

 IS 5


IS 4

Y
Intermediate range
Keynesian range
 IS 3
iV
IS 2
IS1
IS 0
Y0 Y1 Y2 Y3 Y4 Y

 Why are the three sections into which the LM function has been divided labeled in this
fashion?
 In the simplified version of the classical theory money is demanded only for transactions
purpose. Therefore classical theory assumes that the speculative demand for money is zero at
each interest rate. That is why at the highest interest rate LM is perfectly inelastic. Wealth-
holders believe the interest rate will rise no higher and that security prices will fall no lower
and as a result they prefer to hold only securities and no idle cash.
 At the other extreme at some very low interest rate the speculative demand for money becomes
perfectly elastic since the interest rate will fall no lower and security prices will rise no higher.
In this case wealth holders prefer to exchange securities for cash at existing security prices,
which produces the liquidity trap on the speculative demand function. On the LM function, it
produces what is known as the Keynesian range.

EFFECT OF THE FISCAL POLICY IN THE THREE RANGES OF THE LM FUNCTION

The Keynesian case
 Imposition of fiscal policy (increased government expenditure or reduction of taxes) shifts the
IS curve outwards. In the Keynesian range, the fiscal policy is very effective since output
increases from Y0 to Y1 , with no changes in the interest rate. Borrowing by government to

finance the deficit takes place at a constant interest rate, iv there is no crowding out of
investment.
The classical case
 The fiscal policy is powerless. A shift in IS due to an increase in government spending from
IS 4 to IS 5 over the vertical section of LM produces no changes in interest rates.
 Given the classical assumption that investment demand function is highly interest elastic, the
rise in interest rates resulting from fiscal expansion reduces or crowds out private investment
and consumption, leaving no change in total spending and therefore no change in income.

The intermediate change

 A more realistic range of intermediate intersection exists where fiscal policy is effective. There
is some crowding out of private investment, which reduces effectiveness of fiscal policy.

EFFECTS OF THE MONETARY POLICY IN THE THREE RANGES OF THE LM.

 An increase in money supply shifts down the LM from LM 1 to LM 2 as shown in figure 8.8
below
Figure 8.8: Effects of monetary policy
LM 1 LM 2
i

IS 3

IS1
iV
IS 3
IS 0
Y
Y0 Y2 Y3 Y4 Y5

The Keynesian case

 Monetary policy is utterly helpless. An increase in the money stock, given a relatively elastic
IS function, IS 0 , merely extends the liquidity trap, leaving the interest rate iv unaltered. No
new investment will be forthcoming in the economy if the interest rate cannot be pushed
 downwards. Thus, extreme Keynesian regard monetary policy as theoretically and practically
ineffectual as a means of stimulating income, employment, or economic activities.

The classical (monetarist) case

 Monetarists placed great emphasis on monetary policy. Given the classical assumptions that
investment expenditures are highly sensitive to changes in the rate of interest, expansionary
monetary policy that decreases the interest rate would bring about large increases in investment
expenditures, increasing the income level from Y4 to Y5 .

The intermediate range

 Effectiveness of monetary policy is subject to the elasticity of the IS function. In the case of a
perfectly inelastic IS 2 increase in money supply only decreases the interest rate but leaves the
income level unaffected.
 However, where IS is elastic, as in the case of IS1 , the monetary expansion leads to reduction

in interest rate and increase in income level from Y2 to Y3

 At the intermediate range both fiscal and monetary policy are effective.

REVIEW QUESTIONS
1. The IS-LM frame work is widely used to show the impact of fiscal and
monetary policies on the economic output. Using a well labeled diagram
show and explain the effect of fiscal policy in the ranges of the LM
function.

2. Explain the effects of monetary policy in the three ranges of LM curve.