Applied Macroeconomics

Lecture 11:
Keynesian Economics and ISLM Analysis B

Anna Egle | a.egle@cbs.de

11.05.23 | Anna Egle

Course Outline
Agenda
Keynesian Economics and ISLM Analysis B
1. Key Concepts
• Basics
• Relationship between Y & i
• IS curve
• LM curve
• A simultaneous equilibrium in the market for G/S and the money market
• Fiscal vs. monetary policy
2. Applications
3. Questions

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Key Concepts

Lecture 11: Keynesian Economics and ISLM Analysis B

Key Concept (Repetition)
Keynesian economics: basics
1. Assumes closed economy (NX=0), no trade with other economies
2. Assumes sticky prices and sticky wages à almost no short-run inflation

Model of the market for all goods and services (aggregate) à The IS-curve
Model of the market for money à The LM-curve

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Key concept
Relationship between income Y & interest rate i
Income (Y) depends on the interest rate (i)
Example: I = 1040 – 80i
i determines the level of investment (I), which is needed for generating income (Y)
à Therefore, we adjust the expenditure function for I

Previously: I = 240 à (E =) Y = 600 + 0.6Y (I was assumed to be fixed)

Now: I = 1040 - 80i à (E =) Y = 1400 + 0.6Y - 80i à i = 17.5 – 0.005Y

à Including the interest rate into the expenditure function creates the function for the IS-curve

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Key concept
IS curve
à Including the interest rate into the expenditure function creates the function for the IS-curve
Now: i = 17.5 – 0.005Y

à There is an negative relationship between i and Y

à The higher i is, the lower (I and thus also) Y is

Result: the IS-curve shows the combinations of interest

rate (i) and income (Y) at which the market for goods
and services is in equilibrium

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Key Concept
LM curve
The LM-curve extends the model by money supply (MS)
and money demand (MD)
• MD depends on the price level (P)
à Keynes assumes sticky prices (P can be ignored)
à As P is assumed to be constant, there is no inflation
(nominal i = real i)
• MS is chosen by the central bank

Result:
When Y rises à more transactions, MD rises
When i rises à cash less attractive, MD falls
Equilibrium at MD = MS

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Key Concept
LM curve

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Key Concept
LM curve
The LM-curve:
• Shows combinations of Y and i at which the money
market is in equilibrium
• Shows a positive relationship between Y and i
• When Y rises à more transactions, MD and i increase
• A higher GDP increases the demand for money, which
drives up the interest rate if the supply of money
does not rise accordingly

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Key Concept
A simultaneous equilibrium in the G/S market & the money market
Both markets are connected through interest rate (i) and
national income (Y)

Where both curves meet, there is a simultaneous

equilibrium in both markets (no shortages, no surpluses)

Mathematically: set IS = LM à solve for Y à set Y into either

function to find i (must be the same for both functions)
Example
IS: i= 17.5 – 0.005Y (equilibrium in G/S market)
LM: i= 0,02Y – 20 (equilibrium in the money market)
IS = LM à 17.5 – 0,005Y = 0,02Y -20 à 0,025 Y = 37.5 à Ye = 1500, ie= 10

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Key Concept
Fiscal vs. monetary policy
Fiscal policy Monetary policy
• Expansionary (G rises or T falls): IS curve shifts right • Expansionary (MS rises): LM curve shifts right
• Contractionary (G falls or T rises): IS curve shifts left • Contractionary (MS falls): LM curve shifts left

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Applications
Application
IS-LM analysis
C = 50 + 0.8Yd
I = 210 – 12i Reminder: Finding the equilibrium
• IS: Y = E
G = 400
• LM: MD = MS
T = 0.5Y • General Equilibrium: IS = LM

MD = Y – 100i
MS = 500

1. Determine the equation describing the equilibrium in this economy’s goods market (IS curve).
2. Determine the equation describing the equilibrium in this economy’s money market (LM curve).
3. Briefly explain what the IS curve and LM curve show.
4. Identify the simultaneous equilibrium in the goods market and the money market.

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Application
IS-LM analysis
Use the IS-LM model to briefly describe the effects the following four events have on an
economy in the short-run.
(Verbal answers are sufficient, but draw one IS-LM diagram to support your answers.)

1. The government institutes significant cuts in public expenditure.

2. The central bank expands the money supply by performing a large open-market operation.
3. The central bank fears that inflationary pressures are rising and increases interest rates.
4. The government increases taxes to try to reduce a large budget deficit.

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Application
IS-LM analysis
The IS-LM model is used to analyse simultaneous equilibrium in the goods market and the money market in the short-run.
You have the following information about an economy:
C=160+0.8Yd (consumption function with respect to disposable income) T=0.25Y (taxes with respect to Y)
I=1040-80i (investment function with respect to i) G=200 (government spending)
MD=0.3Y-15i (money demand function) MS=300 (money supply)

1. Determine the equation describing the equilibrium in this economy’s goods market (IS-curve).
2. Determine the equation describing the equilibrium in this economy’s money market (LM-curve)
3. Mathematically identify the simultaneous equilibrium in the goods market and the money market: calculate the
equilibrium values of national income and the interest rate.
4. Show how a decrease in government spending affects the equilibrium national income and interest rate in a diagram.
Also, briefly describe the changes verbally.
5. If the central bank wants to keep national income constant at the level before the fall in government spending, what
should it do, and what will happen to the interest rate? Show your recommendations in the diagram, and briefly
explain verbally.

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Any more questions?