Escuela de

Economía
y Finanzas
MACROECONOMÍA GENERAL
EC0113

Cesar E. Tamayo
Daniel S. Medina
The full IS-LM Model
 The IS relation again
Thinking again about investment

 • Recall the Equilibrium in the godos market ():

 

• Now drop the assumption of exogenous/fixed investment. Assume it depends

upon income available for new ventures and upon the interest rate (assume all
firms can borrow at the same interest rate):

𝑌 =𝑐 0 +𝑐 1 (𝑌 − 𝑇 )+𝐼 (𝑌 ,𝑖 )+𝐺 The IS relation

 
The IS relation again
Identical interest rate for all firms?
The IS relation again
Drawing the IS Relation
The IS relation again
Shifting the IS Relation
The LM curve
Deriving the LM

• If central banks were to target the money supply (as they did in the past) the LM
would slope upwards.
 The LM curve
Deriving the LM

Now that Central Banks

target the interest rate:
LM
IS
𝑖=´𝑖
 

𝑌 =𝑐 0 +𝑐 1 (𝑌 − 𝑇 )+𝐼 (𝑌 ,𝑖 )+𝐺
 

Any point on the downward-sloping IS curve

corresponds to equilibrium in the goods market.
Any point on the horizontal LM curve corresponds
to equilibrium in financial markets.
Solving a versión of the IS
Simple investment function

Suppose investment depends on Y,i as follows:

𝐼 =𝑏 0+ 𝑏1 𝑌 − 𝑏2 𝑖
 

So we replace investment:
  𝑌 =𝑐 0 +𝑐 1 (𝑌 − 𝑇 )+𝑏0 +𝑏 1 𝑌 −𝑏 2 𝑖 +𝐺
And solve for income:
  1
𝑌= [ 𝑐 0 − 𝑐 1 𝑇 +𝑏 0 −𝑏2 𝑖+ 𝐺 ]
1 − 𝑐1 −𝑏1
Fiscal policy in the IS-LM model
Shifting the IS Relation with a tax increase

The increase in taxes

shifts the IS curve. The LM
curve does not shift. The
economy moves along the
LM curve.
Monetary policy in the IS-LM model
Shifting the LM Relation

A monetary expansion
shifts the LM curve down,
and leads to higher output.
Policy mix I
Shifting the IS and LM Relation

The Effects of a Combined Fiscal

and Monetary Expansion:

The fiscal expansion shifts the IS

curve to the right. A monetary
expansion shifts the LM curve down.
Both lead to higher output.
Policy mix II
Shifting the IS and LM Relation

The Effects of a Combined Fiscal

Consolidation and a Monetary
Expansion:

The fiscal consolidation shifts the IS

curve to the left. A monetary expansion
shifts the LM curve down. Both lead to
higher output.
 IS-LM: Which interest rate?
Looking into real and nominal interest rates

 • The policy interest rate is a nominal rate, i.e., does not consider inflation

• When deciding on the level of investment agents (firms, households) care mostly
about the real interest rate, (why?)

• The real return on any asset at time is given by:

• And if we define then we write approx:

• So we rewrite the IS:

 IS-LM: Which interest rate?
Looking into risk and risk premia

 • Beyond money and bonds: some assets are risky. How much should we ask in
return from a risky asset?

• Simple expected return of a risky asset:

• Write . Then we should be indifferent between assets:

( 1+𝑖 )=(1− 𝑝)(1+𝑖 + 𝑥)

 

• So that and we write the IS:

 𝑌 =𝑐 0 +𝑐 1 (𝑌 − 𝑇 )+𝐼 (𝑌 ,𝑖 𝑡 + 𝑥 − 𝜋 𝑒𝑡 +1 )+𝐺
IS-LM: Which interest rate?
Looking into risk and risk premia