IS - LM Model

• Prof J.R. Hicks and Prof A. P. Lerner

This model refines Keynes’ Economics as it

interfaces the Goods and the Money Markets

This model is used for economic policy-making

 Derivation of IS Curve
• R AD
oI
C2
i1
1 C1
i2
A2 3

ID A1
2 Curve 4

I1 I2 Dd (Invst) Y1 Y2 Income
RoI
1. -ve Trajectory of IS Curve
i1 S1

↑𝒀  
4A
i2
1A

S2
 
3 IS
4A

↑ 𝑰𝒏𝒗𝒕  ( ¿ ∆ 𝑰 ) 2
Y1 Y2 Income
↓𝑹𝒐𝑰
 
1
 2. Slopedness of IS Curve
AD AD
C2

C1
C2

C1
A2 A2

A1
A1

Y1 Y2 Income Y2
Y1 Income
RoI
RoI

S1
i1 i1 S1

i2 S2 S2
i2
IS
IS
Y1 Y2 Income Y1 Y2 Income
 3. Position of IS Curve

RoI RoI

IS2

IS1 IS2
IS1

Income
Income

Expansionary Fiscal Policy : IS curve shifts upwards to the right

Contractionary Fiscal Policy : IS curve shifts downwards to the left

 Derivation of LM Curve
• R DY2 SSm RoI
LM

oI DY1 Curve

M2
1 i2
i2
2A M1
2
i1 i1

0A

Y1 Y2
Mo Dm; Sm Income
0A
1. + ve Trajectory of LM Curve
↑𝑹𝒐𝑰 
2A

=K  
1

↑𝒀
 
0A
 2. Slopedness of LM Curve
• RoI
RoI
DY2
SSm LM
DY1
Curve

M2 Income elasticity of
i2
i2 the demand for
money is low
M1
i1
i1

Mo DDm; SSm Y 1 Y2 Income

RoI SSm RoI

DY2
LM
Curve
Income elasticity of DY1
i2
the demand for i2
money is High M2

i1 i1
M1

Mo DDm; SSm Y1 Y2 Income

 3. Position of LM Curve

RoI RoI
LM1

LM2

LM1

LM2

Income Income
Easy Monetary Policy : LM curve shifts downwards to the right

Tough Monetary Policy : LM curve shifts upwards to the left

 IS Curve LM Curve
RoI
RoI
LM

IS

Income Income

1. -ve Trajectory of IS Curve 1. + ve Trajectory of LM Curve

2. Slopedness of IS Curve depends 2. Slopedness of LM Curve depends

on status of MPC on status of Income El. of Invt

3. Position impacted by type of FP 3. Position impacted by type of MP

Expansionary: Up - Rightwards Easy: Down – Rightwards
Contractionary: Down - Leftwards Tight: Up - Leftwards

The ISc is the LOCUS of the equilibrium pts b/w ROI and NI in the GM
The LMc is the LOCUS of the equilibrium pts b/w ROI and NI in the MM
 Find the general RoI and the corresponding equilibrium NI from the following macro
parameters: (interpret the results)
C = 380 + 0.6Y, I = 120 – 3i, X = 450, M = 600, (R – P ) = - 260, G = 250,
Ms = 450 and Md = 0.6Y – 5i

IS Function
1. Y = C + I + G + [(X – M) + (R – P)]
2. Y = 380 + 0.6Y + 120 – 3i + 250 + 450 – 600 + (- 260)
3. 0.4Y + 3i = 340 ….. (I)

LM Function 4. Md = Ms 5. 0.6Y – 5i = 450 ….. (II)

Simultaneously Work with Equations (I) & (II)

6. 0.4Y + 3i = 340 …. (I) 7. 02Y + 15i = 1700 8. 3.8Y = 3050

0.6Y – 5i = 450 … (II) 1.8Y – 15i = 1350
9. Y = Rs. 802.6

Substituting for Y in eq. I

10. (0.4)(802.6) + 3i = 340 11. 321.04 + 3i = 340 12. 3i = 18.96 13. i = 6.32 %
 Find the general RoI and the corresponding equilibrium NI from the following macro
parameters: (interpret the results)
C = 380 + 0.6Y, I = 120 – 3i, X = 450, M = 600, (R – P ) = - 260, G = 250,
Ms = 450 and Md = 0.6Y – 5i

i = 200 – 0.133Y ….. (IV)

IS Function

i = 113.33 – 0.133Y ….. (Ia)

0.133 Y + i = 200 ….. (V)

LM Function 4. Md = Ms 5. 0.6Y – 5i = 450 ….. (II)

 Determination of General Interest Rate

RoI

IS Curve LM Curve

ie E

Ye Income
 Determination of General Interest Rate

RoI

IS Curve LM Curve

ie E

Ye Income
Restoration of Equilibrium RoI, if RoI is greater than it

RoI

IS Curve
LM Curve

ie E

Ye Income
Restoration of Equilibrium RoI, if RoI is lower than it

RoI

IS Curve LM Curve

ie E

Ye Income
Non-Restoration of Equilibrium RoI, if RoI is not equal to it

IS Curve
RoI
LM Curve

E
ie

Ye Income
Case
A B Comments
No.

1 FP = K & MP easy FP = K & MP tough

1 policy constant & the
other changes
2 FP exp. & MP = K FP cont. & MP = K

3 FP exp. > MP easy FP cont. > MP tough

Both policies change in
the SAME DIRECTION but
in
4 FP exp. < MP easy FP cont. < MP tough DIFFERENT
5 FP exp. > MP tough FP cont. > MP easy PROPORTIONS
Both policies change in
DIFFERENT
DIRECTIONS & in
6 FP cont. < MP easy FP exp. < MP tough DIFFERENT
PROPORTIONS
Both policies change in
7 FP exp. = MP easy FP cont. = MP tough the SAME DIRECTION &
SAME proportions
Both policies change in
the DIFFERENT
8 FP exp. = MP tough FP cont. = MP easy DIRECTION
but in SAME
PROPORTIONS
16
 Case Nos. 1B
Case Nos. 1A

FP = K & MP FP = K & MP

RoI RoI
LMn

LMo LMo
LMn
in En
io Eo io Eo
in En

ISo ISo

Yo Yn Income Yn Y o Income

RoI falls & Income increases RoI rises & Income decreases

17
 Case Nos. 2A Case Nos. 2B

MP = K & FP MP = K & FP

RoI RoI

LMo LMo

in
En io Eo
io Eo In En

ISn ISo
ISo ISn

Yo Yn Income Yn Yo Income

RoI rises & Income increases Price falls & Income decreases

18
 Case Nos. 3A Case Nos. 3B

MP MP FP
FP

RoI RoI
LMn
LMo LMo
LMn
io Eo
in En In En
io Eo

ISn ISo
ISo ISn

Yo Yn Income Yn Yo Income

RoI rise < increase in Income RoI fall < decrease in Income

19
 Case Nos. 4A Case Nos. 4B

MP MP FP
FP

RoI RoI LMn

LMo En LMo
in
LMn Eo
io Eo io
in En
ISo
ISn ISn
ISo

Yo Yn Income Yn Yo Income

RoI fall < the increase in Income RoI rise < the decrease in Income

20
 Case Nos. 5A Case Nos. 5B

MP FP MP FP

RoI RoI

LMo
LMn
LMn LMo
En
io Eo in

in En io Eo
ISo ISn

ISn
ISo

Yn Yo Income
Yo Yn Income

RoI fall > the decrease in Income RoI rise > the increase in Income

21
 Case Nos. 6A Case Nos. 6B

MP MP FP
FP

RoI RoI
LMn
LMo
LMn in En LMo

io Eo io Eo

in En ISn
ISo ISo
ISn

Yo Yn Income Yn Yo Income

RoI fall > the increase in Income RoI rise > the decrease in Income

22
 Case Nos. 7A Case Nos. 7B

MP MP FP
FP

RoI RoI
LMo LMn

LMn LMo
En
Eo io Eo
io En

ISn ISo
ISo ISo

Yo Yn Income Yn Yo Income

RoI = K & Income increases RoI = K & Income decreases

23
 Case Nos. 8A Case Nos. 8B

MP FP MP FP

RoI RoI LMn

LMo in LMo
En
io LMn
Eo
io Eo
in En
ISo ISn
ISo
ISn

Yo Income Yo Income

RoI falls & Income = K RoI rises & Income= K

24
Case
A B Comments
No.

1 FP = K & MP easy FP = K & MP tough

1 policy constant & the
other changes
2 FP exp. & MP = K FP cont. & MP = K

3 FP exp. > MP easy FP cont. > MP tough

Both policies change in
the SAME DIRECTION but
in
4 FP exp. < MP easy FP cont. < MP tough DIFFERENT
5 FP exp. > MP tough FP cont. > MP easy PROPORTIONS
Both policies change in
DIFFERENT
DIRECTIONS & in
6 FP cont. < MP easy FP exp. < MP tough DIFFERENT
PROPORTIONS
Both policies change in
7 FP exp. = MP easy FP cont. = MP tough the SAME DIRECTION &
SAME proportions
Both policies change in
the DIFFERENT
8 FP exp. = MP tough FP cont. = MP easy DIRECTION
but in SAME
PROPORTIONS
25
 TYPES OF FISCAL POLICIES
EXPANSIONARY FP: CONTRACTIONARY FP:
• Increase in govt’s exp. • Reduction in govt’s exp.
• Rise in income generating • Fall in income generating
capacity in the economy, due capacity in the economy due to
to Positive Multiplier Effect the Reverse Multiplier Effect
• IS curve shifts upwards to the • IS curve shifts downwards to
right the left

TYPES OF MONETARY POLICIES

EASY MONETARY POLICY:
• Credit creation and credit access is
made easier
• Fall in RoI; Fall in CRR,
Rediscount Rates are lowered
• LM curve shifts downwards to the
right
TIGHT MONETARY POLICY:
• Credit creation and credit
access is made tougher
• Rise in RoI; Rise in CRR,
Rediscount Rates are hiked
• LM curve shifts upwards to
the left 2
6
 Crowding Out Effect
COE Dynamics

ISSUE
RoI IS2
LM1 1.Higher government expenditures
IS1
2.IS shifts upwards to the right (E1 to E2)
LM2
3.Increase in income, via (+)KG (Y1 to Y2)
4.But RoI increases (i1 to i2) due to increase in
MD by Govt & MS = constant
i2 E2
5. Private investments deterred
E1
i1 E3 SUPPOSE:
1. RoI is at i1 and FP is expansionary (E2 to E3),
Pvt. Investments increase and so Income
increases (by Y2 Y3)
2. As this does not happen, COE (Y3 Y2 ) occurs

SOLUTION:
If Mon Policy becomes easy, causing LM to
Y1 Y2 Y3 Income shift towards E3, COE is overcome

COE
 Crowding In Effect
CIE Dynamics

RoI ISSUE
IS1 1.Lesser government expenditures
LM1 2.IS shifts downwards to the left (E1 to E2)
IS2
3.Fall in income, via (-)KG (Y1 to Y2)
LM2
4.But RoI falls (i1 to i2) due to decease in
MD by Govt & MS = constant
5. Private investments encouraged
i1 E1
SUPPOSE:
i2 E2 1. RoI is at i2 and FP is original (E2 to E3),
E3
Pvt. Investments increase and so Income
increases (by Y1 Y3)
2. If this happen, then CIE (Y2 Y3 ) occurs

SOLUTION:
1.If Mon Policy becomes easy, causing LM to
Y2 Y1 Y3 Income
shift downwards towards E3, then,

CIE CIE becomes a permanent occurrence

 Crowding Out Effect Crowding In Effect

RoI IS2
LM1
IS1
RoI
LM2
LM1
IS1

IS2 LM2

i2 E2

E1
i1 E3 E1
i1

i2 E2
E3

Y1 Y2 Y3 Y2 Y1 Y3
Income Income

CIE
COE