Unit 2

 Unit 2: Economy in the short run

IS–LM framework
 fiscal and monetary policy
 determination of aggregate demand
 shifts in aggregate demand
 aggregate supply in the short and long run, and
aggregate demand aggregate supply analysis.

slide 1
 The IS-LM model

 The IS-LM model translates the General Theory of Keynes into

neoclassical terms (often called the neoclassic synthesis )
 It was proposed by John Hicks in 1937 in a paper called “Mr Keynes
and the "Classics": A Suggested Interpretation” and enhanced by
Alvin Hansen (hence it is also called the Hicks-Hansen model).

 The model examines the combined equilibrium of two markets :

 The goods market, which is at equilibrium when investments equal
savings, hence IS.
 The money market, which is at equilibrium when the demand for liquidity
equals money supply, hence LM.
 Examining the joint equilibrium in these two markets allows us to
determine two variables : output Y and the interest rate r.

slide 2
 The IS-LM model: Demand side
model
 The model rests on two fundamental assumptions
 All prices (including wages) are fixed and set =1.
 Only one commodity (Y) is produced in the economy.
 There exists excess production capacity in the economy, i.e, the
economy is not producing the full employment level of output.
 So, in short run,
 Y=Aggregate demand: Supply is demand determined in short run
 The supply is demand determined as long as the economy doesn’t
reach the full employment level. Full employment is a concept related to
long run .
 This is why, ISLM is called a demand side model.
.

slide 3
 IS curve

 IS curve is the locus of alternative combinations

of income and rate of interest that ensures the
commodity market equilibrium.
 IS curve is a downward sloping straight line

slide 4
 Why the IS curve is negatively
sloped
 A fall in the interest rate motivates firms to
increase investment spending, which drives up
the Aggregate demand.
 To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.

slide 5
 Points off IS curve

 All the points on IS

represent Commodity
market equilibrium.
 Any point above the
IS represents excess
supply of commodity,
i.e, Y has to be
reduced to bring the
economy back to
equilibrium
slide 6
 Points off the IS continued

 Any point below the

IS represents excess
demand for
commodity, i.e, Y
must increase to bring
the economy back to
equilibrium.

slide 7
 Class Quiz

 An IS curve represents ______________ equilibrium.

 Along and IS curve we must have saving ___ investment
 Slope of IS curve is ________________.
 In IS LM model, we consider 2 markets, namely _________ and
___________market.
 The IS LM model is a __________ side model
 In IS LM model, we assume that firms have excess capacity in
________.
 In IS LM model, supply is _______________________.
 Investment is __________ related to rate of interest.

slide 8
 Fiscal Policy and the IS curve

 Examples of fiscal policy: tax cut or decrease in

taxes , increase in government expenditure
 Examples of fiscal policy:
a) Fiscal expansion: increase in government
expenditure or decrease in tax
b) Fiscal contraction: decrease in government
expenditure or increase in tax

slide 9
 Shifting the IS curve following
increase in G or decrease in T
At any value of r,
G   Y
…so the IS curve
shifts to the right.

r Y1 Y2

r1

Y
IS1 IS2
Y
Y1 Y2

slide 10
 Fiscal policy and the IS curve:
continued
 Fiscal expansion increase in G or decrease in T increase in
Aggregate demand outward shift of IS
 If taxes are decreased, consumption is positively affected, i.e, C
increases-> aggregate demand increases->Y increases-> outward
shift in IS
 Fiscal contraction decrease in G or increase in T decrease in
aggregate demand inward shift of IS
 If taxes are increased, consumption is negatively affected, i.e, C
falls-> Aggregate demand falls -> Y decreases-> inward shift in IS.

slide 11
 Class assignment
 How will the following policies affect the IS curve?
a. A COVID income tax on rich people.

b. Instead of 100 days job guarantee scheme, government

decided to offer a 200 days job guarantee scheme.

c. The government decided to buy more arms.

d. Government decides to lower income tax rate on low
income group

slide 12
 The LM curve

 The LM curve shows all the combinations of

interest rates r and outputs Y for which the
money market is in equilibrium
The money market equilibrium condition is given by:
Money demand = money supply

slide 13
The LM curve
 LM curve in The LM curve
standard case is r
upward rising LM

r2

r1

Y1 Y2 Y

slide 14
 Why the LM curve is upward sloping

 An increase in income raises money demand.

 Since the supply of money is fixed, there is now
excess demand in the money market at the
initial interest rate.
 The interest rate must rise to restore equilibrium
in the money market.
 So, the Lm curve is upward rising.

slide 15
 Points off the LM

 All the points on the LM

curve represents
equilibrium in money
market
 Any point below LM
represents excess
demand of money, i.e,
rate of interest must be
increased to bring the
economy back to
equilibrium

slide 16
Points off the LM continued

 Any point above LM

represents excess
supply of money, i.e,
rate of interest must
be decreased to bring
the economy back to
equilibrium

slide 17
 The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets,
i.e, it is achieved at the point
of intersection between IS IS
and LM curves Y
Y  C (Y  T )  I (r )  G Equilibriu
m Equilibrium
interest level of
M P  L (r ,Y ) income
rate
slide 18
 Fiscal Policy and the IS curve

 We can use the IS-LM model to see

how fiscal policy (G and T ) affects
aggregate demand and output.
 Examples of expansionary fiscal policy: tax cut
or decrease in taxes , increase in government
expenditure

slide 19
 Shifting the IS curve: G

At any value of r, G  Aggregate

Expenditure (E)  Y
…so the IS curve
shifts to the right.

r
r1

Y
IS1 IS2
Y1 Y2 Y

slide 20
 Steps involved in expansionary
fiscal policy
 G increases
 Aggregate Expenditure (or aggregate
demand) increases
 IS shifts outward to IS’
 Y increases to Y’
 At Y’ the economy is below the LM curve
 So, there is disequilibrium in money market
 The rate of interest increases to restore
money market equilibrium
 Increase in interest rate leads to decrease in
private investment
 The output decreases to Y**.
 So, a part of increase in Y due to fiscal
expansion is crowded out. This is called
crowding out effect.
slide 21
 Shifting the IS curve: T<0 or tax cut

At any value of r,
Decrease in T=>
increase in
E=>increase in Y

…so the IS curve r

shifts to the right. r1

Y
IS1 IS2
Y1 Y2 Y

slide 22
 Steps involves in Tax cut

 T decreases
 Aggregate demand increases
 IS shifts outward to IS’
 Y increases to Y’
 But economy is below LM
 Excess demand for money
 Rate of interest increases
 private investment decreases
and finally Y decreases to Y**.
 Difference between Y’ and Y**
is called crowding out effect.

slide 23
 Shifting the IS curve: T>0

At any value of r,
Increase in T=>
Decrease in
E=>decrease in Y

…so the IS curve

shifts to the left.

slide 24
 Steps involves in increase in
taxes
 T increases
 Aggregate demand decreases
 IS shifts inward to IS’
 Y decreases to Y**

slide 25
 Crowding out effect: Definition

 The crowding out effect is an economic theory

arguing that rising public sector spending drives
down or even eliminates private sector
spending.
 Increase in public spending leads to excess
demand for money, causing increase in rate of
interest. As a result, private investment
decreases, causing decrease in Aggregate
demand and GDP of the economy.

slide 26
 Class assignment
 How will the following policies affect the IS or LM curves
and equilibrium values of Y and r?
a. A COVID income tax on rich people
b. Instead of 100 days job guarantee scheme, government
decided to offer a 200 days job guarantee scheme.
c. The government decided to buy more arms and
ammunition
d. Government decides to lower income tax rate on low
income group

slide 27
 Class assignment

 Calculate the impact on fiscal expansion on

aggregate output and investment of the
economy in the following situations
 a) the economy is at liquidity trap
 b) the economy faces a vertical LM curve

slide 28
 Monetary policy and LM curve

Example of monetary policy: increase in money supply

As money supply increases, LM curve shifts rightward.

 the shift in LM affects both output and interest rate

 Money is not neutral !!
 This is one of the central contributions of Keynes

slide 29
Monetary policy

1. An increase in money supply shifts

LM to the right ….

2. …Which reduces the rate of

interest...

3. …And increases output by

stimulating investment.

30 slide 30
 Monetary policy: continued

 As money supply increases, LM curve shifts

outward to LM’
 As a result, the rate of interest decreases at the
point of intersection between IS and LM’
 As rate of interest decreases, private investment
increases.
 As a result, aggregate demand increases,
causing increase in Y to Y2

slide 31
 Class Assignment

• Examine the impact of the following policies on

ISLM model
• Because of COVID the government decided to
print money
• The government reduces the money supply by
increasing CRR

slide 32
 Class assignment

 Explain the impact of following policies on Y, r

and I using ISLM model
 An increase in defense expenditure
 A new income tax regime, where the tax rate is
increases for high income group
 A monetary expansion
 A strict policy measure to reduce availability of
loan in the economy

slide 33
 IS-LM model and aggregate
demand curve continued
 M=Ky-hr (equation of LM in case of fixed price)
 If price is flexible, equation of becomes
 M/P=kY-hr (M/P is called real money balance)
 As price increases, real money balance falls
causing inward shift in LM at constant money
supply.
 As price decreases, real money balance rises ,
causing outward shift in LM at constant money
supply
slide 34
 IS-LM model and aggregate
demand curve continued
 Given IS curve is
unchanged, Y decreases
as price increases.
 So, there is and inverse
relation between
aggregate income (Y) and
price level (P)
 So, there is inverse
relationship between price
and output and it is
represented by aggregate
demand (AD ) curve.
slide 35
 IS-LM model and aggregate
demand curve continued
 So, given flexible price, the Aggregate demand
curve is downward sloping .
 The long run equilibrium occurs at the point of
intersection between Aggregate demand and
aggregate supply curve.
 Any fiscal or monetary expansion leads to
outward shift in Aggregate demand curve.
 Any fiscal or monetary contraction leads to inward
shift in aggregate demand curve.
slide 36
• There are three reasons for this negative
relationship.
• As the price level falls, real wealth rises,
interest rates fall.
• These effects stimulate spending on
consumption, investment.
• Increased spending on any or all of these
components of output means a larger
quantity of goods and services demanded.

slide 37 3
 Aggregate-Demand
Curve
• The AD curve might shift because of:
– Changes in consumption
– Changes in investment
– Changes in government purchases

• Recall, these are the four expenditure

components of real GDP in a closed
economy
– Y=C+I+G

slide 3838
 Shifts to the AD
Curve
-Increase in consumer spending
• Aggregate demand curve shifts to the right
-Decrease in consumer spending
• Aggregate demand curve shifts to the left
-Increase in investment
• Aggregate demand curve shifts to the right
-Decrease in investment
• Aggregate demand curve shifts to the left

slide 3939
 Shifts to the AD
Curve
– Increase in government purchases
• Aggregate demand curve shifts to the right
– Decrease in government purchases
• Aggregate demand curve shifts to the left.

slide 4040
 Class Assignment

 Identify the impact of the following policies on

AD curve
 i) post COVID19 fiscal stimulus package
 Ii) Post COVID 19 monetary expansion
 Iii) Increase in government expenditure on
health and education
 Iv) Increase in income taxes on higher income
group

slide 41
 Aggregate Supply
Curve
• AS: the total quantity of goods and services that
firms produce and sell at a given price level
– Importantly, its shape depends on the time horizon
• Long run aggregate-supply curve, LRAS
• Price level doesn’t affect long-run determinants of GDP:
– It is the supplies of labour, capital, natural resources
and technology that matter
– LRAS is vertical
– Real variables (GDP) do not depend on nominal ones
(prices)
• Short run
– Aggregate-supply curve is upward sloping slide 4242
 Shifts in the LRAS
curve
• The LRAS curve might shift because of:
– Any change in the natural rate of output
– Changes in labour
• immigration, births…
• changes in frictional and structural unemp. due to
government policy (minimum wage etc.)
– Changes in capital
• Increases in K increase productivity
– Changes in natural resources
– Changes in technological knowledge
slide 4343
Figure 9
The Short-Run Aggregate-Supply
Curve
Price Short-run
aggregate
Level 1. A decrease in
supply
the price level . . .
P1

P2 2. . . . reduces the quantity of

goods and services supplied
in the short run

Quantity of Output
Y2 Y1

In the short run, a fall in the price level from P1 to P2 reduces the quantity of output
supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky
prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this
positive relationship is only temporary.
slide 4444
 The short run or “surprise” AS
curve
• When the price level rises above the level
expected, output rises above its natural
rate
• When the price level falls below the level
expected, output falls below its natural
rate

slide 4545
 Shifts to the SRAS
curve
• The short-run AS curve might shift because of:
– Changes in labour, capital, natural resources, or
technological knowledge
• i.e. all those factors that explained movements in the
LRAS curve (since they shift SRAS and LRAS), but also
– Increase in expected price level leads to leftward
shift of AS
– Decrease in expected price level leads to rightward
shift of AS

slide 4646
 How will the following events affect the long run
and short run AS curve?
a) Labor migration causing increase in labor force.
b) improvement in technology leading to better
production efficiency.
c) Increase in expected price level.
d) Decrease in labor supply during COVID
pandemic.

slide 47 4
Exhibit
7The Long-Run Equilibrium
Price Long-run
aggregate
Level Short-run
supply
aggregate
supply

Equilibrium A
price

Aggregate
demand
Natural rate Quantity of Output
of output

The long-run equilibrium of the economy is found where the aggregate-demand

curve crosses the long-run aggregate-supply curve (point A). When the economy
reaches this long-run equilibrium, the expected price level will have adjusted to equal
the actual price level. As a result, the short-run aggregate-supply curve crosses this
point as well.
slide 4848
 Aggregate demand- aggregate
supply analysis
 Following any fiscal or
monetary expansion:
 AD curve shifts
outward, keeping AS
curve unaffected.
 As a result, both
aggregate price level
and output increase in
the economy.

slide 49
 Aggregate demand- aggregate
supply analysis
 Following any fiscal or
monetary contraction
 AD curve shifts
inward, keeping AS
curve unaffected.
 As a result, both
aggregate price level
and output decrease
in the economy.

slide 50