IS-LM Model

Where macroeconomic equilibrium is

 IS-LM the Definition
• The intersection of the "investment–saving" (IS) and
"liquidity preference–money supply" (LM) curves
models "general equilibrium" where supposed
simultaneous equilibrium occur in both the goods
and the asset markets. Yet two equivalent
interpretations are possible:
• first, the IS–LM model explains changes in national
income when price level is fixed short-run;
• second, the IS–LM model shows why an aggregate
demand curve can shift.
 IS-LM and AD curve
• AD can shift with monetary and fiscal policy
instruments to provide stability;
• However the shift of AD is related with IS-LM.
• It is important to understand the main theory
on IS-LM to be more clear on the movements
of AD.
 Characteristics of the IS-LM
• The three critical exogenous, i.e. external, variables in the
IS-LM model are liquidity, investment, and consumption.
According to the theory, liquidity is determined by the size
and velocity of the money supply. The levels of investment
and consumption are determined by the marginal decisions
of individual actors.
• The IS-LM graph examines the relationship between output,
or gross domestic product (GDP), and interest rates. The
entire economy is boiled down to just two markets, output
and money; and their respective supply and demand
characteristics push the economy towards an equilibrium
point.
 Velocity of the Money Supply
• The velocity of money is a measurement of the rate
at which money is exchanged in an economy. It is
the number of times that money moves from one
entity to another. It also refers to how much a unit
of currency is used in a given period of time. Simply
put, it's the rate at which consumers and businesses
in an economy collectively spend money.
• High money velocity is usually associated with a
healthy, expanding economy. Low money velocity is
usually associated with recessions and contractions.
 Velocity of the MS and Business Cycles
• Economies that exhibit a higher velocity of money
relative to others tend to be more developed. The
velocity of money is also known to fluctuate with
business cycles. When an economy is in an
expansion, consumers and businesses tend to
more readily spend money causing the velocity of
money to increase. When an economy is
contracting, consumers and businesses are usually
more reluctant to spend and the velocity of money
is lower.
 Example to Velocity of the Money Supply

• For example, assume a very small economy that has

a money supply of $100 and only two people. Bob
sells pencils and Jane sells paper. Bob starts with the
$100 and buys $100 worth of paper from Jane. Jane
turns around and buys $100 worth of pencils from
Bob. Bob and Jane's economy now has a "gross
domestic product" of $200 even though the money
supply is only $100. If Bob and Jane do the same two
transactions every month, their "GDP" will be $2,400
per year, though the money supply is only $100.
 The Formula

• Velocity = GDP / Money Supply

• Velocity of the money for the example can be
calculated like that....
• V = $2,400 / $100
• V = 24

• GDP = Money Supply x Velocity of Money

 Why does velocity of money matter?
• As the equation illustrates, GDP cannot be controlled
through money supply alone. If money supply is
increased, but velocity decreases, GDP may stay the
same or even decline. If money supply is decreased
but velocity increases, GDP could increase. Velocity
is much more difficult to control than money supply,
so be wary of macroeconomic analysis that equates
an increase in money supply with an increase in GDP
and/or inflation (and vice versa) without taking
velocity of money into consideration.
Velocity of Money examples from...
• Eurozone countries has less than 1 velocity of
money.
• In US it is around 1.4
 Back to IS-LM
• The LM curve depicts the set of all levels of
income (GDP) and interest rates at which
money supply equals money (liquidity)
demand. The LM curve slopes upward
because higher levels of income (GDP) induce
increased demand to hold money balances for
transactions, which requires a higher interest
rate to keep money supply and liquidity
demand in equilibrium.
f
 IS Curve
• The IS curve is the set of combinations of
interest rate r and national income Y that keep
the goods market in equilibrium. If the interest
rate r increases, business demand for
investment will decline, and so (in most
models) will consumer demand. That will
create excess supply at the original value of
national income; to restore equilibrium in the
goods market, national income must fall.
WHY IS curve is downward sloping
• It slopes downward because a high price level, ceteris
paribus, means a small real money supply, high interest rates,
and a low level of output.
• Investment is not constant. It depends primarily on two
factors:
• Production (+)
• Interest rate (-):
• the higher the interest rate, the more expensive it is to
borrow in order to invest, the lower the level of investment.
• Investment function: I = I (Y, i )
• AD = C (Y, T) + I (Y, i) + G
 LM Curve
• The LM curve shows the combinations of interest rates
and levels of real income for which the money market is in
equilibrium. It shows where money demand equals
money supply. For the LM curve, the independent variable
is income and the dependent variable is the interest rate.
• In the money market equilibrium diagram, the liquidity
preference function is the willingness to hold cash. The
liquidity preference function is downward sloping (i.e. the
willingness to hold cash increases as the interest rate
decreases). Two basic elements determine the quantity
of cash balances demanded:
 The LM Curve
• The LM curve, "L" denotes Liquidity and "M"
denotes money, is a graph of combinations of
real income, Y, and the real interest rate, r,
such that the money market is in equilibrium
(i.e. real money supply = real money demand).
The Financial Market LM relation
 Two basic elements determine the quantity of cash balances
demanded:

• 1) Transactions demand for money: this includes both (a) the

willingness to hold cash for everyday transactions and (b) a
precautionary measure (money demand in case of
emergencies). Transactions demand is positively related to
real GDP. As GDP is considered exogenous to the liquidity
preference function, changes in GDP shift the curve.
• 2) Speculative demand for money: this is the willingness to
hold cash instead of securities as an asset for investment
purposes. Speculative demand is inversely related to the
interest rate. As the interest rate rises, the opportunity cost of
holding money rather than investing in securities increases.
So, as interest rates rise, speculative demand for money falls.
 IS-LM and AD
• Imagine a fixed IS curve and an LM curve shifting hard
left due to increases in the price level. As prices
increase, Y falls and i rises. Now plot that outcome on
a new graph, where aggregate output Y remains on the
horizontal axis but the vertical axis is replaced by the
price level P. The resulting curve, called the aggregate
demand (AD) curve, will slope downward, as below.
The AD curve is a very powerful tool because it
indicates the points at which equilibrium is achieved in
the markets for goods and money at a given price
level.
• Because the AD curve is essentially just another
way of stating the IS-LM model, anything that
would change the IS or LM curves will also shift the
AD curve. More specifically, the AD curve shifts in
the same direction as the IS curve, so it shifts right
(left) with autonomous increases (decreases) in C,
I, G, and NX and decreases (increases) in T. The AD
curve also shifts in the same direction as the LM
curve. So if MS increases (decreases), it shifts right
(left), and if Md increases (decreases) it shifts left.
 The IS-LM model - Fiscal policy
• What happens when taxes increase?
• Leftward shift of the IS curve. Why?
• No shift of the LM curve. Why?
• The increase in taxes shifts the IS curve. The
LM curve does not shift, the economy moves
along the LM curve.
• When taxes increase:
• Consumption goes down, leading to a
decrease in output/income.
• The decrease in income reduces the demand
for money. Given that the supply of money is
fixed, the interest rate must decrease to push
up the demand for money and maintain the
equilibrium.
The impact of tax increase on IS-LM
The IS-LM model - Monetary policy
• What happens when the money supply
increases?
• No shift of the IS curve. Why?
• Downward shift of the LM curve. Why?
• The increase money supply shifts the LM
curve. The IS curve does not shift, the
economy moves along the IS curve.
• When money supply increases:
• To maintain the equilibrium, the demand for
money should go up. For that to happen, the
interest rate must decrease.
• The decrease in the interest rate favor
investment, demand for goods and
equilibrium output.
The effects of an increase in money supply
 The IS-LM model - Policy Mix
• The combination of monetary and fisscal
policies is called the policy mix.
• Bigger impact on output Allows a change in
the output level without a too large change in
the interest rate.
Policy mix for recession
 Questions
• 1) According to the IS-LM model, what happens
in the SR to the interest rate, income,
consumption, and investment under the
following circumstances? Be sure your answer
includes an appropriate graph.
• a.) The central bank increases the money supply.
• b.) The government increases government
purchases.
• c.) The government increases taxes.