The IS-LM model

The IS curve

The LM curve

Macroeconomic equilibrium and policy

IS

LM

Macroeconomic equilibrium and policy

Income, Output Y

Inte

rest ra

tei

Y*

i*

The intersection of IS and

LM represents the

simultaneous equilibrium on

the goods and the money

market…

…For a given value of

government spending G,

taxes T, money supply M

and prices P

Macroeconomic equilibrium and policy

• IS-LM can be used to assess the impact of exogenous shocks on the endogenous variables of the model (interest rates and output)

• One can also evaluate the effectiveness of the policy mix, i.e. the combination of:– Fiscal policy: changes to government spending

and taxes

– Monetary policy: changes to money supply

Policy in the IS-LM Model

• Fiscal Policy

– Expansionary fiscal policy shifts the IS

curve to the right

– Contractionary fiscal policy shifts the IS

curve to the left

• Monetary Policy

– Expansionary monetary policy shifts

the LM curve to the right

– Contractionary monetary policy shifts

the LM curve to the left

Fiscal Policy, the Interest Rate and the IS

Curve

• Fiscal contraction: a fiscal policy that reduces the budget deficit.

– Reducing G or increasing T

• Fiscal expansion: increasing the budget deficit.

– Increasing G or decreasing T

• Taxes (T) and government expenditures (G) affect the IS curve, not the LM curve.

Monetary Policy, the Interest Rate, and

the LM Curve

• Monetary contraction (tightening)

refers to a decrease in the money

supply.

• An increase in the money supply is

called monetary expansion.

• Monetary policy affects only the LM

curve, not the IS curve.

Policy Analysis with

the IS-LM Model

A Closer Look at Policy

• Fiscal Policy and Crowding Out

• Monetary Policy and the Liquidity Trap

Real World Monetary and Fiscal Policy

Fiscal Crowding Out1. The multiplier is 2 and

government spending increases by

$500, so the IS increases by $1000.

$6600

IS0

LM

Aggregate Output

IS1

$1000

4%

$6000

5%

$7000

2. The increase in income

increases money demand

which increases interest

rates from 4% to 5%.

3. The increase in the interest

rate causes a decrease in

investment so that the increase

in income is only $600, less that

the full multiplier effect.

Fiscal Policy and Crowding Out

• When government expenditures increase or taxes are reduced, output and income begin to increase.

• The increase in income increases the demand for money.

• The increase in money demand increases the interest rate.

• Higher interest rates cause a decrease in investment, offsetting some of the expansionary effect of the increase in government spending.

Full Crowding Out1. The multiplier is 2 and

government spending increases by

$500, so the IS increases by $1000. 2. If the demand for money

is totally insensitive to the

interest rate, the interest rate

increases from 4% to 9%.

3. The increase in the interest

rate causes a decrease in

investment that completely offsets

the increase in government spending.

IS0

LM

Aggregate Output

IS1

$1000

4%

$6000

9%

$7000

Ineffective Fiscal Policy

• When complete crowding out occurs, fiscal policy is ineffective, changing only interest rates, not output.

• Crowding out is greater if:

– Money demand is very sensitive to income changes

– Money demand is not very sensitive to interest rate changes

Monetary Policy and Liquidity Traps

In a liquidity trap, increases

in the money supply do not

decrease interest rates, so

investment and output do

not increase.

The RBI increases the

money supply which

decreases interest rates

and increases investment

and output.

Y1

IS

LM0

Aggregate Output

Y0

r0

r1

LM1

IS

LM0

Aggregate Output

Y0

r0

LM1

Ineffective Monetary Policy

• Investment is not sensitive to the interest rate

– If investment does not respond to interest rate changes (the IS curve is steep), monetary policy in ineffective in changing output.

• Liquidity trap

– If increases in the money supply fail to lower interest rates, monetary policy is ineffective in increasing output.

Interaction between monetary and fiscal policy

• IS-LM Model: Monetary and fiscal policy variables (M, G, and T) are exogenous.

• Real world: Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa.

• Such responses by the central bank may affect the effectiveness of fiscal policy

The RBI’s response to G > 0

• Suppose the government increases G.

• Possible RBI responses:

1. hold M constant

2. hold r constant

3. hold Y constant

• In each case, the effects of G on Yare different…

When G increases,

the IS curve shifts right.

IS1

Response 1: Hold M constant

Y

rLM

r1

Y1

IS2

Y2

r2

If RBI holds M constant,

then LM curve does not

shift.

As a result, interest rates

rise. This has a crowding-

out effect. Consequently,

GDP increases, but not a

lot.

Response 2: Hold r constant

If Govt. raises G,

the IS curve shifts right.

To keep r constant, Fed

increases M

to shift LM curve right.

Results:

3 1Y Y Y

0r

Y

r

IS1

IS2

LM1

LM2

Y1 Y2 Y3

r2

r1

Response 3: Hold Y constant

To keep Y constant, RBI

reduces M

to shift LM curve left.

0Y

3 1r r r

If Govt. raises G,

the IS curve shifts right.

IS1

Y

rLM1

r3

r1

LM2

Y2Y1

IS2

r2

Shocks in the IS-LM model

IS shocks: exogenous changes in the demand for goods & services.

Examples: – stock market boom or crash

change in households’ wealthC

– change in business or consumer confidence or expectations

I and/or C

Shocks in the IS-LM model

LM shocks: exogenous changes in the demand for money.

Examples:– a wave of credit card fraud increases demand

for money.

– more ATMs or the Internet reduce money demand.

Analyze shocks with the IS-LM Model

Use the IS-LM model to analyze the effects of

1. a boom in the stock market that makes consumers wealthier.

2. after a wave of credit card fraud, consumers using cash more frequently in transactions.

For each shock,

a. use the IS-LM diagram to show the effects of the shock on Y and r.

b. determine what happens to C, I, and the unemployment rate.

Macroeconomic equilibrium and policy

The two policies are not independent, as they bothaffect the endogenous variables:

The interest rate i

Income Y

Hence the idea of a policy mix…

3 examples of policy mix issues

The good: the Clinton deficit reduction in 1993,

The bad: the German reunification in 1992,

The ugly : the debate on the “liquidity trap”.

LM’

Macroeconomic equilibrium and policy

1. Clinton decides to reduce the US

deficit (by increasing taxes) , which

shifts IS to the left

3. The end result is that output is held

constant, with a strong fall in interest

rates

2. At the same time, Alan Greenspan

increases money supply in order to

stimulate output

IS’

LM

Income, Output Y

Inte

rest ra

tei

Y2

i2

Y1

i3

IS

The Clinton deficit reduction in 1993

i1

IS’

LM

Macroeconomic equilibrium and policy

1. The German reunification resulted in

a large shift of IS to the right, mainly

because of the extra government

spending and increase in consumption

from the ex DDR

3. The end result of this lack of

coordination is that output was slightly

reduced, with a large increase in

interest rates.

2. At the same time, the Bundesbank

drastically reduced money supply due

to inflation fears, as the ostmark/DM

exchange rate had been set at 1 for 1

due to political reasons

IS

LM’

Income, Output Y

Inte

rest ra

tei

Y2

i2

Y1

i1

The German reunification in 1992

i3

IS’

LM’

Macroeconomic equilibrium and policy

1. The subprime-based financial crisis

has frozen credit markets as well as

depressed consumption. This has

caused a large fall in investment,

shifting IS to the left

3. But these policies have had no

effect, and the rate of interest is

practically zero (ZIRP!)

2. The central bank have responded by

injecting large amounts of liquidity in

the markets, and making credit easily

available(“Quantitative easing”). This

pushes LM to the right.

IS

LM

Income, Output Y

Inte

rest ra

tei

Y1

i1

Y2

i2

The current liquidity trap ?

3. The only way out is a large fiscal

policy push.