IS LM presentation

7/30/2019 IS LM presentation

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IS & LM ModelPresented

by

MUHAMMAD HASEEB

Assistant Professor

Department of Economics

DA COLLEGE FOR WOMEN PH-VIII, KARACHI


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the IS curve, and its relation to:

the Keynesian cross

the LM

curve, and its relation to: the theory of liquidity preference

how the IS-LM model determines income and the

interest rate in the short run when P

is fixed

In this topic you will learn:


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def: a graph of all combinations of r and Y that result

in goods market equilibriumi.e. actual expenditure (output)

= planned expenditure

The equation for the IS curve is:

The IS curve


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r I

Deriving the IS curve

Y2Y1

Y2Y1Y

PE

r

Y

PE =C +I(r1)+GPE =C +I(r2)+G

r1

r2

PE =Y

IS

IPE

Y


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A fall in the interest rate motivates firmsto increase investment spending, whichdrives up total planned spending (PE).

To restore equilibrium in the goods

market, output (a.k.a. actualexpenditure, Y) must increase.

Why the IS curve is negatively sloped


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Interest sensitivity of investment demand(responsiveness of investment demand due

to change in interest rate).Higher the interest sensitivity ofinvestment demand flatter the IS curve

Multiplier = 1/(1 mpc) (for three sectorclosed economy model with lump sum tax)

Higher the mpc (lower mps) higher the

multiplier flatter the IS curve

Factors affecting the slope of IS curve


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Government purchases

Taxes Investment

Wealth

Exchange rate (for an open economy)

Factors that shift the IS Curve


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We can use the IS-LM model to see

how fiscal policy (G and T) affectsaggregate demand and output.

Lets start by using the Keynesiancross to see how fiscal policy shiftsthe IScurve

Fiscal Policy and the IS curve


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At any value of r, GPE Y

Shifting the IS curve: G

Y2Y1

Y2Y1Y

PE

r

Y

PE =C +I(r1)+G1PE =C +I

(r1

)+G2

r1

PE =Y

IS1

The horizontal

distance of the

ISshift equals

IS2

so the IScurve

shifts to the right.

Y


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Reasons for holding money classified byKEYNES according to motive. He

identified the TRANSACTIONS,PRECAUTIONS and SPECULATIVEDEMAND FOR MONEY.

A simple theory in which the interestrate is determined by money supply and

money demand.

The Theory of Liquidity Preference


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The supply ofreal moneybalances

is fixed:

Money supply

M/Preal money

balances

rinterest

rate


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Demand forreal moneybalances:

Money demand

M/Preal money

balances

rinterest

rate

L(r)


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The interestrate adjuststo equate the

supply anddemand formoney:

Equilibrium

M/Preal money

balances

rinterest

rate

L(r)

r1


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To increase r,

Central bank

reduces M

How central bank raises the interest rate

M/Preal money

balances

rinterest

rate

L(r)

r1

r2


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Now lets put Y back into the money demand function:

The LM curve

The LMcurve is a graph of all combinations ofr

and Y that equate the supply and demand for

real money balances.

The equation for the LMcurve is:


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Deriving the LM curve

M/P

r

L(r,Y1)

r1

r2

r

YY1

r1

L(r,Y2)

r2

Y2

LM

(a) The market forreal money balances(b) The LMcurve


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An increase in income raises moneydemand.

Since the supply of real balances isfixed, there is now excess demand inthe money market at the initial interest

rate. The interest rate must rise to restore

equilibrium in the money market.

Why the LM curve is upward sloping


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Interest sensitivity of money demand(responsiveness of money demand due tochange in interest rate).

Higher the interest sensitivity of

money demand flatter the LM curve

Factors affecting the slope of LM curve


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Factors that shift the LM Curve Nominal Money Supply

Price level

Expected Inflation

All those factors that change the moneydemand (increase/decrease of wealth,increase/decrease in the risk of alternativeassets, increase/decrease in liquidity of

alternative assets and increase and decrease inthe efficiency of payment technologies


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How Money supply shifts the LM curve

M/P

r

L

(r

,

Y1

)

r1

r2

r

YY1

r1

r2

LM1

(a) The market forreal money balances(b) The LMcurve

LM2


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The short-run equilibrium isthe combination of r and Y

that simultaneously satisfies

the equilibrium conditions in

the goods & money markets:

The short-run equilibrium

Y

r

IS

LM

Equilibrium

interest

rate

Equilibrium

level of

income


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Fiscal Policy

An increase in Government Spending We begin by examining how changes in fiscal policy(taxes and spending) alter the economys short-runequilibrium.

An increase in government spending is represented in

the next slide. The equilibrium of the economy moves from point A to

point B. Income rises from Y1 to Y2 and the real interestrate rises from r1 to r2.

When the government increases its spending, total incomeY begins to rise (from the Keynesian cross model). As Yrises, the economys demand for money rises and so,assuming that the supply of real balances is fixed, theinterest rate r begins to rise. As r rises, I falls thus partiallyoffsetting the effects of the increased government

spending.


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Fiscal Policy

An increase in Government Spending

The increased government spending has crowded-

out some of the investment spending in theeconomy.

The case of a tax cut is similar. This is represented inthe next slide.


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Fiscal PolicyA decrease in Government Tax


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Monetary Policy

An increase in Money Supply We now examine the effects of monetary policy. This

is represented in the next slide. Consider an increase in the money supply. An increase in M

leads to an increase in M/P since we are assuming that P isfixed. The LM curve shifts downward and the economymoves from point A to point B. The increase in the moneysupply lowers the interest rate and raises the level of income.

This is because the increase in M/P lowers r and this causes I

to increase since I is inversely related to r. This, in turn,increases planned expenditure, production and income Y.

This process is called the monetary transmission

mechanism.


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Monetary PolicyAn inc rease in Money Supply


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Fiscal And Monetary Interaction

We can now consider simultaneous fiscal andmonetary policy in the IS/LM model in the next slide.

Slide (a) shows the effects of a tax increase, holding thereal money supply constant.

Slide (b) shows the effects of a tax increase,accompanied by a contraction in the real money supply.

This keeps the interest rate constant in the economy. Slide (c) shows the effect of the tax cut combined with

an expansion of the real money supply. The effect ofthis policy is to keep the level of income constant in theeconomy.


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Fiscal And Monetary Interaction


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The Big PictureKeynesianCross

Theory of

Liquidity

Preference

IScurve

LM

curve

IS-LM

model

Agg.

demand

curve

Agg.

supply

curve

Model of

Agg.

Demandand Agg.

Supply

Explanation

of short-run

fluctuations


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Macroeconomics 4th Edition by Gregory Mankiw

Macroeconomics by 7th Edition Dornbusch & Fisher

Macroeconomics by 5th Edition Richard T Froyan

Economics 3rd Edition by John Sloman

Internet

REFERENCES


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Documents

IS LM presentation