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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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