IS-LM Summary

The IS Curve: Describes the combinations of income Y and interest rate

i for which the goods market (and savings market) is in equilibrium:
 IS-LM Summary
The LM Curve: Describes the combinations of income Y and interest
rate i for which the money (and other assets) market is in equilibrium:

Ms = Md = P Y L(i)

‡ Numerical Example: Assume L(i) = a / i

with a = 1, P = 5 and Ms = 12.

Assume Y = 0.24. What is a price of a (zero coupon)

bond that promises to pay $100 in one year?
Pb * (1 + i) = 100 ; i = 5 * 0.24 / 12 =10%
Pb = 100 / 1.1 = $ 90.91
 IS curve LM curve
Real i Real i

I Li
Y Y

S LY
S = I + G – NT + NX Ms = Li +LY
IS-LM
Real i
Excess supply
LM Excess demand
of money for money

Y
Real i
Excess demand Excess supply
for goods of goods
IS

Y
Equilibrium
In the short run, Real i
LM Short Run
Fiscal policy (IS) and
Equilibrium
Monetary policy (LM) IS
can change the
equilibrium output and Y
interest rate.

In the long run, Real i Ypot

equilibrium output is LM Long Run
given by the potential Equilibrium
IS
output (available
resources and Y* Y
technology)
Fiscal Policy Expansion
Ypot
In the short run, Real i
LM0 E1
an increase in G or a Short Run
decrease in NT increases IS1 Equilibrium
GDP and real interest IS0
rate. Y
In the long run, Ypot LM2
prices increase, Real i LM0 E2
thus the real supply of Long Run
Equilibrium
money decreases. The IS1
IS0
equilibrium output is
given by the potential Y
output, real interest
increases increases even
more.
Monetary Policy Expansion
Ypot LM0
In the short run, Real i
LM1 E1
an increase in nominal Short Run
money balances IS0 Equilibrium
increases Ms and GDP
and decreases the real Y
interest rate. Ypot LM0=LM2
In the long run, Real i LM1 E2
as prices increase, Long Run
the real supply of money IS0 Equilibrium
decreases.
GDP and real interest Y
rate return to its original
levels.
Problem (Demand for money & Fiscal & Monetary policies)
Suppose that interest is paid on money balances at the rate: iM
(a) How would you expect this to affect the specification of the demand for
money?
(b) Suppose that iM = a i where i is the nominal interest rate on bonds and
0 < a < 1. What is the new money market equilibrium condition?
(c) How is the slope of the LM curve affected?
(d) What does your analysis suggest will be the impact of the introduction
of interest bearing current accounts on the effectiveness of fiscal and
monetary policies.
Problem (Demand for money & Fiscal & Monetary policies)
Suppose that interest is paid on money balances at the rate: iM
(a) How would you expect this to affect the specification of the demand for
money?
(b) Suppose
Previously, thatMoney
iM = aidemand
where i was
is thegiven
nominal
by: interest rate
Mdon bonds and
= PYL(i)
0where
< a <money
1. What is the new
demand money
depends market equilibrium condition?
positively
(c) How is the and
on income slopenegatively
of the LMoncurve affected?
interest rates,
(d) What
i, paiddoes your analysisE.g.
on bonds. suggest will be the impact ofMd the= introduction
αY – β i
of interest
(where bearing
α and β arecurrent
positiveaccounts on the effectiveness of fiscal and
constants)
monetary policies.
Now, when interest rate is paid on money balances, Md = PYL(i , iM)
where money demand depends positively
on income, negatively on interest rates, i,
paid on bonds and positively on interest
rates, iM paid on money balances. E.g. Md = αY – βi + γ iM
(where α, β and γ are positive constants)
(b) Suppose that iM = a i where i is the nominal interest rate on bonds and
0 < a < 1. What is the new money market equilibrium condition?

Money demand: Md = αY – βi + γ iM
Md = αY – βi + γ a i
Money market equilibrium: Md = Ms:
Ms = αY – βi + γ a i

(c) How is the slope of the LM curve affected?

The LM curve represents the combinations of income Y and interest rate

i for which the money market is in equilibrium.

From money market equilibrium condition, Ms = αY + i [γ a - β]

From money market equilibrium condition, Ms = αY + i [γa - β]
We can write the equation of the LM curve as:
MS αY
i= −
γa − β γa − β
α
Previously, a = 0 and slope =
β
α
Now, a > 0 and slope =
β − γa

If β > γa, the slope of the LM curve increases so that the LM curve
becomes steeper.
If β < γa , the slope of the LM curve becomes negative and we will
then have a downward sloping LM curve!
(d) What does your analysis suggest will be the impact MS αY
of the introduction of interest bearing current accounts i = γa − β − γa − β
on the effectiveness of fiscal and monetary policies.
If β > γa , fiscal policy will have less impact on the economy.
Consider an expansionary fiscal policy, say i i
LM
an increase in government spending G. IS

↑ G ⇒↑ Z ⇒↑ Y ⇒↑ M d ⇒↑ i ⇒↓ I ⇒↓ Z ⇒↓ Y
The increase in G increases demand Z. Pictured from the
Keynesian cross diagram, the demand function shifts
upwards while the IS curve shifts to the right (a change in Y M
Z
exogenous variable G shifts both curve) leading to upward
pressure on output Y.
However, the increase in output, leads to a rise in demand
for money, so that in the money market diagram, the Md
curve shifts to the right.
Interest rate rises and this leads to a fall in investment
which manifests itself via a movement along the IS curve Y
(since i is an endogenous variable in the i-Y plane) and via a downward shift for the expenditure
function in the Keynesian cross diagram (since i is an exogenous variable in the Z-Y plane) .
Output falls but the fall in output as a result of the rise in the interest rate is less than the
initial rise in output so that overall, aggregate output rises.
(d) What does your analysis suggest will be the impact MS αY
of the introduction of interest bearing current accounts i = γa − β − γa − β
on the effectiveness of fiscal and monetary policies.
If β > γa , fiscal policy will have less impact on the economy.
Consider an expansionary fiscal policy, say
an increase in government spending G. LM
Now, if the LM curve were steeper, the effect of an
expansionary fiscal policy on output would be even
lower. This is because interest rates rise more with
a steep LM curve and therefore the fall in
investment is bigger than with the less steep LM
IS
curve.

Furthermore, if β < γa , the slope of the

LM curve becomes negative! In this case LM
an expansionary fiscal policy has the
opposite effects from what is expected!

IS
Now, let us consider the impact of MS αY
an expansionary monetary policy, i= −
γa − β γa − β
say an increase in Money supply.
i
An expansionary monetary policy
increases money supply. As a result
the LM curve shifts to the right and LM
interest rates falls, leading to a rise
in investment and a rise in output Y.

If , β > γa monetary policy will

IS

have greater impact on the economy. Y

The expansionary monetary policy would lead to the same rightward

horizontal shift in both LM curves. As can be seen from the diagram, this
leads to a greater impact of monetary policy on the economy.

⎛ β − γa ⎞
s
To see this, consider first the equation of the M
Y= +⎜ ⎟i
LM curve when interest rate is kept constant: α ⎝ α ⎠
 MS αY
To see this, consider first the equation of the i= −
LM curve when interest rate is kept constant: γa − β γa − β
⎛ β − γa ⎞
s i
M
Y= +⎜ ⎟i
α ⎝ α ⎠ LM
−
Keeping i fixed at i while
varying the money supply Ms
lead to a similar change in Y. IS
∂Y 1
= if i is fixed.
∂M s
α Y

Thus, the expansionary monetary

policy would lead to the same
rightward horizontal shift in both LM curves.

As can be seen from the diagram, this leads to a greater impact of

monetary policy on the economy when LM is steeper (and a greater.)
 MS αY
Finally, if β < γa , the slope of i= −
the LM curve becomes negative. γa − β γa − β
In this case we an expansionary i
monetary policy has an even
greater effect on output. LM

IS

KEYNES FRIEDMAN
i
i

Md Md