The IS-LM model

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Transcript The IS-LM model

Chapter 17
The IS-LM Model
Geog 3890: Ecological Economics
Economics is a two digit science …..
Outline of Topics
The Money Supply Theory of Income
IS: The Real Sector
LM: The Monetary Sector
The Federal Reserve Bank
Exogenous Changes in IS & LM
Junk Bonds and Timber Companies
Monetary vs. Fiscal Policy
Why is the Fed anti-inflation?
Relation of Bond Prices to Interest rate
Transaction Demand for Money
Inflation & Disinflation
S – Savings
I - Investment
L – Demand for Money
M – Money Supply
Liquidity Preference
Extending the Basic Market Equation?
• Muxn*MPPax = Muyn*MPPay to all goods (x, y, z,...), all
commodities (a, b, c, …), and all consumers (n, m, o, …)
• Crippling from a policy perspective. In order to predict anything you
have to know everything.
• What are the policy tools at the macroeconomists disposal?
• Monetary Policy (Money Supply and Interest Rates)
• Fiscal Policy (taxes & govt spending)
• IS-LM model (compromise between completeness & simplicity)
• John Hicks (1937) ‘Two Digit” compromise
• Real Sector (National Income, Savings, Investment, Rates of
Productivity of Capital, Government Spending, Taxation)
• Monetary Sector (Money Supply, interest Rates, Bond Sales)
The “Velocity” of Money
IS: The Real Sector
• In equilibrium when:
• Supply of Goods & Services (firms) = Demand for Goods & Services (households)
Leakages equal injections
National Income (Y) = National Output (GNP)
Leakages are Savings (S)
Injections are Investments (I)
Equilibrium Condition for Real Sector is S= I
• (leakages = injections)
• All of this is a function of interest rate ‘r’ and Income ‘Y’
• S(r, Y) = I(r, Y)
Why does the IS curve slope downward?
Lower interest rates -> more Investment (I)
Higher interest rates -> more Savings (S)
Low Income -> Low Savings
High Income -> High Savings
There are really two curves;
One for S and one for I. We
Look at how they vary with
Two other variables: Income (Y)
And interest rate ‘r’
An exercise for the student? 
LM: The monetary sector
We hold cash to avoid the
inconvenience of barter.
‘Transaction demand for money’
We also have a preference for
Higher the National Income the
more money is needed for
Real commodity money vs. Fiat
or token money
DM (demand for $) (M)
SM (Supply of $) (L)
SM = M = L(r, Y)
Key: The LM curve consists of all
those combinations of ‘r’ and
‘Y’ such that the aggregate
demand for cash balances is
equal to the given money
The ‘given money supply’
What’s up with that?
Combining IS and LM
• By combining IS and LM curves we find unique combinatin of ‘r’ and
‘Y’ (namely r* and Y*) that satisfies both S=I condition of the real
sector and the L=M condition of the monetary sector.
• The model is used in a comparative statics way to analyze the effect
on ‘r’ and ‘Y’ of the
• Endogenous Determinants
• Propensity to Save
• Efficiency of Capital Investment
• Liquidity Preference
How does economy move toward
Equilibrium after policies try to
Push it in a direction? (changing
Taxes, Spending, Interest Rates,
Money Printing, etc)
Junk Bonds &
Timber Companies
Exogenous Changes in IS & LM
• Changes outside domain of Monetary and Fiscal Policy
• Example – Changes in the Marginal Propensity to Save
• Such a change in savings rate might result from fears of an
economic downturn that would lead to lower wages and
greater unemployment. People decide to save more and
spend less of their extra income. This means that now S > I for
all the combinations of r and Y on the IS curve. We need a new
IS curve for which S = I again. If people save more at every r,
this means that S > I, or leakage greater than injection, so the
flow of income will fall to the level at which S = I again.
• In increase in the marginal propensity to save will therefore
result in a fall in national income and a fall in the interest rate.
• This is the Paradox of Thrift we saw earlier
Shifting IS and LM Curves
• This can be caused by
exogenous forces:
• Changes in Marginal
propensity to save or
change in marginal
efficiency of investment
• This can be caused by
changes in Monetary and
Fiscal Policy
• Changes to Money
• Changes In Government
Taxation and Spending
Monetary Policy
• Monetary policy basically affects the money supply.
When the monetary authority (The Federal Reserve in
the U.S.) increases money supply, the LM curve shifts
downward and M > L, which drives interest rates down.
Lower interest rates stimulate the economy, and
income grows. If the money supply is increased too
much, there can be too much money chasing too few
goods, and inflation can be a problem. Reducing the
money supply drives interest rates up, shrinks the
economy, and can help control inflation.
Fiscal Policy
• Fiscal policy is bacially government expenditure
and taxation. When the government spends
money, industry has to produce more goods
and services to meet the increased demand.
This drives up income and also increases the
demand for investments, driving up interest
rates. The IS curve shifts to the right.
Decreasing government spending has the
opposite effect.
A Steady – State Economy?
Impacts of Monetary and Fiscal
Policies on Interest Rates & Income
If you are sitting on a lot of cash –
What does inflation do to you?
Biophysical Equilibrium vs.
Economic Equilibrium