Chapter 11 – IS LM Framework

Money, Interest and Income: Goods Market Equilibrium; Deriving IS curve; Slope of IS
curve; Position of IS curve; Disequilibrium Position away from IS line

Key Terms
1. Aggregate Demand Schedule
2. Central Bank
3. Demand for Real Balances
4. Fiscal Policy Multiplier
5. Goods Market Equilibrium Schedule
6. IS Curve
7. IS – LM Model
8. LM Curve
9. Monetary Policy Multiplier
10. Money Market Equilibrium Schedule
11. Real Money Balances

Summary
1. The IS-LM model presented in this chapter is the basic model of aggregate
demand that incorporates the money market as well as the goods market. It lays
particular stress on the channels through which monetary and fiscal policy affect
the economy.
2. The IS curve shows combinations of interest rates and levels of income such that
the goods market is in equilibrium. Increases in the interest rate reduce
aggregate demand by reducing investment spending. Thus, at higher interest
rates, the level of income at which the goods market is in equilibrium is lower:
The IS curve slopes downward.
3. The demand for money is a demand for real balances. The demand for real
balances increases with income and decreases with the interest rate, the cost of
holding money rather than other assets. With an exogenously fixed supply of real
balances, the LM curve, representing money market equilibrium, is upward-
sloping.
 4. The interest rate and level of output are jointly determined by simultaneous
equilibrium of the goods and money markets. This occurs at the point of
intersection of the IS and LM curves.
5. Monetary policy affects the economy first by affecting the interest rate and then
by affecting aggregate demand. An increase in the money supply reduces the
interest rate, increases investment spending and aggregate demand, and thus
increases equilibrium output.
6. The IS and LM curves together determine the aggregate demand schedule.
7. Changes in monetary and fiscal policy affect the economy through the monetary
and fiscal policy multipliers.

IS-LM Model
 So far Autonomous spending and fiscal policy shown as chief determinants of
aggregate demand, and consequently determining income
 Now extend the model to include Investment
 Investment no longer autonomous
 What determines Investment? Interest rate
 o So interest rate is an
additional determinant
of aggregate demand
through investment
 What determines interest
rate? Money Supply and
Money demand.
 Fed Reserve/ RBI - role in
setting the supply of money
 Demand for money depends on
income and interest rates.
How?

Demand for Money

 Money is a medium of exchange, unit of account and a store of value.
 Cost of holding money is the interest forgone by not holding other assets. The
cost is estimated to be the short term interest rate.
 Sources of money demand are the speculative or asset demand and transactions
and precautionary demand for money.
 Transaction Demand: Since payment occurs at discrete intervals but expenditure
occurs regularly, people may demand to hold money for purchases and
transactions.
o Transaction demand is usually increasing in income.
 Precautionary demand is to meet unforeseen circumstances.
o Increases with income
 Money may also be held speculatively as an asset, and this demand is low in most
advanced economies but not that low in developing countries such as India.
o Asset demand for money is inversely related to the interest rate
 Money plays a central role in the determination of income and employment
through impact on interest rate
 Include money market in the model, i.e, money demand and money supply
 Expansionary fiscal policy (goods market) raises interest rates by raising income,
and dampens aggregate demand by reducing investments (increase in interest
rates may be sufficient to offset fully expansionary effects of fiscal policy)
Need to study interaction between money market and goods market
 Interest rates and income
are jointly determined by
equilibrium in goods and
money market.
 Strong link between money
growth and output growth:
money to interest rates to
investment to output
 Implies importance of
Monetary policy in
determining income and
employment
o What determines interest rates?
o What is the role of interest rates in the business cycle?

Figure shows interest rate on Treasury bills = the payment received by someone who
lends to the government
 Ex. At an interest rate of 5%, a $100 loan to government will earn $5 in interest
 Figure shows that interest rates:
o Are high just before a recession
o Drop during recession
o Rise during recovery
Figure shows the strong link between
money and output growth
 Therefore, need to explore the
link from money to interest
rates to output

IS-LM model is the core of short-run

macroeconomics
  Maintains the details of earlier model, but adds the interest rate as an additional
determinant of aggregate demand
 Includes the goods market and the money market, and their link through interest
rates and income

Figure 11-2 shows the strong link between money and output growth

Goods Market and the IS Curve

 The IS curve shows combinations of interest rates and levels of output such that
planned spending equals income
 Derived in two steps:
1. Link between interest rates and investment
2. Link between investment demand and AD to find combinations of income
and interest rates that keeps goods market in equilibrium

 Investment is no longer treated as exogenous, but dependent upon interest

rates (endogenous)
 o Investment demand is lower
the higher are interest rates
 Interest rates are the
cost of borrowing
money
 Increased interest
rates raise the price
to firms of borrowing
for capital equipment,
impacting profit
reduce the quantity
of investment
demand

Investment and the Interest Rate

 The investment spending function can be specified as:
I = I(bar) – bi, where b > 0 (1)
o i = rate of interest
o b = the responsiveness of investment spending to the interest rate
o I = autonomous investment spending
 Figure illustrates the investment schedule of equation (1)
o Negative slope reflects assumption that a reduction in i increases the
quantity of I as profitability will increase
  The position of the I schedule is determined by:
o The slope, b
 If investment is highly responsive to i, the investment schedule is
almost flat
 If investment responds little to i, the investment schedule is close to
vertical
o Level of autonomous spending
 An increase in I(bar) shifts the investment schedule out
 A decrease in I(bar) shifts the investment schedule in

Interest Rate and AD: The IS Curve

 Need to modify the AD function to reflect the new planned investment spending
schedule

 An increase in i reduces AD for a given level of income because higher i reduces I

 At any given level of i, can determine the equilibrium level of income and output
as done earlier
o A change in’ i ‘will now change the equilibrium
 Derive the IS curve using figure
o For a given interest rate, i1, the last term in equation (2) is constant bican
draw the AD function with an intercept of A(bar) – bi1
 The equilibrium level of income is Y1at point E1
o Plot the pair (i1, Y1) in the bottom panel as point E1->a point on the IS
curve
 Combination of ‘ i ‘ and Y that clears the goods market

 Consider a lower interest rate, i

 Investment spending is higher when the interest rate falls
 Shifts the AD curve upward to AD’ with an intercept of A(bar) – bi2
 Given the increase in AD, the equilibrium shifts to point E2, with an associated
income level of Y2 (goods market clears)
 Plot the pair (i2, Y2) in panel (b) for another point on the IS curve

 We can apply the same procedure to all levels of i to generate additional points
on the IS curve

 All points on the IS curve represent combinations of i and income at which the
goods market clears ->goods market equilibrium schedule (IS curve)
 Figure shows the negative relationship between i and Y (increase in aggregate
demand associated with reduction in interest rate)
o Downward sloping IS curve
 We can also derive the IS curve using the goods market equilibrium condition:
 where
alpha G, the multiplier derived earlier
higher interest rate implies a lower level of income for given A
Slope of the IS Curve
 The steepness of the IS curve depends on:
o How sensitive investment spending is to changes in i (i.e., ‘b’
o The multiplier, alpha G
 Suppose investment spending is very sensitive to i ->the slope, b, is large
o A given change in i produces a large change in AD (large shift)
o A large shift in AD produces a large change in Y
o A large change in Y resulting from a given change in i -> IS curve is
relatively flat
 If investment spending is not very sensitive to i (i.e., ‘b’ is small), the IS curve is
relatively steep

Role of Multiplier
 Figure shows the AD curves corresponding to different multipliers
o The coefficient con the solid black AD curve is smaller than that on the
dashed AD curve ->multiplier larger on the dashed AD curves
 A given reduction in i, from i1to i2raises the intercept of the AD curves by the
same vertical distance
o Because of the different multipliers, income rises to Y2’ on the dashed line
and Y2on the solid line
o Larger the multiplier, flatter the IS curve (larger multiplier produces larger
change in income)
  The smaller the sensitivity of investment spending to the interest rate AND
smaller the multiplier, the steeper the IS curve
 This can be seen in equation (5):
 We can solve equation (5) for i:

 Thus for given change in Y, associated change in i will be larger in size as b is

smaller and as αG is smaller.
 Since slope of IS curve depends on multiplier, fiscal policy can affect slope
 Multiplier affected by tax rate: increase in tax rate reduces multiplier
o Higher tax rate, steeper IS curve

Position of the IS Curve

 Figure shows two different IS curves differ by levels of autonomous spending
o Initial AD with A (bar) and i1 -> corresponding point E1on IS curve in Figure
(b)
o If autonomous spending increases to A(bar), equilibrium level of income
increases at i1 - > point E2 in panel (b), shifting out IS’ to the right
o With different rates i new IS’ curve
 The change in income as a result from a change in autonomous spending is
IS Curve
 IS curve is schedule of combinations of ‘i’ and level of income such that goods
market is in equilibrium
 IS curve is negatively sloped because increase in i reduces planned investment
spending and thus AD, reducing level of income
 Smaller the multiplier and less sensitive investment spending to change in i, the
steeper the IS curve

 The IS curve is shifted by changes in autonomous spending. An increase including

increase in G, shifts IS curve to right

L M Curve and Money Market

Asset Market: Wealth-Budget Constraint; Derivation of LM curve; Slope of LM curve;
Position of LM curve; Disequilibrium Positions away from LM curve
Money Market and the LM Curve
 LM curve shows combinations of interest rates and levels of output such that
money demand equals money supply -> equilibrium in the money market
 LM curve is derived in two steps:
1. Explain why money demand depends on interest rates and income
 As people care for purchasing power of money, demand for money
is theory of real (money balances) rather than nominal demand
2. Equate money demand with money supply, and find combinations of
income and interest rates that maintain equilibrium in the money market
 (i, Y) pairs meeting this criteria are points on a given LM curve

Demand for Money

 demand for money, is actually a demand for real money balances
o People are concerned with how much their money can buy, rather than
the number of dollars in their pockets (Purchasing Power)
o Higher the price level, more nominal balances required for purchasing a
given quantity of goods-if price level doubles, hold twice the nominal
balances for buying same amount of goods.
 The demand for real balances depends on:
o Real income: people hold money to pay for their purchases, which, in
turn, depend on income
o Interest rate: the cost of holding money
 The higher the interest rate, the more expensive it is to hold
money, and the less cash will be held at each level of income
 Individuals will economize on holding cash if interest rate is high: if
it is 1% there is little benefit from holding bonds rather than money;
but if it is 10% then may not like to hold more cash than is needed
to finance day-to-day transactions.
 Demand for money (real balances) is defined as:

 k,h +
 Increases with level of income, and decreases with the interest rate
  The parameters k and h reflect the sensitivity of the demand for real balances to
the level of Y and i
 The demand function for real balances implies that for a given level of income,
the quantity demanded is a decreasing function of i
o Figure illustrates the inverse relationship between money demand and i -
> money demand curve
o Higher level of income, larger the demand for real balances: the demand
curve will shift to right

Supply of Money, Money Market

Equilibrium, and the LM Curve
 nominal quantity of money
supplied, M, is controlled by
the central bank
 Real money supply is
M(bar) / P(bar), where M and
P are assumed fixed
 Figure shows combinations of
i and Y such that the demand
for real money balances
exactly matches the available
supply
  Starting at Y1, the corresponding demand curve for real balances is L1 ->shown in
panel (a)
 Supply of real balances is fixed, shown by vertical line as it is given and
independent of interest rate
 At interest rate i1 demand for real balances equals the supply
o Point E1 is the equilibrium point in the money market
 Point E1 is recorded in panel (b) as a point on the money market equilibrium
schedule, or the LM curve

 If income increases to Y2, higher level of income causes demand for real balances
to be higher at each level of interest rate, so demand curve for real money
balances shifts to the right -> money demand shifts to L2
o The interest rate increases to i2to maintain equilibrium in the money
market at that higher level of income
o The new equilibrium is at point E2
 Record E2 in panel (b) as another point on the LM curve

LM Curve
 LM schedule shows all combinations of interest rates and levels of income such
that the demand for real balances is equal to the supply ->money market is in
equilibrium
 LM curve is positively sloped:
o An increase in the interest rate reduces the demand for real balances
o To maintain the demand for real money balances equal to the fixed
supply, the level of income has to rise
o Accordingly, money market equilibrium implies that an increase in the
interest rate is accompanied by an increase in the level of income
  The LM curve can be obtained directly by combining the demand curve for real
balances and the fixed supply of real balances
 For the money market to be in equilibrium, supply must equal demand:

– (7)

Slope of the LM Curve

 The steeper the LM curve:
o The greater the responsiveness of the demand for money to income, as
measured by k
o The lower the responsiveness of the demand for money to the interest
rate, h
o These points can be confirmed by experimenting with Figure or examining
equation (7a),
o A given change in income has a larger effect on i, the larger is k and the
smaller is h

Position of the LM Curve

 The real money supply is held constant along the
LM curve ->a change in the real money supply will
shift the LM curve
 Figure shows the effect of an increase in money supply
o Panel (a) shows the demand for real money balances for income level Y1
o Equilibrium occurs at point E1with interest rate i1 - > corresponding
  If real money supply increases, the money supply curve shifts to the right
o To restore equilibrium at the income level Y1, the i must decrease to i2
o The new equilibrium is at point E2
 In panel (b), the LM curve shifts to the down and to the right
o At each level of income, the equilibrium interest rate has to be lower to
induce people to hold the larger real quantity of money
o Alternatively, at each level of interest rate the level of income has to be
higher to raise the transactions demand for money and thereby absorb the
higher real money supply. This can also be seen from the LM equation

LM curve
 The LM curve shows combination of interest rates and levels of income such that
the money market is in equilibrium
 It is positively sloped. Given fixed money supply, an increase in level of income
which increases in quantity of money demanded, has to be accompanied by an
increase in interest rate. This reduces the quantity of money demanded and
thereby maintains money market equilibrium
  LM curve is steeper when demand for money responds strongly to income and
weakly to interest rates
 LM curve is shifted by changes in money supply. An increase in money supply
shifts LM curve to right.

IS-LM Framework:
Super Imposition of IS and LM curve to derive equilibrium; Adjustments towards
equilibrium; Numerical Examples

Equilibrium in the Goods and Money Market

 The IS and LM schedules summarize the conditions that have to be satisfied for
the goods and money markets to the in equilibrium
o How are they brought into simultaneous equilibrium?
 o Satisfied at point E in Figure, corresponding to the pair (i0, Y0)
 Assumptions:
o Price level is constant
o Firms willing to supply
whatever amount of
output is demanded at
that price level

Changes in the Equilibrium Levels of Income and the Interest Rate

 equilibrium levels of income and the interest rate change when either the IS or
the LM curve shifts
 Figure shows the effects of an increase in autonomous spending on equilibrium i
and Y
 Shifts IS curve out by if autonomous investment is the source of increased
spending
 Change in income should be multiplier times change in autonomous spending
 But the resulting change in Y is smaller -> due to slope of LM curve
 If LM curve horizontal, then change would be to extent of horizontal shift of the
IS curve, because no change in rate of interest
 With increase in income due to autonomous spending, demand for money
increases.
 As supply of money is fixed, i increases.
  This lowers investment and
consequently income

Deriving the AD Schedule

 The AD schedule maps out
the IS-LM equilibrium
holding autonomous
spending and the nominal
money supply constant
and allowing prices to vary
 Suppose prices increase
from P1to P2
o M/P decrease from
M/P1to M/P2 - > LM
decreases from LM1to LM2
o Interest rates increase from i1to i2, and output falls from Y1to Y2
o Corresponds to lower AD
 Derive the equation for the AD curve using the equations for the IS-LM curves:

 Substituting LM equation into the IS equation:

 Equation (8) shows that AD depends upon:
1. Autonomous spending
2. Real money stock

 Equilibrium income is:

o Higher the higher the level of autonomous spending
o Higher the higher the stock of real balance
 Equation (8) is the AD schedule
o It summarizes the IS-LM relation, relating Y and P for given levels of
autonomous spending and nominal balances
o Since P is in the denominator, AD is downward sloping