IS-LM MODEL:

Money, Interest, and Income

INSTRUCTOR:
Ms. Resa Mae C. Laygan
 LEARNING OBJECTIVES:

At the end of this topic you will be able to:

• Describe the combinations of income and interest
rates at which the goods market is in equilibrium.
• Describe the combinations of income and interest
rates at which the money market is in equilibrium.
• Derive IS and LM models.
THE STRUCTURE OF THE IS-LM MODEL
THE GOODS MARKET AND
THE IS CURVE
 THE GOODS MARKET AND THE IS CURVE
• The IS curve (or schedule) shows combinations of interest
rates and levels of output such that planned spending equals
income.
• The IS curve is derived in two steps:
1. We explain why investment depends on interest rates.
2. We insert the investment demand function in the
aggregate demand identity and find the combinations of
income and interest rates that keep the goods market in
equilibrium.
 THE INVESTMENT DEMAND SCHEDULE
• Investment is spending on additions to the firm’s capital,
such as machines or buildings.
• The higher the interest rate for such borrowing, the lower
the profits that firms can expect to make by borrowing to
buy new machines or buildings, and therefore the less they
will be willing to borrow and invest.
• Conversely, firms will want to borrow and invest more
when interest rates are lower.
INVESTMENT AND THE INTEREST RATE
THE INVESTMENT SCHEDULE

This figure shows for each level of the

interest rate the amount that firms
plan to spend on investment.
THE INVESTMENT SCHEDULE

An increase I means that at each

level of the interest rate, firms plan
to invest at a higher rate.

I’
THE INTEREST RATE AND AGGREGATE DEMAND:
THE IS CURVE
DERIVATION OF THE
IS-CURVE
 DERIVATION OF THE IS-CURVE
The IS curve is negatively sloped, reflecting the increase in aggregate
demand associated with a reduction in the interest rate. We can also
derive the IS curve by using the goods market equilibrium condition,
that income equals planned spending, or
EFFECT OF THE
MULTIPLIER ON
THE SLOPE OF
THE IS CURVE

A higher marginal
propensity to spend
results in a steeper
aggregate demand
curve and, a flatter IS
curve.
EFFECT OF THE MULTIPLIER ON THE
SLOPE OF THE IS CURVE
 THE
POSITION OF
THE IS CURVE
An increase in
autonomous spending
increases aggregate
demand and increases
the income level at a
given interest rate.
 Here are the major points about the IS curve:

• The IS curve is the schedule of combinations of the

interest rate and level of income such that the goods
market is in equilibrium.

• The IS curve is negatively sloped because an increase in

the interest rate reduces planned investment spending
and therefore reduces aggregate demand, thus reducing
the equilibrium level of income.
 Here are the major points about the IS curve:

• The smaller the multiplier and the less sensitive

investment spending is to changes in the interest rate, the
steeper the IS curve.

• The IS curve is shifted by changes in autonomous

spending. An increase in autonomous spending, including
an increase in government purchases, shifts the IS curve
out to the right.
 Computation: PROBLEM 1
Given the following equations describe an economy, where C (consumption), I
(Investment), G (Government purchases) are being measured in billions and
interest rate (i) as a percentage. Derive the equation that describes the IS curve.
 Computation: PROBLEM 2
Given the following equations describe an economy, where C (consumption), I
(Investment), G (Government purchases) are being measured in billions and
interest rate (i) as a percentage.
a. Using the derived IS equation, compute the Y (income) if the interest rate is
4%.
b. Using the derived IS equation, compute the Y (income) if the interest rate is
2%.
QUESTIONS???
THE MONEY MARKET AND
THE LM CURVE
 THE MONEY MARKET AND THE LM CURVE
• The LM curve (or schedule) shows combinations of
interest rates and levels of output such that money
demand equals money supply.
• The LM curve is derived in two steps.
1. We explain why money demand depends on interest
rates and income.
2. We equate money demand with money supply and find
the combinations of income and interest rates that
keep the money market in equilibrium.
 THE DEMAND FOR MONEY
• The demand for money is a demand for real money
balances because people hold money for what it will buy.
• The demand for real balances depends on the level of real
income and the interest rate.
• The demand for money depends also on the cost of
holding money.
• The higher the interest rate, the more costly it is to hold
money and, accordingly, the less cash will be held at each
level of income.
THE DEMAND FOR MONEY
DEMAND FOR REAL BALANCES AS A FUNCTION OF
THE INTEREST RATE AND REAL INCOME
The higher the rate of interest,
the lower the quantity of real
balances demanded, given the
level of income.
 THE SUPPLY OF MONEY, MONEY MARKET EQUILIBRIUM, AND
THE LM CURVE

• The LM schedule, or money market equilibrium schedule,

shows all combinations of interest rates and levels of
income such that the demand for real balances is equal to
the supply.

• Along the LM schedule, the money market is in

equilibrium.
THE SUPPLY OF MONEY, MONEY MARKET EQUILIBRIUM, AND
THE LM CURVE
THE SLOPE OF THE LM CURVE

• The greater the responsiveness of the demand for

money to income, as measured by k, and the lower
the responsiveness of the demand for money to the
interest rate, h, the steeper the LM curve will be.

• The slope of the LM curve is positive.

DERIVATION OF THE LM CURVE
AN INCREASE IN THE SUPPLY OF MONEY
SHIFTS THE LM CURVE TO THE RIGHT
 The following are the major points about the LM
curve:
• The LM curve is the schedule of combinations of interest
rates and levels of income such that the money market is
in equilibrium.
• The LM curve is positively sloped.
• The LM curve is steeper when the demand for money
responds strongly to income and weakly to interest rates.
• The LM curve is shifted by changes in the money supply.
An increase in the money supply shifts the LM curve to
the right.
 Computation: PROBLEM 2
Given the following equations that describe an economy, where L (liquidity
ഥ
𝑀
preference) are ത (real money supply) are being measured in billions and interest
𝑃
rate (i) as a percentage. Derive the equation that describes the LM curve.
QUESTIONS???
EQUILIBRIUM IN THE GOODS
AND MONEY MARKETS
EQUILIBRIUM IN THE GOODS AND
MONEY MARKETS

At point E, interest rates and income

levels are such that the public holds
the existing money stock and
planned spending equals output.
CHANGES IN THE EQUILIBRIUM LEVELS OF
INCOME AND THE INTEREST RATE

AN INCREASE IN
AUTONOMOUS SPENDING
SHIFTS THE IS CURVE TO
THE RIGHT.
A FORMAL TREATMENT OF THE IS-
LM MODEL
DERIVING THE AGGREGATE DEMAND SCHEDULE

• The aggregate demand schedule maps out the IS-

LM equilibrium holding autonomous spending and
the nominal money supply constant and allowing
prices to vary.
DERIVING THE
AGGREGATE
DEMAND SCHEDULE
 Computation: PROBLEM 4
Given the following equations describe an economy,
where C (consumption), I (Investment), G (Government
purchases) and etc. are being measured in billions and
interest rate (i) as a percentage.
a.Derive the IS equation.
b.Derive the LM equation.
c.Determine the equilibrium level of income (Y*).
d.Determine the equilibrium level of interest rate (i*).
e.Suppose that the real money supply increases to 750,
what would be the levels of equilibrium income and
interest rate? Given the changes, illustrate the
aggregate demand curve.
QUESTIONS???
 SUMMARY:
• The IS-LM model presented is the basic model of
aggregate demand that incorporates the money market
and the goods market.
• The IS curve shows combinations of interest rates and
levels of income such that the goods market is in
equilibrium.
• The demand for money is a demand for real balances.
• The interest rate and level of output are jointly
determined by simultaneous equilibrium of the goods and
money markets.
 SUMMARY:
• Monetary policy affects the economy first by affecting the
interest rate and then by affecting aggregate demand.
• The IS and LM curves together determine the aggregate
demand schedule.
• Changes in monetary and fiscal policy affect the economy
through the monetary and fiscal policy multipliers.
 REFERENCES:
Rudiger Dornbusch, Stanly Fischer and Richard Startz. Macroeconomics.
12th Edition. McGraw-Hill. 2014