Goods & Financial Markets: The IS-LM Model
The IS-LM Model
The determination of output and
interest rates in the short-run
Slide #1
Goods & Financial Markets: The IS-LM Model
The goods market and the IS relation
 Equilibrium in the goods market:
Production (Y) = Demand (Z)

Or Investment = Saving  “IS” Relation
 Demand (Z)=

C+I+G
C=C(Y-T)
T & G are given
Now let Investment depend on the level of sales (Y) and the
interest rate (i):
I  I (Y , i )
( ,)
Slide #2
Goods & Financial Markets: The IS-LM Model
The IS curve
Equilibrium:
Y  C (Y  T )  I  G
I  I (Y , i )
Y  C (Y  T )  I (Y , i )  G
Supply of
Goods
Demand for
Goods (Z)
In the goods market, the higher the
interest rate, the lower is investment and
the lower is equilibrium output.
Slide #3
Goods & Financial Markets: The IS-LM Model
Interest Rate, i
The IS curve
Shifts in the IS Curve:
An increase in taxes shifts the IS curve to the left
i
IS (T)
IS´ (T´ > T)
Y´
Y
Output, Y
Slide #4
Goods & Financial Markets: The IS-LM Model
Interest Rate, i
The IS curve
Shifts in the IS Curve:
An increase in G shifts the IS curve to the right
i
IS´ (G´ > G)
IS (G)
Y
Y´
Output, Y
Slide #5
Goods & Financial Markets: The IS Curve
Shifts in the IS curve
What do you think:
How would a decrease in consumer
confidence shift the IS curve?
Slide #6
Financial Markets and the LM Relation
Money market equilibrium:
Demand for liquidity (L) = Supply of Money (M)
M=
nominal money supply (controlled by
the Central Bank)
$YL(i) = Demand for money (function of
nominal income and the interest rate)
Equilibrium Interest Rate:
M=$YL(i)
Slide #7
Financial Markets and the LM Relation
Real money, real income, and the interest rate
$Y
Real Income (Y ) 
P
Real Money Supply
LM relation:
M 
 
 P
=Real Money Demand: Y(L)i
M
 Y ( L)i
P
Slide #8
Financial Markets and the LM Relation
An increase in demand for real balances:
Interest Rate, i
Ms
Increase in Y => increases Md which increases i
i´
i
A´
A
Md´ (for Y´ > Y)
Md (for Y)
M/P
(Real) Money, M/P
Slide #9
Financial Markets and the LM Relation
The LM curve
Interest Rate, i
Interest Rate, i
Ms
A´
i´
A
i
i´
i
LM (M/P)
A´
A
Md´ (for Y´ > Y)
Md (for Y)
M/P
(Real) Money, M/P
Y
Y´
Income, Y
Slide #10
Financial Markets and the LM Relation
Shifts in the LM Curve:
Showing changes in M & P
The LM curve
Interest Rate, i
Ms
i
LM´
(M´/P > M/P)
b
i´2
b´
a
i
a´
i2
LM (M/P)
i´
b
i´
i´2
Interest Rate, i
Ms´
Md´ (for Y´ > Y)
b´
a
i2
a´
Md
M/P
M´/P
(Real) Money, M/P
(for Y)
Y
Y´
Income, Y
Slide #11
The IS-LM Model Exercises
Equilibrium Requires:
IS : Y  C (Y  T )  I (Y , i)  G
M
LM :
 YL (i )
P
or IS  LM
Slide #12
The IS-LM Model Exercises
The IS-LM Equilibrium Graphically
Interest Rate, i
LM
i & Y is the only interest rate,
output combination that
yields a simultaneous
equilibrium in the goods and
financial markets
i
IS
Y
Output, Y
Slide #13
Fiscal Policy, Activity, and the Interest Rate
A Scenario:
Question:
The President and Congress agree
on a policy to reduce the budget
deficit by increasing taxes, while
holding gov’t spending constant.
What impact will this fiscal
contraction policy have on
output and interest rates?
What shifts? IS, LM or both?
ANSWER: IS
Slide #14
Fiscal Policy, Activity, and the Interest Rate
The IS-LM Equilibrium Graphically
Interest Rate, i
LM
• IS & LM: Before the tax increase
Equilibrium A: i & Y
• IS´: After the tax increase
• Would the tax increase change
LM?
A
F
i
A´
i´
• Disequilibrium at i (F, A) after
tax increase
• i´, Y´ New equilibrium A´
• The fiscal contraction lowered
interest and output
IS (T)
IS´ (T´ > T)
Y´ Y
Output, Y
Slide #15
Fiscal Policy, Activity, and the Interest Rate
Here’s one for the devil’s advocate…
Is deficit reduction good or bad for
investment?
Interest rate falls  good for investment
But
Output falls  bad for investment
Slide #16
Monetary Policy, Activity, and the Interest Rate
Monetary Policy, Activity, and the Interest Rate
A Scenario:
Question:
The Fed engages in monetary
expansion, i.e., it increases the
money supply through open
market operations
What impact will the monetary
expansion have on output and
interest?
What shifts? IS, LM, or both?
ANSWER: LM
Slide #17
Monetary Policy, Activity, and the Interest Rate
The IS-LM Equilibrium Graphically
LM (M/P)
Interest Rate, i
LM´ (M´/P > M/P)
• IS & LM: Before increasing M
Equilibrium A: i & Y
i
• LM´: After increasing M
B
A
• Disequilibrium at i (A, B)
A´
• New equilibrium A´: i´ & Y´
i´
• Monetary expansion
lowered i & increased Y
IS
Y Y´
Output, Y
Slide #18
Fiscal Policy and Monetary Policy:
Activity and the Interest Rate
The effects of fiscal and monetary policy
Shift in IS
Shift in LM
Movement in
Output
Movement in
Interest Rate
Increase in taxes
left
none
down
down
Decrease in taxes
right
none
up
up
Increase in spending
right
none
up
up
Decrease in
spending
left
none
down
down
Increase in money
none
down
up
down
Decrease in money
none
up
down
up
Slide #19
Using a Policy Mix
The Clinton-Greenspan Policy Mix
The policy
dilemma of
1992:
Recall:
Record high federal budget deficit
(4.5% of GNP)
High unemployment and slow
growth
Deficit reduction reduces output
Expansionary fiscal policy increases the
deficit
Solution:
Policy Mix
Deficit reduction and expansionary
monetary policy
Slide #20
Using a Policy Mix
The Clinton-Greenspan Policy Mix
LM
Interest Rate, i
LM´
• IS & LM: Before policy changes
Equilibrium A: i & Y
• IS´: After deficit reduced
A
i
• B equilibrium without monetary
expansion
B
• LM´ after monetary expansion
i´
A´
IS
• New equilibrium i´, Y´
IS´
Y Y´
Output, Y
Slide #21
Using a Policy Mix
The Clinton-Greenspan Policy Mix
Observations:
• Strong consumer confidence and
stock market shifting IS from 1992
to 1998
• The strong expansion automatically
reduced the deficit (1% growth reduces
the deficit to GNP ratio by 0.5%)
Slide #22
Using a Policy Mix
The Clinton-Greenspan Policy Mix
The U.S. Economy 1991-1998
1991
1992
1993
1994
1995
1996
1997
1998
Budget surplus
(% of GDP)
(minus sign:
deficit)
-3.3
-4.5
-3.8
-2.7
-2.4
-1.4
-0.3
-0.8
GDP growth (%)
-0.9
2.7
2.3
3.4
2.0
2.7
3.9
3.7
Interest rate (%)
7.3
5.5
3.7
3.3
5.0
5.6
5.2
4.8
Slide #23
Adding Dynamics
Observations:
•Changes in output adjust slowly to changes
in the goods market (IS)
•Interest rates adjust instantaneously to
changes in the financial markets (LM)
Slide #24
Adding Dynamics
Dynamics Graphically
Adjusting to a
monetary contraction
B
A´
iA
Output
decreases
slowly
IS
B
iB
iA
A
IS´
Yb
Ya
Output, Y
LM´
LM
Interest Rate, i
Interest Rate, i
Adjusting to a
tax increase
Interest rates
adjust
instantaneously
Ya
Output, Y
Slide #25
Adding Dynamics
The Dynamics of Monetary Contraction with IS-LM
LM´
Interest Rate, i
LM
• A: Initial equilibrium (i & Y)
A´´
i´´
• LM´: After reducing money
supply
A´
i´
• i rises to i´´
• Higher i reduces demand and
output slowly A´´ to A´
A
i
• Equilibrium restored at A´: i´, Y´
IS
Y´
Y
Output, Y
Slide #26
Adding Dynamics
A Summary
•Monetary policy changes interest rates
rapidly and output slowly
•The Central Bank must consider the output
lag when implementing monetary policy
Slide #27
Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the Federal
Funds Rate
Slide #28
Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the Federal
Funds Rate
Slide #29
Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the Federal
Funds Rate
Slide #30
Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the Federal
Funds Rate
Slide #31
Does the IS-LM Model Actually Capture What
Happens in the Economy?
The Empirical Effects of an Increase in the Federal
Funds Rate
Slide #32
Does the IS-LM Model Actually Capture What
Happens in the Economy?
Summary
The IS-LM model is consistent with
economic observations
The IS-LM model explains movements in
economic activity over the short-run
Slide #33