Is LM Framework 2008

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Macro- Economics

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IS-LM MODEL

Hicks and Hansen have shown Keynesian

synthesis of the real and money market with the

curves popularly known as IS and LM curves.

The ISLM model is a macroeconomic tool that

shows the relationship between interest rates and

real output, in the goods & services market and the

money market.

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THEGOODSMARKETANDTHEISCURVE

IS Curve is a graph of all combinations of r and Y

that result in goods market equilibrium.

In the simple model, it is assumed that the interest

rate does not affect the demand for goods. The

equilibrium condition was given by:

Y C Y T I G ( )

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since, Investment depends primarily on Y & I, we

have

Y C Y T I Y i G ( ) ( , )

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SHIFTSOFTHEISCURVE

We have drawn the IS curve, considering Tand Gconstant. Changes in either T, G. mpc (c) willshift the IScurve.

To summarize:

Equilibrium in the goods market implies that an increasein the interest rate leads to a decrease in output andvice- versa. The relation is represented by thedownward-sloping IScurve.

Changes in factors that decrease the demand forgoods, given the interest rate, shift the IS curve to theleft. Changes in factors that increase the demand forgoods, given the interest rate, shift the IS curve to theright.

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SHIFTINGTHEIS CURVE

Changes in G, T, or c cause Y tochange for any level of r. This causesa shift in the IS curve.

IS

Y

E

Y1 Y2

G

Y1 Y2

r1

E=Y

E=C+I+G2

E=C+I+G1

Suppose an increase in G by

G.

Y

rFor any given r the rise in G

causes rise in Y by multiplier

times G.

Consequently, IS curve

shifts to the right

IS

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KEYNESLIQUIDITYPREFERENCETHEORY

Keynes believed there were 3 motives to holding money:

Transactions dd for Money :Money is a medium of exchange,and people hold money to transactions. Higher the income moreis transactions dd for Money.

Precautionary dd for Money : People also hold money foremergencies .This also depends on the amount of transactionspeople expect to make, precautionary money demand is againexpected to rise with income.

Speculative dd for Money : Money is also a way to storewealth. Keynes assumed that people stores wealth either asmoney or bonds. When interest rates are high, bond price wouldthen be expected to fall and bond prices would be expected to

rise. So bonds are more attractive than money when interestrates are high. When interest rates are low, they then would beexpected to rise in the future and thus bond prices would beexpected to fall. So money is more attractive than bonds wheninterest rates are low. So under the speculative motive, moneydemand is negatively related to the interest rate. 8


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SPECULATIVEDEMANDFORMONEY

M

r

Md

r0

People decide to hold money

instead of bonds when

interest rates get so low that

they cannot possibly go

lower. The move to money toavoid capital losses.

L p= L p(r)


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The total liquidity preference function is expressed

as M = L (Y, r).

Supply of Money:The supply of money refers to

the total quantity of money in the country. It is

assumed to be fixed by the monetary authorities.

Hence the supply curve of money is taken as

perfectly inelastic represented by a vertical straight

line.

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MONEYANDOUTPUT : A KEYNESIAN

VIEW

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Similarly, decreasing the money supply would decrease

aggregate demand and therefore, real output.

However, if economy is in liquidity trap, there will not be

decrease in r and so I will not increase.


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BLOCKINGOFKEYNESIANTRANSMISSION

MECHANISM

Some economists believe that investment is not alwaysresponsive to interest rates and the link between themoney market and the goods and services marketwould be broken.

Keynesians have sometimes argued that the demand

curve for money could become horizontal at some lowinterest rate. This is called the Liquidity Trap.

Liquidity Trap is a situation in which prevailing interestrates are so low that it makes monetary policyineffective. In a liquidity trap, consumers choose to avoid

bonds and keep their funds in savings because of theprevailing belief that interest rates will soon rise.Because bonds have an inverse relationship to interestrates, they do not want to hold an asset whose price isexpected to decline. 12


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LM CURVE

LM curve depicts the money market. It gives the

combinations of income and the interest rate for

which the demand for money (or desired liquidity)

equals the money supply.

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SHIFTINGTHELM CURVE

r

Real

MoneyBalances

r2

r1

(M1/P)s

L(r,Y)

(M2/P)s

LM

Y

r2

r1

Y

r

LM

While changing money demand allows us to map out the

LM curve, changes in M or P cause r to change for any

level of Y. This causes a shift in the LM curve

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IS=LM: THESHORTRUNEQUILIBRIUM

Given IS and LM curves, we can determine the short run

equilibrium r and Y.

LM

Y*

r*

Y

r

IS

By plotting the relationship between Y and r when the goodsmarket is in equilibrium we get the IS curve.

By mapping out the relationshipbetween Y and r when the moneymarket is in equilibrium we get theLM curve.

When IS=LM we have theequilibrium levels of r and Y. Thisrepresents simultaneousequilibrium in the goods marketand the money market.

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SLOPE/STEEPNESS OFISCURVE

The slopeof the IScurve is determined by two

factors: (1) Elasticity of I demand curve (I versus r)

and (2) the marginal propensity to consume or the

size of multiplier

A highlyinterest-sensitive investment function will result

in a flat IScurve

A high MPC also implies a flat IScurve

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THESLOPEOFTHELMCURVE

It depends on two factors:

(1) The responsiveness of demand for money to the

change in Y.

(2)

The responsiveness of demand for money to thechange in r.

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MONETARYPOLICYANDTHELMCURVE

An increase in the money supply causes the LM

curve to shift to the right

Therefore, RBI can increase the potential

equilibrium level of GDP associated with a given

interest rate.

However a change in income is not the only way

an increase in the money supply can be

absorbed into the economy.

Since the supply of money exceeds the demand

at the old rate, the interest rate may fall to

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THESIMULTANEOUSDETERMINATIONOFINCOME

ANDINTEREST


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THESIMULTANEOUSDETERMINATIONOF

INCOMEANDINTEREST

Point E is a stable equilibrium-as long as

nothing shifts the IS or LM curves, there is no

tendency for Y or r to change

However, this YE may or may not be a full

employment level of output.

If not, the Govt. uses monetary or fiscal policy to

shift one or both of the curve to move the

economy to the full employment level.

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ANEXPANSIONARYMONETARYPOLICY

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MONETARYPOLICYISMOREEFFECTIVE

THEFLATTERTHEISCURVE.

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ANEXPANSIONARYFISCALPOLICY.

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CROWDING-OUTEFFECT

Increased government borrowing to finance the

spending will increase interest rates.

Higher interest rates will reduce investment spending

which will tend to reduce the increase in GDP

Therefore, the net effect of increased governmentspending will be diminished by the reduction in

investment spending

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A SUMMARYOFMONETARYANDFISCALPOLICY

EFFECTIVENESS

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LAFFERCURVE

Tax

Revenue

Marginal Tax Rate0%

100%tmax thigh

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Incentives Matter


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Thanks

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Documents

Is LM Framework 2008