• IS-LM model

• IS Curve

• LM Curve

• IS-LM Examples

• Fiscal and Monetary policies

• Keynesians vs. Monetarists

IS-LM modelModels short run changes in the GDP

Short run = changes in prices not known

Short-run Production Equilibria (IS curve)Production = Total demand (expenditures)

Short-run Asset Allocation Equilibria (LM curve)

Money demanded = Money supplied

Y

Real iLM

IS

Short Run

Equilibrium

IS

Y

Real i

IS

Excess demand

for goods

Excess supply

of goods

Short-run Asset Allocation Equilibria (LM curve)Money demanded = Money supplied

Y

Real iLM

Excess supply

of money

Excess demand

for money

Short-run Production Equilibria (IS curve) Production = Total demand (expenditures)

LM

IS-LM model

Y

Real GDP

i

Real

Interest

Rate

LM

IS

Short Run Equilibrium

• IS-LM model

• IS Curve

• LM Curve

• IS-LM Examples

• Fiscal and Monetary policies

• Keynesians vs. Monetarists

IS Curve

Y

Real i

IS

Excess demand

for goods

Excess supply

of goods

Short-run Production Equilibria (IS curve) Production = Total demand (expenditures)

A. When Income (Y) increases both Consumption (C) and Private Savings (S)

increase.

B. When real interest rate (i) increases companies’ investments (I) decrease.

C. In equilibrium: Total Demand (ZZ) = Production (Y) = Income (Y)

We will derive IS curve based on these three facts:

I. IS curve FigureII. IS curve Equation

I

Households

Firms

Wages

FINANCIALMARKET

Goods

& Services

MARKET

Rent Interest

ProfitC

S

Factors M.

(Capital Labor)Government

G

BudgetDeficitT

Rest of world

I Ex

Im

BOPDeficit

IS Curve FigureC. In equilibrium: Total Demand (ZZ) = Production(Y) = Income (Y)

Households

Firms

FINANCIALMARKET

Goods

& Services

MARKETGovernment

G

BudgetDeficitT

IS Curve Figure

Budget Deficit = G – T

FINANCIALMARKET

Goods

& Services

MARKET

Rest of world

Ex

Im

BOPDeficit

IS Curve Figure

BOP Deficit = Im – Ex +/- foreign wages, profits,…

Budget Deficit = G – T

I

HouseholdsFINANCIAL

MARKET

Goods

& Services

MARKET

S

TWIN DEFICITS:

(G – T) = S – I + (Im – Ex)

Budget deficit ≈≈≈≈ BOP def.

Government

BudgetDeficit

Rest of world

BOPDeficit

IS Curve Figure

S = I + (G – T) + (Ex – Im)

S = I + G – T + NX

BOP Deficit = Im – Ex +/- foreign wages, profits,…

Budget Deficit = G – T

S = I + G – T + NX

In case of (1) closed economy: NX = 0

(2) balanced budget: T = G

S = I

Private Saving = Investment

Note that if G-T or NX changes then so do S and I

Investment I and Real Interest Rate i (exp.)

B. When real interest rate (i) increases

companies’ investments (I) decrease.

Private Saving S and Income Y

A. When Income (Y) increases both

Consumption (C) and Private Savings (S) increase.

I

S

I

(Real) i

Y

S

IS Curve Figure

S = I + G – T + NX

In case of (1) closed economy: NX = 0

(2) balanced budget: T = G

S = I

Private Saving = Investment

Note that if G-T or NX changes then so do S and I

Investment I and Real Interest Rate i (exp.)

B. When real interest rate (i) increases

companies’ investments (I) decrease.

Private Saving S and Income Y

A. When Income (Y) increases both

Consumption (C) and Private Savings (S) increase.

I

S

I

(Real) i

Y

S

IS Curve Figure

G increases, T decreases(fiscal expansion)

X increases, Im decreases(depreciation=weakening of currency)

Expected Profitability of I increases(less regulation, smaller corp. taxes, …)

Willingness to save increases(consumers scarred,…)

S

I

Real i

Y

LY

Li

Real i

Y

LM curve

Ms = Li +LY

IS curveI

S

I

(Real) i

Y

S

IS Curve Figure

S

I

Real i

Y

LY

Li

Real i

Y

LM curve

Ms = Li +LY

IS curveI

S

I

(Real) i

Y

S

IS Curve Figure

fiscal expansion or depreciation

S

I

Real i

Y

LY

Li

Real i

Y

LM curve

Ms = Li +LY

IS curveI

S

I

(Real) i

Y

S

IS Curve Figure

less regulation, smaller corp.

taxes (with unchanged budget deficit)

S

I

Real i

Y

LY

Li

Real i

Y

LM curve

Ms = Li +LY

IS curveI

S

I

(Real) i

Y

S

IS Curve Figure

consumers scarred