5/10/2016

Semester 2
The
IS/LM model, introduced by Sir John Hicks to explainSession
a 2014-2015
major part of Keynesian macroeconomics since 1937

Learning outcomes

Money market

IS

curve (goods market)

The important of IS curve
How to develop IS curve
Factors that cause the IS curve to shift

LM

IS-LM model
How the goods market and the money market combine to set up the
overall equilibrium of the economy?
The process of adjustments that integrates the markets for overall
equilibrium.
The limitations of the IS-LM model.
The tools of monetary and fiscal policies for use in the following chapters.

curve (money market)

The important of LM curve
How to develop LM curve
Factors that cause the LM curve to shift

Copyright 2017 Pearson Education, Inc. All rights reserved.

Product market

9-1

The IS-LM model

The initial IS/LM model concludes that the government can

influence the economy via inflation and unemployment, through
a rightward shift of the IS curve by the fiscal policy or by a shift of
2015 Assis Kamu, SJ20203 Macroeconomics II
the LM curve by the monetary policy.

Price, Output & Unemployment

The model examines the combined equilibrium of two

markets :
The goods market, which is at equilibrium when
investments equal savings, hence IS.
The money market, which is at equilibrium when the
demand for liquidity equals money supply, hence LM.
Examining the joint equilibrium in these two markets
allows us to determine two variables : output Y and
the interest rate i.

Based on the model of AD and AS:

Long run
prices flexible
output determined by factors of production &
technology
unemployment equals its natural rate
Short run
prices fixed
output determined by aggregate demand
unemployment negatively related to output
slide 4

IS-LM Model

This topic focus on the development of the ISLM model, the basis of the AD curve.
But focus on the short run and assume the price
level is fixed (so, SRAS curve is horizontal).
Focus on the closed-economy case.

the IS curve, and its relation to

the Keynesian cross
the loanable funds model
the LM curve, and its relation to
the theory of liquidity preference
how the IS-LM model determines income and
the interest rate in the short run when P is fixed

slide 5

slide 6

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What is the Keynesian cross?

Keynesian cross
contains two lines

demand
Y = AD

1. 45-degree line
diagram - A simple
closed economy model
in which income is
determined by
expenditure

Desired total
spending (or
aggregate
expenditure,
or "aggregate
demand")

supply

2.consumers will have a larger demand with

a rise in disposable income, which increases
with total national output. This increase is
due to the positive relationship between
consumption and consumers' disposable
income in the consumption function

Assumptions of Keynesian Cross

Ignore AS
Assume prices or inflation fixed for businesscycle analysis,

Flat/ non-vertical AS curve used for short-run

analysis (that means any changes in Keynesian
cross is due to AD)

No financial markets
Ignore rest of the world (Closed economy)

The Keynesian cross diagram demonstrates the relationship between

aggregate demand (shown on the vertical axis) and aggregate supply (shown
slide 7
on the horizontal axis, measured by output).

Building the IS curve based on the Keynesian

CrossE

slide 8

Building the IS curve based on the loanable fund

model

E=Y
E=C+I(r1)+G
E=C+I(r2)+G

Y2
r

Y1

r
S(Y1)

r2
r1

I(r)
I(r2)

I(r1)

r2

r1

r1

r2

IS
Y2

Y1

S(Y2)

r1

I(r)

r2
I

IS
Y1

Y2

The theory of liquidity preference

A change in autonomous factors that is unrelated
to the interest rate

changes in autonomous consumer expenditure

changes in planned investment spending
unrelated to the interest rate

A simple theory in which the interest rate is determined

by money supply and money demand.

liquidity preference refers to the demand for money (or

changes in net exports unrelated to the interest

rate (for open economy)

changes in government spending

changes in taxes

Introduced by John Maynard Keynes in 1936.

also considered as liquidity).

According to Keynes, demand for liquidity is determined

Fiscal
policy

by three motives:
transactions motive for basic transactions (YL)
precautionary motive for unexpected problems/ costs (YL)
speculative motive due to speculation on interest rate
slide 12

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The LM Curve: Asset Market

Equilibrium

DerivingtheLM curve
(a) The market for

The equality of money demanded and money

supplied

Equilibrium in the asset market requires that the real

money supply equal the real quantity of money
demanded
Nominal money supply is determined by the central
bank and isnt affected by the real interest rate
Real money demand falls as the real interest rate
rises
Money demand rises as the level of output rises
The LM curve (Fig. 9.4) is derived by plotting money
demand for different levels of output and looking at
the resulting equilibrium

Copyright 2017 Pearson Education, Inc. All rights reserved.

real money balances

(b) The LM curve

r
LM

r2
r1

r2
L ( r , Y2 )

r1

L ( r , Y1 )
M/P

Y1

9-13

The LM Curve

HowM shiftstheLM curve

Factors that shift the LM curve

(a) The market for

Any change that increase/ reduces real money

supply relative to real money demand shifts the
LM curve down/ up
Similarly, any change that increases/ reduce
real money demand relative to real money
supply shifts the LM curve

real money balances

(b) The LM curve

LM2
LM1

r2

r2
r1

L ( r , Y1 )

r1

M/P

Copyright 2017 Pearson Education, Inc. All rights reserved.

Y2

Y1

9-15

IS-LM Model
Relationship between I (Investment) and r (real interest rate)
Developing IS curve (IS represents E in goods market)
I-driven (the Keynesian cross)
S-driven (loanable fund model)

Developing LM curve (LM represents E in money market)

Liquidity of preference Money supply

IS-LM, the basis of AD curve (How to derive AD curve from IS-LM model)

Copyright 2017 Pearson Education, Inc. All rights reserved.

9-17

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Deriving the AD curve

HowP shiftstheLM curve

(a) The market for

real money balances

(b) The LM curve

LM2
LM1

r2

r2
r1

L ( r , Y1 )
M/P

Intuition for slope

of AD curve:
P (M/P )
LM shifts left
r

r1

Y1

PReal money supply curve shift to the leftrLM curve shift to left

CHAPTER 11

LM(P2)
LM(P1)

r2
r1

IS

Y2

Y1

Y2

Y1

P2
P1

Aggregate Demand II

AD

Y
slide 20