Macroeconomics

Lecture 11: Building IS-LM Model

Sahana Roy Chowdhury

International Management Institute, Kolkata

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This lecture introduces you to:

the IS (Investment-Saving) curve

the LM (Liquidity-Money) curve
how the IS-LM model determines income and the interest rate

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Context

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

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IS curve

money ss asserts significant impact on hhld behavior, not in SKM - kept simple.
assets: physical - buildings, machines; financial- equity/shares
P is still kept fixed - SR
AD and r: Investment function - projects financed by borrowing funds at rate r.

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PV of inc stream

Yield after 1 year if you lend Rs. 1 at rate r: (1+r)

alternatively, I need to lend 1/(1 + r ) (PV) to get return of Rs. 1 after 1 year,
1/(1 + r )2 after 2 years, and so on.
PV of inc stream of Rs. R1,R2,...,Rn after year 1,2,...,n is:
R1/(1 + r ) + R2/(1 + r )2 + .... + Rn/(1 + r )n
PV varies inversely with r.
NPV = PV − cost. NPV has to be > 0 for a project to be viable. had there been
changes in P, real r would have influenced NPV, not nominal r.
planned inv varies inversely with r.
like I planned cons, govex varies inversely with r: r fall stimulates purchase of
durable goods. Thus AD = C + I + G varies inversely with r

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Let us recollect: The Keynesian Cross

A simple closed economy model in which income is determined by

expenditure.
Notation:
1 I = planned investment
2 PE = C + I + G = planned expenditure
3 Y = real GDP = actual expenditure
Difference between actual & planned expenditure
= unplanned inventory investment
= The difference between goods produced (production) and goods
sold (sales) in a given year.

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Elements of the Keynesian Cross

1 Consumption Function: C = C(Y − T )

2 Govt. policy variables: G = Ḡ; T = T̄
3 For now, Planned investment exogenous: I = Ī
4 PE = C(Y − T̄ ) + Ī + Ḡ
5 Eqm. condition: actual expenditure=planned expenditure Y = PE

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Graphing planned expenditure

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Equilibrium value of income

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An increase in govt. purchase

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An increase in taxes

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The IS Curve

we have seen that I = I(r )

As the cost of funds increase investment reduces, I 0 (r ) < 0.
Definition: a graph of all combinations of r and Y that result in
goods market equilibrium i.e. actual expenditure (output)=
planned expenditure.
Equation: Y = C(Y − T̄ ) + I(r ) + Ḡ

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Deriving the IS curve
↓ r ⇒↑ I ⇒↑ PE ⇒↑ Y

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Why the IS curve is negatively sloped

A fall in the interest rate motivates firms to increase investment

spending, which drives up total planned spending (PE).
To restore equilibrium in the goods market, output (actual
expenditure, Y) must increase.

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Fiscal policy and IS curve

We can use the IS-LM model to see how fiscal policy (G and T)
affects aggregate demand and output.
Let’s start by using the Keynesian cross to see how fiscal policy
shifts the IS curve.....
Observations: larger interest elasticity of I or smaller mps the
flatter will be IS curve. Because, I is a component of AD, fall in r
increases I more in such case, and if multiplier is large (mpc large)
Y rise will be larger in case of r fall.
position of IS curve depends on the autonomous component of
AD. Higher value indicates higher position of IS towards right.

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Shifting the IS curve rightward
Fiscal policy: ↑ G

At any value of r the Y that is needed to keep goods market in eqm. is

higher, implies IS curve shifts rightward.
1
Horizontal distance between IS curves is ∆Y = 1−mpc ∆G.
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The Theory of Liquidity Preference

A simple theory in which the interest rate is determined by money supply and
money demand.
Basis of LM curve
Asset market: two mrkts for simplicity - money and bond
if someone holds wealth in money - zero return (negative if P rises); if in bond
yield positive. Should he hold in Bond? Loss: if bond price falls capital loss.
return is called coupon rate.
a bond holder gets coupon rate, he may sell it in secondary market as well. at
what price?
bond is nothing but stream of returns in specified period. its mrkt price is its PV
at any point of time at rate r. no seller will sell it below PV.
if the bond promises to pay Rs. X over next n periods and currently prevailing int
rate is r, P = X /(1 + r ) + X /(1 + r )2 + X /(1 + r )3 ; if r falls the PV rises hence P
rises.
a drop in r causes capital gain.

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The Theory of Liquidity Preference

Transaction demand for money: M d = kPY , k > 0; hhlds prefer to hold cash
in hand for goods transactions. People care more about ‘Real balance’ M d /P.
Liquidity preference: For wealth creation (speculation) people keep money. If r
is high (bond price low) they expect it to fall (bond price to rise) hence hold more
bond to reap benefit of capital gain. Hence demand for money (real balance) will
be low.
LP estimates in India (Rao, 1997): for every 1% rise in real income SR real M d
rises by .44%, a rise in 1% r causes it to fall by .2%.

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Money supply

Supply of real money balances is fixed: (M/P)S = M̄/P̄

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Money demand

Demand for real money balances: (M/P)D = L(r )

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Equilibrium

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How RBI can increase r
To increase r RBI reduces money supply:

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LM curve

Now let’s put Y back into the money demand function:

 d
M
= L(r , Y )
P

The LM curve is a graph of all combinations of r and Y that

equate the supply and demand for real money balances or
equilibrates the money market.
The equation for the LM curve is:
 
M̄
= L(r , Y )
P̄

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Deriving the LM curve

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Why the LM curve is upward sloping

An increase in income raises money demand.

Since the supply of real balances is fixed, there is now excess demand in the
money market at the initial interest rate.
The interest rate must rise to restore equilibrium in the money market.
ALSO: it will be flat if income elasticity (k) of M d is low and interest elasticity of
the same is high (L0 (r ) = h(say )). EXTREME: LM vertical if h=0.
Position of LM depends upon the M s , higher MS causes Y to rise given r,
causing LM to shift right.
there are only two forms to keep wealth - money or bond. If money market is in
eqm. bond market is also in eqm.
Liquidity Trap: r is too low (bond price too high), nobody wants to hold bond.
Money is only there in peoples’ portfolio, any rise in M s will be absorbed in
money; elasticity of money demand is infinite, implying LM is horizontal.

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How ↓ M s shifts LM curve leftward

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Shift in LM curve

Suppose a wave of credit card fraud causes consumers to use

cash more frequently in transactions.
Use the liquidity preference model to show how these events shift
the LM curve.

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Short-run Equilibrium

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The Big Picture

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