1. The IS-LM model
The IS curve
The LM curve
Macroeconomic equilibrium and policy

2. Interest rate i
Macroeconomic equilibrium and
policy
LM
The intersection of IS and
LM represents the
simultaneous equilibrium on
the goods and the money
market…
…For a given value of
government spending G,
taxes T, money supply M
and prices P
i*
IS
Y*
Income, Output Y

3. Macroeconomic equilibrium and
policy
• IS-LM can be used to assess the impact of
exogenous shocks on the endogenous
variables of the model (interest rates and
output)
• One can also evaluate the effectiveness of
the policy mix, i.e. the combination of:
– Fiscal policy: changes to government spending
and taxes
– Monetary policy: changes to money supply

4. Policy in the IS-LM Model
• Fiscal Policy
– Expansionary fiscal policy shifts the IS
curve to the right
– Contractionary fiscal policy shifts the IS
curve to the left
• Monetary Policy
– Expansionary monetary policy shifts
the LM curve to the right
– Contractionary monetary policy shifts
the LM curve to the left

5. Fiscal Policy, the Interest Rate and the IS
Curve
• Fiscal contraction: a fiscal policy that
reduces the budget deficit.
– Reducing G or increasing T
• Fiscal expansion: increasing the budget
deficit.
– Increasing G or decreasing T
• Taxes (T) and government expenditures (G)
affect the IS curve, not the LM curve.

6. Monetary Policy, the Interest Rate, and
the LM Curve
• Monetary contraction (tightening)
refers to a decrease in the money
supply.
• An increase in the money supply is
called monetary expansion.
• Monetary policy affects only the LM
curve, not the IS curve.

7. Policy Analysis with
the IS-LM Model

A Closer Look at Policy
• Fiscal Policy and Crowding Out
• Monetary Policy and the Liquidity Trap

Real World Monetary and Fiscal Policy

8. 1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000.
Fiscal Crowding Out
2. The increase in income
increases money demand
which increases interest
rates from 4% to 5%.
LM
3. The increase in the interest
rate causes a decrease in
investment so that the increase
in income is only $600, less that
the full multiplier effect.
$1000
5%
4%
IS1
IS0
$6000
$6600
$7000
Aggregate Output

9. Fiscal Policy and Crowding Out
• When government expenditures increase or
taxes are reduced, output and income begin
to increase.
• The increase in income increases the
demand for money.
• The increase in money demand increases the
interest rate.
• Higher interest rates cause a decrease in
investment, offsetting some of the
expansionary effect of the increase in
government spending.

10. 1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000.
LM
9%
$1000
Full Crowding Out
2. If the demand for money
is totally insensitive to the
interest rate, the interest rate
increases from 4% to 9%.
3. The increase in the interest
rate causes a decrease in
investment that completely offsets
the increase in government spending.
4%
IS1
IS0
$6000
$7000
Aggregate Output

11. Ineffective Fiscal Policy
• When complete crowding out occurs,
fiscal policy is ineffective, changing
only interest rates, not output.
• Crowding out is greater if:
– Money demand is very sensitive to
income changes
– Money demand is not very sensitive to
interest rate changes

12. Monetary Policy and Liquidity Traps
The RBI increases the
money supply which
decreases interest rates
and increases investment
and output.
In a liquidity trap, increases
in the money supply do not
decrease interest rates, so
investment and output do
not increase.
LM0
LM0
LM1
LM1
r0
r0
r1
IS
Y0
Y1
Aggregate Output
IS
Y0
Aggregate Output

13. Ineffective Monetary Policy
• Investment is not sensitive to the
interest rate
– If investment does not respond to interest
rate changes (the IS curve is steep),
monetary policy in ineffective in changing
output.
• Liquidity trap
– If increases in the money supply fail to
lower interest rates, monetary policy is
ineffective in increasing output.

14. Interaction between
monetary and fiscal policy
• IS-LM Model:
Monetary and fiscal policy variables
(M, G, and T) are exogenous.
• Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
• Such responses by the central bank may affect
the effectiveness of fiscal policy

15. The RBI’s response to
G >0
• Suppose the government increases G.
• Possible RBI responses:
1. hold M constant
2. hold r constant
3. hold Y constant
• In each case, the effects of G on Y
are different…

16. Response 1: Hold M constant
When G increases,
the IS curve shifts right.
If RBI holds M constant,
then LM curve does not
shift.
As a result, interest rates
rise. This has a crowdingout effect. Consequently,
GDP increases, but not a
lot.
r
LM
r2
r1
IS2
IS1
Y1 Y2
Y

17. Response 2: Hold r constant
If Govt. raises G,
the IS curve shifts right.
To keep r constant, Fed
increases M
to shift LM curve right.
r
LM1
LM2
r2
r1
IS2
Results:
IS1
Y
Y3
r
0
Y1
Y1 Y2 Y3
Y

18. Response 3: Hold Y constant
If Govt. raises G,
the IS curve shifts right.
To keep Y constant, RBI
reduces M
to shift LM curve left.
LM2
LM1
r
r3
r2
r1
IS2
IS1
Y
0
r
r3
Y1 Y2
r1
Y

19. Shocks in the IS-LM model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
– stock market boom or crash
change in households’ wealth
C
– change in business or consumer
confidence or expectations
I and/or C

20. Shocks in the IS-LM model
LM shocks: exogenous changes in the
demand for money.
Examples:
– a wave of credit card fraud increases demand
for money.
– more ATMs or the Internet reduce money
demand.

21. Analyze shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of
1. a boom in the stock market that makes consumers
wealthier.
2. after a wave of credit card fraud, consumers using
cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects of the shock
on Y and r.
b. determine what happens to C, I, and the
unemployment rate.

22. Macroeconomic equilibrium and
policy


The two policies are not independent, as they both
affect the endogenous variables:
 The interest rate i
 Income Y
 Hence the idea of a policy mix…
3 examples of policy mix issues
 The good: the Clinton deficit reduction in 1993,
 The bad: the German reunification in 1992,
 The ugly : the debate on the “liquidity trap”.

23. Macroeconomic equilibrium and
policy
Interest rate i
The Clinton deficit reduction in 1993
1. Clinton decides to reduce the US
deficit (by increasing taxes) , which
shifts IS to the left
LM
2. At the same time, Alan Greenspan
increases money supply in order to
stimulate output
LM’
i1
3. The end result is that output is held
constant, with a strong fall in interest
rates
i2
IS
i3
IS’
Y2
Y1
Income, Output Y

24. Macroeconomic equilibrium and
policy
Interest rate i
The German reunification in 1992
1. The German reunification resulted in
a large shift of IS to the right, mainly
because of the extra government
spending and increase in consumption
from the ex DDR
LM’
LM
i3
i2
IS’
i1
IS
Y1
Y2
2. At the same time, the Bundesbank
drastically reduced money supply due
to inflation fears, as the ostmark/DM
exchange rate had been set at 1 for 1
due to political reasons
3. The end result of this lack of
coordination is that output was slightly
reduced, with a large increase in
interest rates.
Income, Output Y

25. Macroeconomic equilibrium and
policy
Interest rate i
The current liquidity trap ?
1. The subprime-based financial crisis
has frozen credit markets as well as
depressed consumption. This has
caused a large fall in investment,
shifting IS to the left
LM
LM’
2. The central bank have responded by
injecting large amounts of liquidity in
the markets, and making credit easily
available(“Quantitative easing”). This
pushes LM to the right.
3. But these policies have had no
effect, and the rate of interest is
practically zero (ZIRP!)
i1
i2
IS’
Y2
Y1
IS
3. The only way out is a large fiscal
policy push.
Income, Output Y