Session 11 – 15

IS-LM
and
Fiscal & Monetary Policies

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 IS-LM MODEL
What is IS-LM Model?

A general equilibrium model

The model of output determination is incomplete without
linking money and interest rate with output
Money and interest rate are determinants of AD
Central bank does play a role in determining output and
income
Real (goods market) and monetary (money market) sectors are
not watertight compartments
IS-LM provides the framework for achieving equilibrium in
goods and money markets and simultaneous determination of
interest rate and output
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 IS-LM Model

IS-LM model is the core of short-run macroeconomics

– Maintains the details of earlier model, but adds the

interest rate as an additional determinant of
aggregate demand

– Includes the goods market and the money market,

and their link through interest rates and income

3
 How are Money and Output Related?
Monetary policy works through the money market to affect output
and employment

The increase in interest rate may offset fully the expansionary

effects of fiscal policy.

The composition of aggregate demand between I and C spending

depends on the interest rate.

Interest rate changes have an important side effect. An

expansionary fiscal policy tends to raise consumption through the
multiplier but tends to reduce investment because it increases
interest rates.
Pump priming will crowd out private investment.
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 Conclusion

Income
Assets Markets Goods Market
Money market Bond Market Aggregate Demand
Output
Demand Demand
Supply Supply

Interest Rate

Monetary Policy Fiscal Policy

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 F-3 GDP=
M-5
C+I+G+X-M
External
Households Firms Government
Sector
(C) (I) (G)
(X-M)

Goods Market Assets Markets Labor Market

Aggregate Demand Money Bond (Wages)
M-1 market Market
(C+I+G+X-M) & Demand Demand
Aggregate supply & & F-5 Debt
F-2 M-4
F-1 M-3 Supply Supply (Domestic/Foreign)
F-4
Employment M-2 F-6
Employment
Prices & Inflation

Monetary Fiscal Policy

Interest Rate
Policy (the Budget)

Exchange Rate
Centre, States &
RBI/Banks, FIs Local Govts 6
 Investment and Interest Rate
• The investment spending function can be specified as:

Interest rate, r
I = c - dr

where d > 0

I(r)
Investment, I
– r = rate of interest
– d = the responsiveness of investment spending to the interest rate
– c = autonomous investment spending
– Negative slope reflects assumption that a reduction in r increases the
quantity of I

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 Investment and Interest Rate

I  c  dr
The position of the I schedule is determined by:
• The slope, d
If investment is highly responsive to r, the investment
schedule is almost flat.
If investment responds little to r, the investment
schedule is close to vertical

• Level of autonomous spending

An increase in c shifts the investment schedule out.
A decrease in c shifts the investment schedule in.
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 Need to modify the AD function of the last chapter to
reflect the new planned investment spending schedule

AD=C+I+G+X-M
= [a+bB+b(1-t)Y]+(c – dr)+G+X-M

─ An increase in r reduces AD for a given level of income.

─ At any given level of r, can determine the equilibrium

level of income and output as in Chapter 10.

─ A change in r will change the equilibrium

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 The Goods Market
• In the multiplier model, stock of money, interest rate and RBI
have no place.
• The model therefore needs to be broadened by introducing
interest rate as an additional determinant of aggregate demand.
C= a+bYd Yd = Y-T+B and T = tY
C= a+b(Y+B-tY)
C= a+bB+b(1-t)Y and I = c - dr
AD=C+I+G+X-M
=[a+bB+b(1-t)Y]+(c – dr) +G+X-M
=a+bB+c+G+X-M+b(1-t)Y-dr
Since Y=AD
Y=A+b(1-t)Y- dr
Therefore, 1
Y ( A  dr )
1  b(1  t )
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 The Aggregate Demand and Output

AD
AD=Y

∆G A+b(1-t)Y-dr0

A+b(1-t)Y-dr1
A-dr0
∆I
A-dr1

Y1 Y0 Y2 Output, Y
 AD AD=Y
The Goods Market and the (b) The AD and Output

IS Curve ∆G
A+b(1-t)Y-dr1

A-dr1 A+b(1-t)Y-dr2
∆I
A-dr2

(a) The Investment Function

Output, Y
Interest rate, r

Interest rate, r

r2 (c) The IS curve

r2 ■D

r1 r1 ■E ■
I(r) IS
I(r2) I(r1) Investment, I Y2 Y1 Y3 Output, Y

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 What is the IS curve?
1
Y  ( A  dr )
1  b (1  t )
A Y [1  b (1  t )]
r  
d d
• The IS curve is called the goods market equilibrium schedule.

• The IS curve is the schedule of combination of the r and Y

such that the goods market is in equilibrium.

• The IS curve is negatively sloped because an increase in the r

reduces planned I spending and therefore reduces AD, thus
reducing the equilibrium level of Y.
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Slope of the IS Curve
• Multiplier: The smaller the multiplier, the steeper the IS curve.
• Slope of the Investment demand schedule: the less sensitive I
spending is to changes in the interest rate, the steeper the IS
curve.
• Fiscal policy can affect the slope. E.g., an increase in tax rate
(t) reduces the multiplier.

Position of the IS Curve

• The IS curve is shifted by changes in autonomous spending.
An increase in autonomous spending, including G, shifts the
IS curve out to the right.
• The IS curve shifts horizontally by a distance equal to the
multiplier times the change in autonomous spending (A).
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 The Money Market and the LM Curve
• The LM curve shows combinations of interest rates and levels
of output such that money demand equals money supply 
equilibrium in the money market
• The LM curve is derived in two steps:
1. Explain why money demand depends on interest rates and
income
– Theory of real money balances, rather than nominal

2. Equate money demand with money supply, and find

combinations of income and interest rates that maintain
equilibrium in the money market
– (r, Y) pairs meeting this criteria are points on a given LM
curve
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 What Determines Interest Rate?

• Demand for money (Liquidity Preference)

Transaction demand: Mt= k(Y)
Precautionary demand: Mp = k(Y)
Speculative demand: Msp= h(r)

M
Real Md =
 L(Y , r )
P
ln M  ln P  ln   k ln Y   ln r

• Supply of money (Ms) is exogenous

• Money market equilibrium, Md=Ms
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 Demand for Money
• L = kY - hr
• The parameters k and h reflect the sensitivity of demand for real balances to
the level of Y and r
• The demand function for real balances implies that for a given level of
income, the quantity demanded is a decreasing function of r
– The inverse relationship between money demand and r  money
demand curve.
r

kΔY
Interest rate

L2=kY2 - hr

L1=kY1 - hr
M/P L1 L
Real balance
L2
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 The Supply of Money and
the Money Market Equilibrium

Interest rate
The nominal quantity of money
supplied, M, controlled by
central bank.
r2 E2

Real money supply is , where

M and P are assumed fixed
r1 E1 L2=kY2 - hr
The figure shows combinations
of r and Y such that demand for
real money balances exactly
matches available supply. L1=kY1 - hr

M/P
Real balance
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 The Money Market
and The LM Curve
B A
Interest Interest
rate
LM rate

E2
r2 r2

L2=kY2 - hr

r1 E1
r1
■
L1=kY1 - hr

Y1 Y2 M/P
Real balance
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 What is the LM curve?

M
 kY  hr
P
1 M
r   kY  
h P
• The LM curve is the schedule of combination of r and Y such
that money market is in equilibrium.

• Money market equilibrium implies that an increase in r is

accompanied by an increase in Y. An increase in r reduces the
demand for real balances. To maintain the demand for real
balances equal to the fixed supply, the level of Y has to rise.
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 Slope and Position of the LM curve?
• The LM curve is positively sloped. Given the fixed money
supply, an increase in Y which increases the quantity of money
demanded, has to be accompanied by an increase in the r.

• The LM curve is steeper when the demand for money responds

strongly to Y and weakly to r, i.e., when k is high and h is low.

• The LM curve is nearly vertical if the demand for money is

relatively insensitive to the r. If the demand for money is very
sensitive to r, the LM curve is close to horizontal.

• The LM curve is shifted by changes in the money supply. An

increase in the money supply shifts the LM curve to the right.
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 General Equilibrium
• The IS and LM schedules summarize the conditions that have to be satisfied for the goods and
money markets to the in equilibrium.
• Assumptions:
– Price level is constant
– Firms willing to supply whatever amount of output is demanded at that price level

LM
Interest rate

I<S, Md < Ms

I > S, Md < Ms
r0 I<S, Md > Ms

I > S, Md > Ms
IS
Y0 Income
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 Changes in the Equilibrium Levels of Income
and the Interest Rate
• The equilibrium levels of income and the interest rate change when either the IS or the LM
curve shifts.
• The figure shows effects of an increase in autonomous spending (say, Δc, autonomous I)
– Shifts IS curve out by 1
c if autonomous investment Δc is the source of
increased spending. 1  b (1  t )

– The resulting change in Y is smaller than the change in autonomous spending due to
slope of LM curve. Interest rate
LM

E1
r1
E
r0
1
c
1  b(1  t ) IS1
ΔY0
IS
Income
Y0 Y1
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 Deriving the AD Curve LM(M0/p2)
LM(M0/p1)
(1)
LM(M0/p0)
At successively higher price A
levels, P0, P1, P2, the LM r2
r1 B
schedule in part (1) is

Interest rate
C
shifted farther to the left. r0
This shift results in IS
successively lower levels of
AD, Y0, Y1, Y2. Y2 Y1 Y0 Output

P2 A
These combinations of price
(2)
Price level

and AD are plotted to give P1 B

the negatively sloped AD
P0 C
schedule in part (2)
AD(M0)
Y2 Y1 Y0 Output
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Monetary and Fiscal Policies
in IS-LM Framework

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How Fiscal & Monetary Policies Work?

• Fiscal policy has its initial impact in the goods market.

• Monetary policy has its initial impact mainly in the assets
markets.
Because the goods and assets markets are interconnected,
both fiscal and monetary policies have effects on both the
level of output and interest rates.

Expansionary (contractionary) monetary policy moves the

LM curve to the right (left).

Expansionary (contractionary) fiscal policy moves the IS

curve to the right (left).
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 Monetary Policy and Output
Open market purchase by RBI
Interest rate

LM • Adjustment to the monetary

expansion:
LM1 – Increase in money supply
(Δ ) creates excess supply of
e1 money
r0 – Public buys other assets
– Asset prices increase, yields
r1 e3 decrease  move to point e2
– Decline in interest rate
e2 results in excess demand for
goods
IS
– Output expands and move
up LM1 schedule
Y0 Y1 output
• Increased money supply reduces interest rate and thereby increases investment.
• The steeper the LM schedule, the larger the change in output.
• If the demand for money is very sensitive to Y (larger k), a given increase in
money supply can be absorbed with a smaller change in Y.
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 The Monetary Transmission Mechanism
• The mechanism by which a change in real money supply affects the AD
and output.

Increase (decrease) in money supply

Portfolio adjustment due to:

1. fall (rise) in interest rate
2. rise (fall) in asset prices

Aggregate spending (C+I)

rises (falls)

Output adjusts to changes in

C and I
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 Horizontal and Vertical LM curves
• Monetary and fiscal policies under liquidity trap (Horizontal
LM curve)
• Changes in quantity of money do not shift LM curve
• Liquidity easing through OMO has no effect on r and Y
• Fiscal policy has maximal effect on Y

• Monetary and fiscal policies under Classical case (vertical LM

curve)
• Shift in the IS do not affect the level of Y when LM curve
is vertical
• Monetary policy has a maximal effect on the level of Y
and fiscal policy has no effect on Y
• An increase in G has no effect on Y. It raises only r
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 Fiscal Policy and Output
An increase in Govt Spending
Interest LM
rate

e3
r1 The effect of crowding out – e2 to e3

r0 e2
e1
IS1
IS

Y0 Y1 Y2 output

Crowding out occurs when expansionary fiscal policy causes interest rates to
rise, thereby reducing private investment.
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 Monetary accommodation of fiscal expansion
Interest LM LM1
rate
RBI monetizes fiscal deficit
e3
r1
The effect of crowding out – e2 to e3
r0 e2
e1

IS1
IS
Y0 Y1 Y2 output
Monetisation of budget deficits means RBI prints money to buy bonds with
which the government pays for its debt.

When RBI accommodates a fiscal expansion, both the IS and LM schedules

shift to the right, increasing output and keeping interest rate unchanged.
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 Effectiveness of
Fiscal & Monetary Policies

• Keynesian range: Fiscal policy is highly

effective

• Classical range: Monetary policy is effective

not Fiscal policy

• Intermediate range: Monetary and fiscal

policies are less effective

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 The Policy Mix
The target income Y can be LM1
attained by easy fiscal policy
LM0
and tight monetary policy.
Equilibrium at A implies higher A
r and low C and I. r1

Interest rate
D C
r0
Alternatively, with easy B
monetary policy and tight fiscal
IS0 IS1
policy r remains lower and C
and I are higher at the same Y Output
output level

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 References
• DFS: Macroeconomics, Chapter 11 & 12.

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