Chapter 5,The Analysis of IS-
LM Model
Gang Gong
March 14,2002
Copyright Notes:This electronic file is
only used as a lecture notes for the
student in this class,It is not allowed to
be used for presentation anywhere else
without the permission from the author.
Introduction
? The objective of this chapter is to put the
previously discussed two models -- the
models of product market and money
market --together and discuss how output
and interest rate is determined
? The model presented in this chapter is often
called the IS-LM model (IS,the product
market model; LM the money market
model),
Investment Determination
? In chapter 3,we have assumed that
investment is autonomous and thus it is
simply given,This is certainly not satisfying,
For a complete model of output
determination,we need to discuss how
investment is determined.
Investment Determination
? The determination of investment is one of
the most complicated issue in
macroeconomics,You can list as many as
possible factors that could affect investment,
Empirically,the investment function is the
most difficult one to be estimated,
Investment Determination
? Yet,there is no doubt that investment
should depend on interest rate,If interest
rate increase,investment should decrease,
Why? (to be expressed in the class)
Investment Determination
? Therefore,we could have a simple
investment function,which could be written
as
I=f(i)
where f ’<0.
The IS Curve
? Given the investment function,the
equilibrium condition in product market
could be written as
])([
)1(1
1
)()(
GifA
tc
GiftYYcA
GICY
??
??
?
?????
???
The IS Curve
? It can easily be detected that there is a
negative relation between interest rate and
income,A curve that reflect such a relation
is called IS (standing for investment and
saving) curve,It represents the equilibrium
condition in the product market (see the
graph presented in class),
The LM Curve
? We are now considering the equilibrium
condition in money market,This can be
written as
MhikY ??
The LM Curve
? It can easily be detected that there is a
positive relation between interest rate and
income for a given my money supply,A
curve that reflects such a relation is called
LM (standing for liquid and money) curve
(see the graph presented in class),
The Equilibrium in Product and
Money Market
? We now can put the IS and LM curve
together:
? This system equation determines the
equilibrium condition in both product and
money market
MhikY
ifGA
tc
Y
??
??
??
? )]([
)1(1
1
The Equilibrium in Product and
Money Market
? Note that in the above system,Y and i are
the endogenous variables which need to be
determined by the system,All the others
can be regarded as being either exogenous
or parameters,which are supposed to be
given,In particular,G and are the policy
variable while t is a policy parameter,
M
Change in Equilibrium
? Apparently,change in policy variables or
parameter can change the equilibrium
? Consider a change in G,denoted as ?G,Is
the change in GDP,denote as ?Y,will
satisfy
as we have described in chapter 3?
GtcY ????? )1(1 1
Change in Equilibrium
? Monetary Transmission Mechanism,The
process by which the change in money
supply influence the economy,Please
describe this process as detail as possible.