Chapter 5,Goods and Financial
Market,The IS-LM Model
5-1:The Goods Market and the IS Relation
5-2:Financial Market and the LM Relation
5-3:The IS-LM Model,Exercise
5-4:Using a Policy Mix
5-5,Adding Dynamics
5-6:Does the IS-LM Model Actually Capture
What Happens in the Economy?
5-1:The Goods Market and the
IS Relation
Summarize what we learned in chapter 3
Investment,Sales,and the interest rate
The IS curve
Shifts in the IS Curve
Summarize
Summarize what we learned in
chapter 3
We characterized equilibrium in the goods
market as the condition that production,Y,be
equal to the demand for goods,Z,We called
this condition the IS relation,because it can
be reinterpreted as the condition that
investment be equal to saving.
Summarize what we learned
in chapter 3
We defined demand as the sum of
consumption,investment,and government
spending,We assumed that consumption
was a function of disposable income(income
minus taxes),and took investment spending,
government spending,and taxes as given,
The equilibrium condition was given by
Y=c(Y-T)+I+G
Summarize what we learned
in chapter 3
Using this equilibrium condition,we then
looked at the factors that changed
equilibrium output,We looked at
particular at the effects of changes in
government spending and of shifts in
consumption demand
Investment,Sales,and the
interest rate
In our first model of output determination,investment
was left unexplained— we assumed it was constant,
even when output changed,Investment is in fact far
from constant,and it depends primarily on two factors,
● The level of sales
● The interest rate
To capture these two effects,we write the investment
relation as follows:
I=I(Y,i) (5.1)
(+,-)
Equation (5.1) states that investment depends on
production,Y,and the interest rate,i.
The IS Curve
Taking into account the investment relation
(5.1),the equilibrium condition in the goods
market becomes
Y=c(Y-T)+I(Y,i)+G (5.2)
The supply of goods (the left side) must be
equal to the demand for goods (the right side)
Equation (5.2) is our expanded IS relation,
We can now look at what happens to output
when the interest rate changes.
Dem an d,Z 45
0
L i ne Z Z
A ( f o r i n t e r e s t i )
Z Z '
(a) (for i nt ere st i ' > i )
A '
Y ' Y Outp ut,Y
i nt ere st ra t e i
(b) i ' A '
i A
I S c u r v e
Y ' Y O u t p u t,Y
Shifts in the IS Curve
Int eres t,i
i
I S ( f o r t a x e s T )
I S ' (f or T ' >T )
Y ' Y Output,Y
Summarize
Equilibrium in the goods market implies that
output is a decreasing function of the interest
rate.
This relation is represented by the downward-
sloping IS curve.
Changed in factors that decrease or increase
the demand for goods given the interest rate
shift the IS curve to the left or to the right.
5-2:Financial Market and the
LM Relation
Real Money,Real Income,and the
Interest Rate
The LM Curve
Shifts in the LM Curve
Summarize
Real Money,Real Income,and
the Interest Rate
The equation M=$YL(i) gives a relation
between money,nominal income,and the
interest rate,Recall that nominal income
divided by the price level equals real
income,Y,Dividing both sides of the equation
by the price level P (which we take as given
here) gives
M/P=YL(i) (5.3)
From now on,we shall refer to equation (5.3)
as the LM relation.
The Effects of an Increase in
Income on the Interest Rate
Int eres t,i
M
s
i ' A '
M
d '
(f or Y ' >Y)
i A
M
d
(f or Income Y)
M /P (Re al)money,M /P
The Derivation of the LM Curve
I nt erest,i I nt erest,i
M
s
L M Cur ve
i ' A ' i ' A '
M
d '
( f or Y ' > Y)
i A i A
M
d
( f or Y)
M / P Y Y '
( Real)Mo ney,M/P I ncom e,Y
( a) ( b)
Shifts in the LM Curve
Interes t,i L M
( f o r M / P )
L M '
i (f or M ' /P> M /P)
i '
Y
I n c o m e,Y
Summarize
Equilibrium in financial markets implies that
the interest rate is an increasing function of
the level of income,This relation is
represented by the upward-sloping LM
curve.
Increases in money shift the LM curve
down; decreases in money shift the LM
curve up.
5-3:The IS-LM Model,Exercise
The IS-LM Model
Fiscal Policy,Activity,and the Interest Rate
Monetary Policy,Activity,and the interest
Rate
Summarize
The IS-LM Model(1)
We can now put the IS and LM relations
together,At any point in time,the supply of
goods must be equal to the demand for
goods,And the supply of money must be
equal to the demand for money,Both the IS
and LM relations must hold
● IS relation,Y=c(Y-T)+I(Y,i)+G
● LM relation,M/P=YL(i)
The IS-LM Model(2)
In ter es t,i L M
E q u i l i b r i u m i n
G o o d s M a r k e t
E q u i l i b r i u m i n
i F i n a n c i a l M a r k e t
I S
Y
O u t p u t ( i n c o m e ),Y
Fiscal Policy,Activity,and the
Interest Rate (1)
In answering any question about the effects of changes
in policy,always follow these three steps:
Step 1,Ask how this change affect goods and financial
markets equilibrium relations,how it shifts the IS
or/and the LM curve
Step 2,Characterize the effects of these shifts on the
equilibrium
Step 3,Describe the effects in words
Fiscal Policy,Activity,and the
Interest Rate (2)
Interes t rate,i
L M
i D A
i ' A ' I S
I S '
Y ' Y
O u t p u t,Y
Monetary Policy,Activity,and
the Interest
Interes t rate,i
L M ( f o r M / P )
L M '
( f o r M ' /P> M /P)
i A
i ' A '
I S
Y Y '
Output,Y
Summarize (1)
Table 5-1,The effects of Fiscal and
Monetary Policy
Shift Shift Movement Movement
in IS in LM in output Interest Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
Summarize (2)
You should remember the method we have
development in this section to look at the effects of
changes in policy on activity and the interest rate,We
shall use it throughout the book
We have used this method to look at the effects of
fiscal and monetary policy on output and the interest
rate,Table 5-1 summarizes what we have learned,
But you should learn to use the same method to look
at other changes as well,
5-4:Using a Policy Mix
We have looked so far at fiscal and
monetary policy in isolation,Our
purpose was to show how each worked,
In practice,the two are often used
together,The combination of monetary
and fiscal policies is known as
monetary-fiscal policy mix,or simply
the policy mix.
5-4:Using a Policy Mix
i L M
L M ′
i A
B
A ′ IS
I S ′
Y O u t p u t,Y
Figur e D ef i ci t R educti on and M onetar y Exp ans i on
The r i ght co m bi nat i o n of de fi c i t re du ct i on and m onet ar y expans i on can
achi eve a re duct i on i n t he def i ci t w i t hout adver se ef fe ct s on out put,
5-5,Adding Dynamics
Fi gure, Int roducing Dy namics in the IS - L M M odel
(a)Goods M arket (b) Fi nanc ial M arket
Int eres t rate,i I n t e r e s t r a t e,i
IS ' IS L M '
Output
de cre ases i
B
B L M
s lo wly
i
A
B A ' i
A
A Int er est
Output ra t e adj ust
Incre ase Sl owly in s ta nt an eo ul y
Y
B
Y
A
Y
A
Output,Y Output,Y
The Dynamic Effects of a
Monetary Contraction
Interes t rate,i
L M '
i " A " LM
A '
i '
i A
IS
Y ' Y
O u t p u t,Y
5-6:Does the IS-LM Model Actually
Capture What Happens in the Economy?
The IS-LM model gives us a way of thinking about the
determination of output and the interest rate,But it is
a theory based on many assumptions and many
simplifications,How do we know that we have made
the right simplifications? How much should we
believe the answer given by the IS-LM model?
These are the questions facing any theory,whether in
macroeconomics or anywhere else,A theory must
pass two tests.
● First,the assumptions and the simplifications must
be reasonable
● Second,the major implications of the theory must
be consistent with what we actually see in the world.
Market,The IS-LM Model
5-1:The Goods Market and the IS Relation
5-2:Financial Market and the LM Relation
5-3:The IS-LM Model,Exercise
5-4:Using a Policy Mix
5-5,Adding Dynamics
5-6:Does the IS-LM Model Actually Capture
What Happens in the Economy?
5-1:The Goods Market and the
IS Relation
Summarize what we learned in chapter 3
Investment,Sales,and the interest rate
The IS curve
Shifts in the IS Curve
Summarize
Summarize what we learned in
chapter 3
We characterized equilibrium in the goods
market as the condition that production,Y,be
equal to the demand for goods,Z,We called
this condition the IS relation,because it can
be reinterpreted as the condition that
investment be equal to saving.
Summarize what we learned
in chapter 3
We defined demand as the sum of
consumption,investment,and government
spending,We assumed that consumption
was a function of disposable income(income
minus taxes),and took investment spending,
government spending,and taxes as given,
The equilibrium condition was given by
Y=c(Y-T)+I+G
Summarize what we learned
in chapter 3
Using this equilibrium condition,we then
looked at the factors that changed
equilibrium output,We looked at
particular at the effects of changes in
government spending and of shifts in
consumption demand
Investment,Sales,and the
interest rate
In our first model of output determination,investment
was left unexplained— we assumed it was constant,
even when output changed,Investment is in fact far
from constant,and it depends primarily on two factors,
● The level of sales
● The interest rate
To capture these two effects,we write the investment
relation as follows:
I=I(Y,i) (5.1)
(+,-)
Equation (5.1) states that investment depends on
production,Y,and the interest rate,i.
The IS Curve
Taking into account the investment relation
(5.1),the equilibrium condition in the goods
market becomes
Y=c(Y-T)+I(Y,i)+G (5.2)
The supply of goods (the left side) must be
equal to the demand for goods (the right side)
Equation (5.2) is our expanded IS relation,
We can now look at what happens to output
when the interest rate changes.
Dem an d,Z 45
0
L i ne Z Z
A ( f o r i n t e r e s t i )
Z Z '
(a) (for i nt ere st i ' > i )
A '
Y ' Y Outp ut,Y
i nt ere st ra t e i
(b) i ' A '
i A
I S c u r v e
Y ' Y O u t p u t,Y
Shifts in the IS Curve
Int eres t,i
i
I S ( f o r t a x e s T )
I S ' (f or T ' >T )
Y ' Y Output,Y
Summarize
Equilibrium in the goods market implies that
output is a decreasing function of the interest
rate.
This relation is represented by the downward-
sloping IS curve.
Changed in factors that decrease or increase
the demand for goods given the interest rate
shift the IS curve to the left or to the right.
5-2:Financial Market and the
LM Relation
Real Money,Real Income,and the
Interest Rate
The LM Curve
Shifts in the LM Curve
Summarize
Real Money,Real Income,and
the Interest Rate
The equation M=$YL(i) gives a relation
between money,nominal income,and the
interest rate,Recall that nominal income
divided by the price level equals real
income,Y,Dividing both sides of the equation
by the price level P (which we take as given
here) gives
M/P=YL(i) (5.3)
From now on,we shall refer to equation (5.3)
as the LM relation.
The Effects of an Increase in
Income on the Interest Rate
Int eres t,i
M
s
i ' A '
M
d '
(f or Y ' >Y)
i A
M
d
(f or Income Y)
M /P (Re al)money,M /P
The Derivation of the LM Curve
I nt erest,i I nt erest,i
M
s
L M Cur ve
i ' A ' i ' A '
M
d '
( f or Y ' > Y)
i A i A
M
d
( f or Y)
M / P Y Y '
( Real)Mo ney,M/P I ncom e,Y
( a) ( b)
Shifts in the LM Curve
Interes t,i L M
( f o r M / P )
L M '
i (f or M ' /P> M /P)
i '
Y
I n c o m e,Y
Summarize
Equilibrium in financial markets implies that
the interest rate is an increasing function of
the level of income,This relation is
represented by the upward-sloping LM
curve.
Increases in money shift the LM curve
down; decreases in money shift the LM
curve up.
5-3:The IS-LM Model,Exercise
The IS-LM Model
Fiscal Policy,Activity,and the Interest Rate
Monetary Policy,Activity,and the interest
Rate
Summarize
The IS-LM Model(1)
We can now put the IS and LM relations
together,At any point in time,the supply of
goods must be equal to the demand for
goods,And the supply of money must be
equal to the demand for money,Both the IS
and LM relations must hold
● IS relation,Y=c(Y-T)+I(Y,i)+G
● LM relation,M/P=YL(i)
The IS-LM Model(2)
In ter es t,i L M
E q u i l i b r i u m i n
G o o d s M a r k e t
E q u i l i b r i u m i n
i F i n a n c i a l M a r k e t
I S
Y
O u t p u t ( i n c o m e ),Y
Fiscal Policy,Activity,and the
Interest Rate (1)
In answering any question about the effects of changes
in policy,always follow these three steps:
Step 1,Ask how this change affect goods and financial
markets equilibrium relations,how it shifts the IS
or/and the LM curve
Step 2,Characterize the effects of these shifts on the
equilibrium
Step 3,Describe the effects in words
Fiscal Policy,Activity,and the
Interest Rate (2)
Interes t rate,i
L M
i D A
i ' A ' I S
I S '
Y ' Y
O u t p u t,Y
Monetary Policy,Activity,and
the Interest
Interes t rate,i
L M ( f o r M / P )
L M '
( f o r M ' /P> M /P)
i A
i ' A '
I S
Y Y '
Output,Y
Summarize (1)
Table 5-1,The effects of Fiscal and
Monetary Policy
Shift Shift Movement Movement
in IS in LM in output Interest Rate
Increase in taxes left none down down
Decrease in taxes right none up up
Increase in spending right none up up
Decrease in spending left none down down
Increase in money none down up down
Decrease in money none up down up
Summarize (2)
You should remember the method we have
development in this section to look at the effects of
changes in policy on activity and the interest rate,We
shall use it throughout the book
We have used this method to look at the effects of
fiscal and monetary policy on output and the interest
rate,Table 5-1 summarizes what we have learned,
But you should learn to use the same method to look
at other changes as well,
5-4:Using a Policy Mix
We have looked so far at fiscal and
monetary policy in isolation,Our
purpose was to show how each worked,
In practice,the two are often used
together,The combination of monetary
and fiscal policies is known as
monetary-fiscal policy mix,or simply
the policy mix.
5-4:Using a Policy Mix
i L M
L M ′
i A
B
A ′ IS
I S ′
Y O u t p u t,Y
Figur e D ef i ci t R educti on and M onetar y Exp ans i on
The r i ght co m bi nat i o n of de fi c i t re du ct i on and m onet ar y expans i on can
achi eve a re duct i on i n t he def i ci t w i t hout adver se ef fe ct s on out put,
5-5,Adding Dynamics
Fi gure, Int roducing Dy namics in the IS - L M M odel
(a)Goods M arket (b) Fi nanc ial M arket
Int eres t rate,i I n t e r e s t r a t e,i
IS ' IS L M '
Output
de cre ases i
B
B L M
s lo wly
i
A
B A ' i
A
A Int er est
Output ra t e adj ust
Incre ase Sl owly in s ta nt an eo ul y
Y
B
Y
A
Y
A
Output,Y Output,Y
The Dynamic Effects of a
Monetary Contraction
Interes t rate,i
L M '
i " A " LM
A '
i '
i A
IS
Y ' Y
O u t p u t,Y
5-6:Does the IS-LM Model Actually
Capture What Happens in the Economy?
The IS-LM model gives us a way of thinking about the
determination of output and the interest rate,But it is
a theory based on many assumptions and many
simplifications,How do we know that we have made
the right simplifications? How much should we
believe the answer given by the IS-LM model?
These are the questions facing any theory,whether in
macroeconomics or anywhere else,A theory must
pass two tests.
● First,the assumptions and the simplifications must
be reasonable
● Second,the major implications of the theory must
be consistent with what we actually see in the world.
