ECN 302 602 5 The IS LM Model

Chapter 4 -The IS-LM Model
 Fundamental inflexibility assumptions:
W -- inflexible
P -- inflexible
i -- flexible
 Overriding theme -- The interest rate
changes as a result of monetary policy
(money supply) as well as other
factors.

The IS Curve
 Re-translation of Simple
Keynesian model at equilibrium
(Investment = Saving).
 A plot of equilibrium output for
various interest rates within the
market for goods and services.

Properties of the IS Curve
 Downward sloping,
i  C, I  Y*

 Shift variables consist of the shift
variables of the EP curve, except
for the nominal interest rate (i).

Shifting the IS Curve
 Increases in autonomous
expenditure which shift the EP curve
upward, simultaneously shift the IS
curve rightward.
 Decreases in autonomous
expenditure which shift the EP curve
downward, simultaneously shift the
IS curve leftward.

Steepness or
Flatness of the IS Curve
 The steepness or flatness of the IS
curve describes the elasticity or
responsiveness of C and I to the
nominal interest rate.

-- Steep IS curve: inelastic.
-- Flat IS curve: elastic.

Considering Additional
Behavior (Curve #2)
 Extra behavior -- decisions to hold
money and financial assets.
 The Demand for Money -- The
decision of how much of total
wealth should be held as money
(I.e. currency and checkable
deposits).

Fundamental Aspects -The Demand for Money
 Group all assets into two categories -money and “bonds”.
 Advantage of holding money -convenience for making desired
transactions.
 Disadvantage of holding money -interest that could be earned by holding
bonds instead.

More Fundamentals:
The Demand for Money
 Major advantage of holding money
implies that we demand money in real
units.
 The Demand for Money (L) -- liquidity
preference.
 For a given level of real wealth, the
demand for money covers the entire
financial asset holding decision (Walras
Law).

The Demand for Money in
Real Terms (L) -- Causes
 Output or Income (Y)
Y  L
 The interest rate (i)
i  L
 Financial Innovation (FI)
FI  L

The Supply of Real
Money (Ms/P) -- Causes
 The Nominal Money Supply (MS) -the Federal Reserve’s variable for
monetary policy.
MS  (MS/P)
 The (Inflexible) Price Level (P)
P  (MS/P)

The LM Curve
 Depicts equilibrium in the money
market (L = M), as well as the Bond
Market (by Walras Law).
 A plot of the equilibrium interest rate
for various levels of output or income
versus the interest rate, within the
money market for a given level of the
nominal money supply.

Properties of the LM Curve

 Upward sloping,
Y  L  i*
 Shift variables consist of the shift
variables of the money demand
and supply curves (except for Y).

Shifting the LM Curve
 Increases in the real money supply
(MS or P) shift the LM curve
rightward.
 Decreases in the real money
supply (MS or P) shift the LM
curve leftward.

Steepness or
Flatness of the LM Curve
 The steepness or flatness of the
LM curve describes the elasticity
or responsiveness of money
demand (L) to the nominal interest

rate.
-- Steep LM curve: inelastic.
-- Flat LM curve: elastic.

Economic Policy:
IS-LM Model
 Equilibrium output (Y*) takes place
where the IS and LM curves intersect
(equilibrium interest rate, i*, as well).
 Keynesian property of model 
Y* < YN, (sluggish economy)

Y* > YN, (accelerating inflation)
Y* = YN (desired state)

Types of Policy:
IS-LM Model
 Fiscal Policy – Federal givernment
changes G0, T0, t, or other components
of autonomous goods and services

expenditure  Shift the IS curve.
 Monetary Policy – Federal Reserve
changes the nominal money supply
(MS)  Shift the LM curve.

Expansionary and
Contractionary Policy
 Expansionary (Y* < YN) -- shifts the
appropriate curve rightward.
 Contractionary (Y > YN) -- shifts the
appropriate curve leftward.

Policy Effectiveness
 An effective policy is one that
obtains a large output response
for a given change - Policy effectiveness depends upon
the steepness or flatness of the IS
and LM curves.