IS-LM model

 

IS-LM model

Part I (IS) good market equilibrium

Part II (LM) money market equilibrium

Part III simultaneous equilibrium model & previous year questions

 

Intro

IS-LM model also called a Hisk- Hansen model

IS-LM model developed by JR Hisk in 1937 and extended by Alvin Hanson.

IS	LM
Product/goods market	Money market
Equality of investment (I) and saving(S)	Equality of money (L) and money supply (M)

 

Keynesian views:

It has been asserted that in the Keynesian model whereas, The changes in rate of interest in the money market affect investment and therefore the level of income and output in the good market,

In others word, in Keynes simple model the level of national income IS shown to be determined by the good market equilibrium.

The rate of interest, according to Keynes, is determined by money market equilibrium by the demand for and supply of money.

In this simple analysis of equilibrium in the goods market Keynes considers investment to be determined by the rate of interest along with the marginal efficiency of capital and IS shown to be independent of the level of national income.

Hicks, Hansen, Learner and Johnson have put forward a complete and integrated model.

Based on the Keynesian framework where in the variables such as investment, national income, rate of interest, demand for and supply of money are interrelated and mutually interdependent and can be represented by the two curves called the IS and LM curves.

Theirs extended Keynesian model IS therefore known as IS-LM curve model.

In this model they have shown how the level of national income and rate of interest are jointly determined by the simultaneous equilibrium I n the two interdependent goods and money market.

Part I

Good Market Equilibrium (IS)

The goods market IS in equilibrium when aggregate demand IS equal to income. The aggregate demand is determined by consumption demand and investment demand.

Like Keynes ROI is an important determinant of investments.

When the rate of interest falls the level of investment increase and vice versa.

Thus, changes in the rate of interest affect aggregate demand or aggregate expenditure by causing changes in the investment demand.

Thus, IS curve relating different equilibrium levels of national income with various rate of interest.

The lower the rate of interest, the higher will be the equilibrium level of national income.

Thus, the IS curve is the locus of those combination of rate of interest and the level of national income at which goods market is in equilibrium.

The relationship between rate of interest and planned investment is depicted by the invest demand curve II

At rate of interest Or₀ the planned investment, aggregate demand curve IS c+I₀ which, as will be seen in panel (b) equals aggregate output OY, level of income.

The rate of interest Or₂, level of income equals to OY₀ has been plotted.

Now of the rate of interest falls to Or2 the planned investment by business man increaser form Oi₀ to Oi₁

The aggregate demand curves shifts upwards to the new position C+11 in panel (b).

General equilibrium is occurred in where both goods market and money market are interacted with each other's.

IS represent investment and saving

LM represent money demand and money supply

IS-good market equilibrium

LM- money market equilibrium

 

 

IS curve

It shows investment saving relationship.

The independent variables is interest rate and dependent variables is level of national income… that’s why

Interest rate - y axis

Level of income - x axis

 

Slope of IS curve

IS curve IS negatively slopped

The slope of IS dependent on-

1.     Sensitiveness (elasticity)

2.     Size of Multiplier

IS curve shift right

IS curve shift  left

 

 

Shift in IS curve

Why IS curve shift right	Why IS curve shift left
Reduction in saving	Increase in saving
Increase in consumption	Decrease in consumption
Autonomous increase in investment	Autonomous decrease in investment
Auto investment IS independent of income and ROI.

 

 

Part II

LM Approach- Money Market Equilibrium

The LM curve can be derived from the Keynesian theory from its analysis of money market equilibrium.

According to Keynes, demand for money to hold depends upon transactions motive, precaution motive and speculative motive.

It is the money held for transaction motive which is a function of income.

The demand for money also depends on the rate of interest which is the cost of holding money.

The LM curves tells what the various rate of interest will be at different level of income.

As income increases, money demand curve shifts outward and therefore the rate of interest which equates supply of money, with demand for money rises.

In diagram we measure income on the x-axis and plot the income level corresponding to the various interest rate determined at those income level through money market equilibrium by the equality of demand for and the supply of money in (a).

There are two factor on which the slope of the LM curve depends.

First, the responsiveness of demand for money (i.e. liquidity preference) to the changes in income.

As the income increases, say from Y₀ to Y₁ the demand curve for money shifts from Md₀ to Md₁ that is,

With an increase in income demand for money would increase for being held for transactions motive, M_d or

L₁=f(Y).

 

In the new eqm, position with the given stock of money supply, money held under the transaction motive will increase where as the money held for speculative motive will decline.

The second factor which determines the slope of the LM curve is the elasticity or responsiveness of demand for money (i.e. liquidity preference for speculative motive) to the changes in rate of interest.

The  lower the elasticity f liquidity preference for speculative motive with respect to the changes in the rate of interest, the steeper will be the LM curve.

On the other hand, if the elasticity of liquidity preference (money demand-function) to the changes in the rate of interest is high, the LM curve will be flatter or less steep.

 

Shift in LM curve

LM curve shift right

LM curve shift left

 

 

Why LM curve shift right	Why LM curve shift left
Increase in money supply.	Decrease in money supply.
Decrease in demand for money.	Increase in demand for money.

 

Effects of changes in supply of money on the rate of interest and income level.

With the increase in the supply of money, more money will be available for speculative motive at a given level of income which will cause the interest rate to fall. As a result, the LM curve will shift to the right.

With this rightward shift in the LM curve, in the new equilibrium position rate of interest will be lower and the level of income greater then before.

Where with a given supply of money, LM and IS curves intersect at point E.

With the increase in the supply of money, L curve shifts to the right to the position LM and with IS schedule remaining unchanged.

Changes in the desire to save or propensity to consume:

When the people's desire to save falls, that is, when propensity to consume rises, the aggregate demand curve will shift upward and, therefore, level of income will rise at each rate of interest.

As a result, the IS curve will shift outward to the right.

Suppose with a certain given fall n the desire to save (or increase in the propensity to consume), the IS curve shifts rightward to the dotted position IS'. With LM curve remaining unchanged,

The new equilibrium position will be established at H corresponding to which rate of interest as well as level of income will be greater then at E.

On the other  hands, if the desire to save rises, that is, if the propensity to consume falls, aggregate demand curve will shift downward which will cause the level of national income to falls for each rate of interest and as a result the is curve will shift to the left.

With this, and LM curve remaining unchanged,

The new equm position will be reached to the left of E, say at point L corresponding to which both rate of interest and level of national income will be smaller the at E.

 

Part III

Simultaneous changes in IS-LM curve

If investment and money supply increases simultaneously then IS-LM curve shift right.

New equm will be set on new IS-LM curve, but ROI remain same.

 

 

Effectiveness of monetary policy and fiscal policy

I. Effectiveness of monetary policy in LM curve.

a.      Monetary policy is perfectly ineffective when LM curve is horizontal.

b.     MP less effective LM flat.

c.      MP more effective LM steeper.

d.     MP perfectly effective LM vertical.

 

II. effectiveness of monetary policy in is curve

a.      MP is perfectly effective when IS curve is horizontal.

b.     MP is more effective IS curve flat

c.      MP less effective IS curve steep.

d.     MP perfectly ineffective IS vertical.

 

III. effectiveness of fiscal policy in LM curve

a.      Fiscal policy is perfectly effective when LM curve is horizontal.

b.     FP more effective LM flatter.

c.      FP less effective LM steep

d.     FP perfectly ineffective LM vertical.

IV. effectiveness of fiscal policy in IS curve

a.      Fiscal policy is perfectly ineffective when IS curve is horizontal.

b.     FP less effective - IS flat

c.      FP more effective- IS steep

d.     FP perfectly effective- IS vertical.