CHAPTER 14

IS-LM Frame work & Equilibrium

Chapter Outline The IS-LM framework & equilibrium

Development of the IS curve (from ch. 12 pg 140-144)

Development of the LM curve (from ch. 13 pg. 177-180

Shifts in the IS curve Changes in real spending Changes in govt. spending Changes in the taxes Other Variables

Equilibrium in money markets

Chapter Outline cont.

Shifts in the LM curve Changes in monetary policy

Fiscal and monetary policy Automatic stabilizers Discretionary fiscal policy ‘Crowding out’ effect

Development of the IS curveIS curve shows alternative combinations of the

real interest rate (r) and real income (Y) such that the market for goods & services is in equilibrium

The IS curve is downward sloping

r

IS

Y

Deriving the IS curve Interest-related expenditure function (IRE)

At an interest rate of r1-5%, IRE is at e1-80 mil. When rate of interest drops to r2-4%, IRE increases to e2- 100

mil. IRE = Interest-sensitive consumption and investment spending

IREe1 e2

r

r2IRE

A

B

r1

Deriving…. The effect of the increase in

IRE resulting from a lower r can be shown as an increase in aggregate expenditures (e)

In rate of interest In IRE (earlier graph) In Aggregate Expenditures

(shifting e1 to e2) In income level

IS curve is shown in Panel (2) which relates real interest rate and real income combinations reflecting equilibrium points in panel (1) – A and B

(2)

e1

B

Y

Y

r1

Y2Y1

Y2Y1

r2

r

A

e2

e1

Y

IS

(1)

A

BY

Effect of an increase in G If G increases

Aggregate expenditures curve shifts from e1 to e2

Income level increases from Y1 to Y2

Rate of interest does not change

Thus, IS curve shifts to the right (IS1 to IS2)

Interest rate remains fixed at r1

Y

e2

e1

Y

A

B

Y2Y1

Y1 Y2

r1

r

IS1

IS2

A

Development of the LM curve

LM (Liquidity-money) curve shows alternative combinations of the interest rate and real income such that the money market is in equilibrium

r

o Y

LM

Deriving LM curve

Money market is in equilibrium at Point A with interest rate r1 Now suppose that income increases. This will shift the demand curve for

money from D1 to D2. D1 corresponds to income level Y1 and D2 corresponds to Y2 Interest rate goes up to r2 LM curve shows equilibrium points A and B in the money market

r2

r

r1

r2

r1D2

D1

M/P1 M/P Y2Y1Y

A

B

LMRLMS

A

B

Effect of an increase in money supply

In money supply by FED In interest rate to r2• Income level remains constant at Y1• LM1 curve shifts to LM2

r1

r2

r1

r2

MS1 M/P Y1Y

A

B

LM1

RLMS1

A

B

MS2

LM2

RLMS2

Effect of an increase in Price level

Draw Graph and Explain.

Equilibrium in IS-LM framework

This Equilibrium shows the level of interest rate and real income where there is simultaneous equilibrium in both money market and the market for goods and services

MS

O

re

IS

A

r

YeY

Effect of an increase in G In G

Shift in IS1, curve to IS2 New equilibrium at point B Interest rate (r1 to r2) Income level (Y1 to Y2)

r2

r

IS1IS2

A

B

C

Y1 Y2 Y3Y

r1

LM

Effect of an increase in G….

Crowding out refers to a decrease in IRE that occurs when interest rate rises due to an increase in G

When government borrows funds to finance increase in G in the financial market, interest rate goes up due to an increase in demand. The difference between point C and B shows crowding out effect

Effect of an increase in Money Supply

In money supply by Fed shift in LM curve In interest rate In income level

A

B

LM1

LM2

r1

r2

Y1 Y2

IS

o