IS LM Model

12 Key excerpts on "IS LM Model"

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  eBook - PDF

  21st Century Economics: A Reference Handbook

  • Rhona C. Free(Author)
  • 2010(Publication Date)
  • SAGE Publications, Inc

    (Publisher)

  The equilibrium condition in the goods market is S=I (sav-ing = investment), and the equilibrium condition in the money market isL = M (money demand = money supply). The basic equations of the IS-LM model are defined as follows: S = a + bY+ci. (1) I = d + eY+fi. (2) L = A+BY+Ci. (3) M=M 0 . (4) a: autonomous savings (a < 0) b: marginal propensity to save (b > 0) c: interest elasticity of savings (c > 0) d: autonomous investment (d > 0) e: marginal propensity to invest (e > 0) /• interest elasticity of investment if < 0) A: autonomous demand for money (A > 0) B: transactions demand for money (B > 0) C: speculative demand for money (C < 0) M: exogenous money supply determined by the central bank Y: aggregate output and income /: interest rate To solve for the IS-LM equations, we set / = S and L = M, and then we solve for the IS and LM equations. The result-ing equations are the following: ( _ _ e ) + ( e _ A ) hs= , -Γ , -τ·Υ· (5) (c -f) (c -f) (M-A) v — · γ -(6) LM K } C-(B/Q Finally, to solve for the equilibrium level of interest rate (/*) and the equilibrium level of output and income (Y*), we have to set i' /5 = i LM and solve for Y*, then plug the Y* value into either Equation 5 or Equation 6 to find the i* value. = (M-A)(b-e)-B(d-d) B(f- c) + C(b -e) p _ (M-A)(c-f)-C(d-a) B(c-f) + C(e-b) Equations 5 and 6 allow us to plot a downward-sloping IS curve and an upward-sloping LM curve. However, the downward slope of the IS curve is possible only under the condition that the marginal propensity to save is greater than the marginal propensity to invest (b > e). Assuming that b is greater than e, the resulting IS-LM model gives us the equilibrium level of interest rate (/'*) and the equilibrium level of output and income (Y*). This equilibrium solution must have four characteristics: 1. it must exist (i.e., the IS and LM curves must intersect), 2. it must be unique (i.e., the IS and LM curves must intersect only once), 3.

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  Classical Macroeconomics

  Some Modern Variations and Distortions

  • James C.W. Ahiakpor(Author)
  • 2003(Publication Date)
  • Taylor & Francis

    (Publisher)

  For some users of the model, the hope seems to be that continuing research in macroeconomic analysis will provide the means for correcting its major deficiencies for it to capture better the workings of a monetary economy, for example, Leijonhufvud (1983), Hillier (1986), Mankiw (1990), and Patinkin (1990). 2 Darity and Young, after their extensive “inquest” into the IS-LM model, are also unable to decide whether the model should be “vilified for its elusive, chameleon-like character or be cherished for its flexibility” (1995:1). But they anticipate that “in its variegated forms” the model will not be “forsaken” and probably will continue to “rule the roost” in the teaching of macroeconomics (37). This chapter explains the success of the IS-LM model in propagating Keynesian economics and Keynes’s misrepresentations of classical macroeconomics, and why the model’s principal deficiencies appear hardly remediable. The IS-LM model The modern IS-LM model derives from J.R.Hicks’s original 1937 article aimed at helping to settle the disputes that arose following the publication of Keynes’s General Theory (1936). The model attempts to depict a simultaneous determination of equilibrium in the market for goods and services (IS) as well as for money variously defined (LM), with respect to the rate of interest and national income. Equilibrium in the market for goods and services is achieved when aggregate output or income just equals aggregate demand (AD) for consumption (C), investment (I), and government expenditure (G) for a closed economy that is, According to the model, equilibrium income falls when AD declines relative to income, because of the build-up of unintended inventories that have to be reduced through a cutback in production and employment

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  Teaching Macroeconomics with Microsoft Excel®

  • Humberto Barreto(Author)
  • 2016(Publication Date)
  • Cambridge University Press

    (Publisher)

  Introducing the model by deriving IS and LM is like teaching someone how to drive a car by showing the person schematics and explaining how a car is built. Everyone learns to drive by actually driving and repeated practice. In my experience, ISLM is better taught by first showing how the model equilibrates and how the intersection of IS and LM determines the solution. After the student develops an awareness of the way the IS and LM curves work and display the equilibrium solution, the IS and LM curves can be derived. This gives the student a much clearer picture of how the IS and LM curves capture equilibrium in the two underlying goods and money markets. Explicitly focusing on equilibration from the very beginning also provides a laser-like focus on the most fundamental part of the model – the feedback mechanism from income to money demand. Once the student grasps that changes in income in the goods market shift money demand and interest rates, which then affect investment and planned expenditures, the logic of the model is laid bare. A great advantage of the Excel implementation of the model is how easily it enables comparison of the model under varying parameter values and elasticities. In a book, a graph that compares, for example, elastic and 160 The ISLM Model: ISLM.xls inelastic investment demand is difficult to follow because the student must reconstruct the argument by imagining how the various curves shift as the elasticity changes. Excel has two powerful advantages over the printed book: (1) the student controls the elasticity, triggering the shifts and movements along curves, and (2) the display eliminates the need to imagine – the con- sequences of a shock are clearly presented. Thus, a student can explore the properties of the model by moving scroll bars to apply different elasticities and connecting the effect of, for example, a flat money demand to the LM curve.

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  Macroeconomics without the Errors of Keynes

  The Quantity Theory of Money, Saving, and Policy

  • James C. W. Ahiakpor(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  Fundamental to the IS-LM model is Keynes’s having turned the classical Quantity Theory of money from determining the level of prices to determining the level of interest rates, and thereby to derive a theory of “output as a whole” (1937a, 1939). Rather than interest rates being determined by the supply and demand for savings or credit (loanable funds) as savers purchase interest-earning fi nancial assets, Keynes argued that savings are a withdrawal from the expenditure stream. But, as Marshall (1920: 192) explains, people invest their “earnings [savings] in trade or on loan, so as to derive interest or pro fi ts from them”; also Marshall (1923: 46) comments: “in ‘Western’ countries even peasant, if well to do, incline to invest the greater part of their savings in Government, or other familiar stock exchange securities, or to commit them to the charge of a bank.” That is why, in Keynes’s view, increased consumption spending or decreased saving is associated with increased business investment and production in the goods market. Keynes’s (1936: 167) assumed lack of a positive connection between savings and the supply of loanable funds underlies Hicks’s derivation of the IS curve such that high levels of nominal interest rates reduce business investment and consumption spending at a low level of real output. Lower nominal interest rates are argued to be necessary for both increased investment and consumption spending, leading to equilibrium at a higher level of real output along the IS curve. The IS-MP model 193 Romer (2000: 150) restates the argument: “a higher interest rate reduces demand, it lowers the level of output at which the quantity demanded equals the quantity produced.

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  An Introduction to Economic Dynamics

  • Ronald Shone(Author)
  • 2001(Publication Date)
  • Cambridge University Press

    (Publisher)

  In a simple model with no trade and no government, equilibrium in the goods market can be shown to satisfy the condition that investment is equal to saving, I S . The money market refers to the demand for money as the liquidity preference and so equilibrium in the money market is where liquidity preference, denoted L , is equal to the money supply, denoted M . Hence LM denotes money market equilibrium. G 330 Y C I G Md 20 0.25 Y 10 r Ms 470 Md Ms Carrying out the same substitutions as we described above, we arrive at the following two equations IS curve : r 205 0.1 Y LM curve : r 45 0.025 Y and solving we obtain the equilibrium values ( Y * , r * ) (2000, 5). All this is the standard IS-LM model found in most elementary or interme-diate macroeconomics textbooks. Analysis proceeds by changing various items in the model. Here we shall just consider two since our real interest is in the dynamics. A rise in government spending raises the intercept A 0 and so shifts the IS curve to the right. In figure 5.2 this is shown by the shift in the IS curve from IS 0 to IS 1 . Similarly, a rise in the money supply reduces the inter-cept B 0 (see (5.4)) and so shifts the LM curve down (or to the right). This results in equilibrium point E 2 . In each case there is a rise in the level of national income; but for a fi scal expansion there is a rise in the rate of interest and in the case of a monetary expansion there is a fall in the rate of interest. For example, using the numerical example, a rise in government spending to 350 raises equilibrium income to 2040 and the interest rate to 6. A rise in the money supply from 470 to 500 leads to a higher equilibrium level of income of 2024 and to a fall in the interest rate to 2.6 All this is a comparative static argument. We simply begin with the equilib-rium point E 0 , then undertake either a fi scal expansion or a monetary expan-sion and the economy moves to point E 1 or E 2 , respectively.

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  Macroeconomics for Managers

  • Michael K. Evans(Author)
  • 2008(Publication Date)
  • Wiley-Blackwell

    (Publisher)

  Figure 7.8 shows the three options facing the Fed when the IS curve shifts out, presumably because of a larger deficit. Assume the initial position is (r 0 , Y 0 ). • The Fed can accommodate the larger deficit by boosting the money supply enough so that the LM curve intersects the new IS curve at the old rate of interest. THE IS/LM DIAGRAM 251 r r 2 r 1 r 0 Y 0 Y 1 Y 2 Y IS 0 IS 1 LM 0 (neutral) LM 2 (offsetting) LM 1 (accommodating) Figure 7.8 r r 0 r 1 Y 0 Y 1 Y IS 0 LM 1 LM 0 Figure 7.9 • The Fed can follow a neutral policy by holding the money supply constant, in which case the interest rate rises somewhat. • The Fed can tighten to offset the allegedly inflationary impact from a bigger deficit; it might even tighten so much that output does not increase and only interest rates rise. Figure 7.9 shows that if the LM curve shifts out, output will always rise unless there is a specific contractionary action taken in fiscal policy. Hence the combination of those two policy shifts – expansionary monetary and contractionary fiscal pol- icy – might appear to leave output unchanged but reduce interest rates. That is what the President’s economic advisors thought in 1968. However, when that combina- tion was tried then, the result was higher inflation and a recession. The explanation for this apparently counterintuitive result is given in the next section. 252 AGGREGATE DEMAND: OUTPUT, INTEREST RATES r r 3 r 2 r 1 r 0 Y 0 Y 1 Y 2 Y 3 Y IS 0 IS 1 IS 2 IS 3 “Keynesian” recession case “Classical” full employment case LM Figure 7.10 7.10 The IS/LM diagram in booms and recessions We now consider the two polar cases of the IS/LM diagram: when the economy is in a recession and real interest rates are low, and when it is at full employment and real interest rates are high. In the first case, the LM curve is almost horizontal and the economy already has excess liquidity, so a change in the money supply will have very little impact on interest rates, and hence on the economy.

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  Monetary Economics in Developing Countries

  • Subrata Ghatak, José R. Sánchez-Fung(Authors)
  • 2017(Publication Date)
  • Red Globe Press

    (Publisher)

  It can be checked easily that the equilibrium r ∗ is stable. In simple terms, a general equilibrium theory of interest rate determination should include the following factors: .................................................................. 76 Monetary economics in developing countries 0 Rate of interest L l S E M 4% 6% r r ∗ (5%) Y 0 (100 bn) Output Y 1 (100 bn) Y 2 (100 bn) Y (Rs) Figure 5.9 Output and the interest rate (numerical example) savings; investment demand; the liquidity preference; and the quantity of money. 5.5 Monetary and fiscal policy ..................................................................................... The IS and LM curves are powerful analytical tools to describe the workings of monetary and fiscal policies. In Figure 5.10, we discuss some theoretical situations. The equilibrium interest rate is given by r ∗ as before, where the IS curve intersects the LM curve. If the monetary policy is expansionary, the LM curve shifts to the right to L 1 M 1 and this leads to a fall of r ∗ to r ∗ 1 . Income rises from Y 0 to Y 1 . Recall our previous comment on the interest inelasticity of the investment function. Given such interest inelasticity of investment (that is, I 1 S 1 rather than I 2 S 2 ) the effect on income generation would be much less (check that Y 0 Y 2 < Y 0 Y 3 ; check also that given an interest inelastic demand for money schedule (that is, a steeper LM curve), an expansionary monetary policy will have a greater impact on Y with an interest elastic IS curve). The effect of fiscal policy can also easily be shown with the help of IS and LM schedules. In Figure 5.11, an expansionary fiscal policy (for example, an expansion of government expenditure), shifts the IS curve to the right to I 1 S 1 and income rises from Y 0 to Y 1 while r rises from r 0 to r 1 .

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  Applied Intermediate Macroeconomics

  • Kevin D. Hoover(Author)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  Consider another case, one in which the economy is already fully employed (at Y * ). Suppose that the LM curve shifts downward (perhaps due this time to an increase in the nominal money supply). There is pressure for aggregate demand to increase to Y 1 , but that pressure cannot be realized because the economy is already at full potential. Firms find themselves with sales exceeding their production and so increase prices. The rising price level implies a falling real money supply, which results in an upward shift of the LM curve (shift 2). This process stops only when LM 2 has shifted all the way back to LM 1 , and the interest rate has risen to r * again at the original level of aggregate demand ( Y * ). Both of these cases are merely preliminaries to show how the LM curve works. We complete the analysis of the LM curve in the appendices to Chap-ters 13 and 16. 7.A.3 The Limitations of the LM Model We have discussed the LM curve in some detail in this appendix because it is so widely used among macroeconomics textbooks. It does not, however, form a core part of the theory on which this book is based. It may be useful – without going into excessive detail – to say why. Mainly, it is because the Summary 257 LM model of financial markets is too limited to address the full range of questions that interest us. To be more specific: The LM model overemphasizes monetary instruments. Table 6.2 (also Figure 6.2) shows that monetary instruments are only 12 percent of all financial assets. M1’s share is even smaller – only 1.2 percent. The LM model considers only a single interest rate, but which one is it? Central banks typically target short-term rates and hope to use them to influence long-term rates. Investment most likely depends on longer-term rates. The relevant opportunity cost for the transactions demand for money may be a short-term rate, whereas the relevant opportunity cost for the speculative demand for money may be a long-term rate.

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  Macroeconomic Theory and Macroeconomic Pedagogy

  • G. Fontana, M. Setterfield, G. Fontana, M. Setterfield(Authors)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  One can only agree with Romer’s criticisms of the traditional treatment of the LM apparatus that still survives even in modern textbooks. Nevertheless, ideally, we would like to have a basic macroeconomic model that conveys clear and theoretically consistent ideas about the relationships among mon- etary policy, the nominal interest rate, output and inflation in the context of short-run business cycles by amending the LM block rather than suppressing it. That is the aim of this chapter. It may be read as a guide to structuring a macro course around a basic New Keynesian model, although its main focus is restricted to the monetary block of the economy. Section 2 overviews the foundations of the macro model. It provides the background for the treatment of the monetary block subsequently 78 Rescuing the LM Curve in a Modern Macro Course expounded, and introduces the AD and AS functions in a form that, accord- ing to current practice, relates ‘output gaps’ to ‘inflation gaps’ with respect to general-equilibrium trend values. Section 3 deals with the foundations of the role of money in the model, and shows how to derive a consistent LM ‘gap function’ in relation to output gaps and inflation gaps. Section 4 expands upon the monetary block, highlighting that it admits of two monetary pol- icy regimes, the ‘exogenous-money regime’ where the central bank controls the rate of growth of the money stock, and the ‘endogenous-money regime’ where the central bank sets the nominal interest rate. The latter leads quite naturally to the Taylor rule, while making it clear that this is a particular choice of the central bank, and that it implies an endogenous path of the money stock determined by the underlying money market equilibrium. It can therefore be seen that, when properly re-worked in an inflationary set- up, the LM apparatus has no faults, and that the exogenous and endogenous monetary regimes are formally equivalent because they are both consistent with monetary equilibrium.

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  India's Economic Prospects - A Macroeconomic And Econometric Analysis

  A Macroeconomic and Econometric Analysis

  • Thampy Mammen(Author)
  • 1999(Publication Date)
  • World Scientific

    (Publisher)

  It re-flects the structural equations of Keynesian theory. However, an IS-LM framework as conceived in real terms suffered from two omissions. First, the structure missed an inflation equation. Secondly, it ignored the role of expectations which Keynes had stressed especially in his analysis of invest-ment decisions in terms of the marginal efficiency of capital in a market system. It is a concept that embodied expectations. If marginal efficiency of capital is low due to unfavorable profit expectations, entrepreneurs will hoard money rather than invest in physical assets for productive purposes. The first of such gaps is filled by the Phillips curve. It is not a theory but an empirical finding in search of a theory (Tobin 1972). Yet it provided a menu for policy-makers to choose between different combinations of the rate of inflation and unemployment rate which are the principal concerns of macroeconomic policy. The observed inverse relationship between these two variables was stable until the end of the 60's. The accelerated infla-tion that followed after the oil crisis and worldwide inflation on commodity prices in the early 70's put an end to the stability of the Phillips curve. Key-nesian analysis tried to explain this as shifts of the Phillips curve to the right, implying a higher rate of inflation for a given rate of unemployment. Actually Phillips formulated his curve as a market clearing relation be-tween supply and demand for labor. It was a relation between wage change and unemployment, and was transformed by others into a relation between price change and unemployment. The link between the two formulations depended on the course of labor productivity, which seriously deteriorated among most of the industrial countries during the supply disturbances of the 1970's. It provided a perfect setting for Friedman to launch a theoretical attack on the IS-LM model which contained no expectations variable.

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  Macroeconomics

  (With Study Guide CD-ROM)

  • Jagdish Handa(Author)
  • 2010(Publication Date)
  • WSPC

    (Publisher)

  r on the vertical axis.

  Restating the LM equation

  The LM equation derived above was:

  Using the assumption that π e = 0, so that R = r, we replace R in the money demand and LM equations by r. This turns the LM equation (5) into:

  Now substitute this value of the interest rate in the IS equation. The resulting AD equation for the open economy is: where: 6.6.3 Diagrammatic determination of aggregate demand

  Figure 6.6 a draws both the IS and the LM curves in the same diagram. The intersection point of the IS and LM curves provides those values of r (and R under our assumption that πe = 0) and y at which there is simultaneous equilibrium in both the commodity and money markets. This point shows the aggregate demand for commodities, after incorporating the impact of the money market on the interest rate, which is needed to determine investment in the commodity market. The demand curve thus derived — just as for demand curves in microeconomic analysis — specifies the quantity demanded of commodities as a function of the price of commodities.

  In Figure 6.6 a, start with the IS curve and the LM curve, labeled as LM0 | M0 /P0 . The latter is drawn for an initial money supply M 0 and an initial price level P 0 . Their intersection at the point d0 indicates the level of aggregate demand yd, at the price level P0 . If, for the given money supply, the price level were somehow to fall to P1 (P 1 < P 0 ), the LM curve would shift to the right to LM1 | M0 /P 1 . Then, the intersection of the IS and the LM1 curves would occur at the point d 1 , so that the level of aggregate demand would become y d 1 , at the price level P 1

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  An Econometric Model of the US Economy

  Structural Analysis in 56 Equations

  • John J. Heim(Author)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Test- ing this model using the prime interest rate, GDP as our income variable, and real M1. The final model, robust to changes in time period sampled and the number of other variables included in the model, is presented in Model 10.2.TR further below. © The Author(s) 2017 259 J. J. Heim, An Econometric Model of the US Economy, DOI 10.1007/978-3-319-50681-4_10 260 10 DETERMINANTS OF THE PRIME INTEREST RATE – LM CURVE METHOD Model 10.1 OLS LM Curve Model of Prime Interest Rate Determination PR = 0.002 Y – 0.015 M1 Real + 0.018 M1 Real AV(–1–2) (t =) (2.1) (–5.2) (4.3) R 2 = 0.31; DW = 1.6 (10.1) Overall, the standard Keynesian model of money demand and interest rate determination explains less than half the variance explained by the Taylor rule model. A third of the variance explained by the Keynesian model is only due to adding a lagged money supply variable (average of M1 –1 and M1 –2 ) variable to test the inflationary effects as well as the liquidity effects of expansion of the money supply. This would not have been done in the early Keynesian models and gives a more modern interpretation to the classic Keynesian function. Further, as was the case with the Taylor rule model, the subsequent inflationary effects of increasing the money supply more than offset the current year liquidity (stimulus) effects, consistent with the more classical notion that inflation is the only long run effect of changing the money supply. 10.2 2SLS MODELS OF THE LM CURVE The M1 real money supply was found Hausman-endogenous with the real prime interest rate. Therefore it was replaced with Wald-strong instrument, Sargan-valid, instrument.

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