1. The IS-LM Model: Framework for Macroeconomic Analysis
Chapter 5
The IS-LM Model:
Framework for Macroeconomic Analysis

2. Chapter 2. Introduction
This chapter integrates the elements of our model covering labor, goods, and asset markets.
It develops a graphical depiction of our theory that is called the IS-LM/AD-AS model.
IS and LM refer to two equilibrium conditions in the model (investment equals saving; money demand, or liquidity preference, equals money supply).
AD and AS refer to aggregate demand and aggregate supply.

3. The IS-LM model
The IS-LM model translates the General Theory of Keynes into neoclassical terms (often called the neoclassic synthesis )
It was proposed by John Hicks in 1937 in a paper called “Mr Keynes and the "Classics": A Suggested Interpretation” and enhanced by Alvin Hansen (hence it is also called the Hicks-Hansen model).
The model examines the combined equilibrium of two markets :
The goods market, which is at equilibrium when investments equal savings, hence IS.
The money market, which is at equilibrium when the demand for liquidity equals money supply, hence LM.
Examining the joint equilibrium in these two markets allows us to determine two variables : output Y and the interest rate i. 3

4. The IS-LM model The model rests on two fundamental assumptions
All prices (including wages) are fixed.
There exists excess production capacity in the economy
This is a complete change in perspective compared to classical economics:
The level of demand determines the level of output and employment.
There can be an equilibrium level of involuntary unemployment.
Why can there be insufficient demand ?
Criticism of Say’s law: Uncertainty can lead to precautionary saving rather than consumption.
Monetary criticism: the preference for liquidity can lead to under-investment as savings are kept in the form of liquidity. 4

5. The IS-LM model
The IS-LM model has become the “standard model” in macroeconomics.
Its essential contribution (linked to that of Keynes) is this potential equilibrium unemployment:
Such a situation is impossible in earlier neoclassic models, as the price of labour (like all prices) is assumed to adjust naturally until supply and demand for labour are balanced.
This is why IS-LM (1937!!) remains central to modern macroeconomics, and has been extended to explain more markets/ variables:
The AS-AD model adds inflation into the problem
The Mundell-Fleming model deals with international trade 5

6. Deriving the IS Curve
Recall the Goods Market Equilibrium Condition:

7. Goods Market Equilibrium
Sd, Id

8. Goods Market Equilibrium
Sd, Id
Sd = Id

9. Consider a Rise in Income
As income rises, the desired saving curve shifts right, and the equilibrium rate of interest falls as we slide down the desired investment curve (next slide).

10. Goods Market Equilibrium
Sd, Id
Sd = Id

11. Goods Market Equilibrium
S (Higher Income) r0 r1 I
Sd, Id
Sd = Id

12. Deriving IS
The previous slide shows that as income varies and goods market equilibrium is maintained, a higher value of income is associated with a lower value of the expected real interest rate
Plot the income-interest rate pairs that satisfy the goods market equilibrium condition to get the IS curve
NOTE : Each Saving curve slopes upward because an increase in the real interest rate causes house hold to increase there desire level of savings.
NOTE :An investment curve slopes downward because an increase in interest rate increases the uses cost of capital which reduces the desired capital stock and hence desired investment.
The inverse relationship between income and interest rate implies that the IS curve is downward sloping

13. Figure 9.2 Deriving the IS curve

14. Shifting IS
For constant Output, Any changes in the economy that reduces the desired national saving relative to desired investment will increase the interest rate that clears the good market thus shifting the IS curve up and to the right.
Similarly for constant output, Any changes in the economy that that increases the desired national saving relative to desire investment will reduce the market interest rate shifting the IS curve down and to the left.

15. Shifting IS
Recall that IS was derived by considering how the desired saving curve moved along the desired investment curve as income changed.
Suppose a shock (say a government spending increase) causes saving to decline at each level of income
Then the interest rate is higher at each level of income.
Then we must redraw IS, with higher r for each level of Y. IS has shifted to the right.
For other shocks that shift saving or investment schedules, we can also infer how IS shifts.

16. Effects on IS curve with increase in Government Purchases

17. IS Curve Shifters Variable Increases IS Curve Shifts
Expected Future Output (Income)
Right (desired saving falls, desired consumption rises
Wealth
Right ( same as above)
Government Spending
Right (direct effect on savings)
Taxes
None (Ricardian) or Left
Expected future MPK
Right
Effective Tax Rate on K
Left

18. The LM Curve
The IS plots income interest-rate pairs such that desired spending is equal to output, or desired saving is equal to desired investment
We will now derive the LM curve, which plots income-interest rate pairs such that the quantity of money demanded is equal to the quantity of money supplied.

19. Money Market Equilibrium Revisited

20. The LM Curve

21. The Derivation of LM

22. Factors that shifts LM curve Changes In the real money supply Ms
For constant output, any changes that reduces the real money supply relative to real money demanded will increase the real interest rate and causes the LM curve to shift up and to the left.
Similarly, for constant output anything that raises the real money supply relative to real money demand will reduce the real interest rate that clears the market and shifts the LM curve down to the to the right.

23. Factors that shift the LM curve changes in the real money demanded Md
With output constant, an increase in real money demanded raises the real interest rate and thus shift the LM curve up and to the left.
Analogously, with output constant, a drop in real money demanded reduces the interest rate and shift the LM curve down to the right.

24. LM Curve Shifters Variable Increases LM Curve Shifts
Nominal Money Supply
Right(Real money supply increases lowering real int rates equates Ms = Md )
Price Level
Left (real money supply falls raising real int rates that clears the asset market )
Expected Inflation
Right (Demand for money falls lowering the real int rates that clears the asset market )
Nominal interest rate on money im
Left (demand for money increases, higher return on money makes people willing to hold more money, raising the real interest rates that clears the asset market )
Anything Else Increasing the Demand for Money
Left

25. General Equilibrium in the IS-LM Model
In general equilibrium, all markets satisfy their respective equilibrium conditions.
Labor, Goods, and Money Markets Must all be in equilibrium.
The logic of general equilibrium:
The labor market determines output.
Given output (income) the goods market then determines an interest rate.
Given output, the interest rate, and the expected inflation rate, then the money market determines the price level.

26. General Equilibrium in the IS-LM Model (Diagram)

27. Equilibrium: A Coincidence?
Labor Market equilibrium requires that the economy be on the FE line
Goods Market equilibrium requires that the economy be on the IS Curve
Money Market equilibrium requires that the economy be on the LM Curve
General equilibrium requires that the economy be on all three curves simultaneously
Does this require a happy coincidence? (No)

28. Review on Equilibrium To review, output is determined by the FE line
Given output the intersection of IS and FE determines the interest rate
Finally, the price level adjusts so that LM intersects both IS and FE

29. Timing of Movement to Equilibrium
Our model, as formulated, does not tell us the order in which variables move—we just infer that the economy moves from one equilibrium to another (after a shock).
Here are some thoughts on timing:
Interest rates (and financial markets generally) adjust very quickly
Nominal (and real) wages adjust slowly (often wages are set for long periods of time
Prices may also adjust slowly
The goods market adjusts with intermediate speed (we often see unanticipated inventory movements, but firms may alter production before revising prices)

30. A Look Ahead: Keynesian and Classical Views
We will say much more about “Keynesian” and “Classical” macroeconomic theories
Keynesians emphasize the short-term rigidity of prices and wages
Classical economists emphasize that all markets reach equilibria rather quickly

31. Aggregate Demand and Aggregate Supply
We have now specified a complete model
However, sometimes it is convenient to look at the model differently—with a different diagram
We next introduce AD and AS curves
These curves plot output, Y, and the price level, P.
These diagrams allow us to focus attention on the determination of the price level, which was not directly visible in the IS-LM diagram.