A Summary of the IS-LM Model

Warning: This summary was written assuming that you have studied the IS-LM model in detail before, so as to provide you with a concise reference. It is not intended to be a substitute for a textbook treatment of the model.

The Main Assumptions of the IS-LM Model

The time horizon: The IS-LM model deals with the short run. Some factors which could have an impact on the predictions of the model are assumed to be fixed:
r LM'

LM

The capital stock (machines etc.) is assumed to be fixed, so supply adjustment takes place through investment into inventory holdings or variable inputs. Prices are assumed fixed for the time period covered, so an increase in demand does not lead to an increase in the price level the supply curve is perfectly elastic equilibrium is re-established by adjusting output (cf. the illustration to the left).

r'

IS

y P

Savings: People are assumed to save by buying bonds, i.e. an interest bearing asset which can be sold on second hand markets.
P* AS

AD y y' y

Closed Economy: The model refers to a closed economy, i.e. imports and exports are not considered and there are no capital movements in and out of the country. Functional Relationships: Savings and consumption depend on the level of income Investment expenditure depends on the rate of interest Demand for real balances depends on both, the level of income and the rate of interest.

AD'

The Money Supply: The supply of real balances is assumed to depend on policy decisions it is fixed unless the government or central bank decides to change it.

Deriving the IS Curve

AE S AE'
AE'

S
s'

AE

AE

y'

y r
r

y'

r
r r'

r'

I
I I'

IS I
y y'

The IS curve summarises all points where the goods market is in equilibrium, given constant prices. IS means I=S: Investment equals Savings. Investment: The I-curve slopes downwards: at higher interest rates profits need to cover higher interest costs, so fewer investment projects are profitable. Credit financed consumption behaves likewise: at higher interest rates it becomes more expensive to borrow for consumption, so less credit is demanded. Savings: Consumers save a certain proportion of their income, so savings are higher at higher income levels. People save by buying bonds as income rises, demand for bonds rises c.p. this drives up bond prices as bonds prices rise, interest rates fall. IS: At higher income levels, goods market equilibrium occurs at lower interest rates: High income high savings low interest rates high investment (via the multiplier) high income.

Deriving the LM Curve

r LM

r'

L' r

L y y' y
M P

M P

The LM curve denotes all the combinations of income levels and the interest rate at which the money market is in equilibrium given constant prices. LM means L=M: Demand for Real Balances equals Money Supply (L stands for Liquidity Preference). Real Balances: The real value of money, as measured by the amount of money divided by the price level. The supply of real balances is assumed fixed at P . Demand for Real Balances: People are motivated to hold money -a liquid asset- rather than interest bearing assets for three reasons: 1. the Transactions motive, 2. the Precautionary motive and 3. the Speculative motive. The amount of money people hold for transactions purposes is a fixed proportion of income transactions demand rises when income rises. Liquidity Preference (the desire to hold liquid rather than interest bearing assets) depends on the rate of interest, i.e. the opportunity cost of holding real balances. LM: At higher income levels, the absolute amount of real balances demanded for transactions purposes increases the supply of real balances does not interest rate has to rise to restrict money demand to the fixed supply.

The IS-LM System in Equilibrium

r LM A

D r* C IS y* y B

The IS-LM system is in equilibrium at the intersection of the IS and LM curve where the levels of income and the rate of interest are such as to ensure simultaneous equilibrium in the goods and money market. What happens off the equilibrium point? Below the LM curve: At points such as C or B, the prevailing rate of interest is too low for the given income level demand for real balances exceeds supply competition for the available supply of real balances drives up the interest rate until the money market is in equilibrium. Above the LM curve: At points such as A or D the opportunity cost of holding real balances is too high savings increase interest rates fall until equilibrium in the money market is restored. Below the IS curve: At points such as C or D, the level of income and production is too low there is an unplanned reduction in inventory holdings equilibrium can be restored through an increase in either output or the rate of interest. Above the IS curve: At points such as A or B, the level of real income (and production) is too high there is an unplanned accumulation of inventory holdings equilibrium can be restored through a reduction in either output or the rate of interest

Appendix: The Basic Algebra of the IS-LM Model

Given the following variables and parameters: A0: Autonomous expenditure C0: Autonomous consumption G0: Government spending I0: Autonomous investment spending L: Demand for real balances M P : Money supply T0: Autonomous taxation y: real income c: Marginal propensity to consume t: Marginal propensity to tax : the income multiplier


The IS-LM model can be derived from the following equations:

  

[1] [2] [3]

y = C 0 + I 0 + G 0 T 0 + c(1 t)y r L = hy kr L=
M P

The components of the goods market in equilibrium are summarised by equation [1]: [1] y = C 0 + I 0 + G 0 T 0 + c(1 t)y r,

where -r reflects the impact of the interest rate on the interest sensitive components of aggregate expenditure1. The term c(1-t)y denotes induced consumption out of disposable income, where the expression 1-t takes the impact of induced taxation into account. Equation [1] can be rearranged to isolate y. Subtracting c(1-t)y from both sides of the equation yields: [1a] y c(1 t)y = C 0 + I 0 + G 0 T 0 r

Defining autonomous expenditure A0 as: [4] A0 = C0 + I0 + G0 T0

and factorising y on the right hand side of equation [1a] yields:



[1b]

y(1 c(1 t)) = A 0 r

Dividing both sides of [1b] by (1-c(1-t)) gives:

1

In the simplest possible case, when only investment is assumed to be influenced by the rate of interest, this would correspond to the interest sensitive component of the investment equation I = I 0 r.


and the coefficient b as:

(1c(1t))


[6]

b=

Equation [1c] can be expressed as:



[7]

y = A 0 br

This can be solved for r by first rearranging:



[7a]

br = A 0 y

and then dividing through by b:



[8]

r = b A0 1 y b

Equations [7] and [8] provide expressions for the equilibrium levels of income and the rate of interest respectively for the goods market. Equation [2] defines money demand as a function of income and the rate of interest, where the coefficients h and k indicate the relationship between demand for real balances and the two variables (y and r). Equation [3] gives the equilibrium condition for the money market. The two equations [2] [3] L = hy kr and L=
M P,

can be used to express the money market equilibrium as: [9]

M P

Rearranging [9] yields: [9a] kr = hy

M P

dividing through by k, this can be solved for r: [10] r = hy 1(M) k k P

or, alternatively: [9b] hy =

M P

[5]

1 (1c(1t))

= hy kr

+ kr

Defining the income multiplier

[1c]

y=

A0 r (1c(1t))

as:

which can be solved for y by dividing both sides of the equation by h: [11]
k y = 1(M)+ hr h P

Equations [10] and [11] provide expressions for equilibrium levels of y and r in the money market. All the four above mentioned equations ([7], [8], [10] and [11]), however, still contain one unknown (r or y respectively). To find expressions for the equilibrium values of y and r in the IS-LM model, one needs to combine the information from both markets as follows: Starting with equation [7],
  

[7]

y = A 0 br

one can substitute the right hand side from equation [10] for r, to obtain: [12] y = A 0 b( h y 1 ( M )) k k P

or, rearranging: [12a] y = A 0 adding

bh k y bh b M k y k(P)

to both sides yields: = A0 b ( M ) k P



[12b] y +

bh k y

factorising the left hand side, this can be expressed as:



[12c] y(1 +

bh k )

= A0 b ( M ) k P
bh k ):

y can then be isolated by dividing through by (1 + [13]

Equation [13] identifies the equilibrium level of income independently of the interest rate. Recalling that equation [10] is [10] r = hy 1(M) k k P

one can now substitute the right hand side of equation [13] for y in this expression to obtain: [14]
0 r = h [ (1+ bh ) k


Equations [13] and [14] give solutions for the equilibrium levels of income and the rate of interest respectively and together identify the equilibrium of the IS-LM model.

y=

A0 (1+ bh ) k

b M k(P) (1+ bh ) k

b m k(P) (1+ bh ) k

] 1(M) k P

Abbreviations
AD: Aggregate Demand AE: Aggregate (planned) expenditure AS: Aggregate Supply etc.: et cetera (and so on...) cf.: confer (compare) c.p.: ceteris paribus (other things being equal) I: Investment i.e.: id est (that is) L: Money demand M: Nominal money supply P: Price level S: Savings r: Rate of interest y: Real income

Further Reading
Introductions to the IS-LM model can be found in the following texts: Gordon, Robert (1998) Macroeconomics, Addison-Wesley, seventh edition Chapter 4 Hillier, Brian (1997) The Macroeconomic Debate, Blackwell Chapters 2 and 3 Mankiw, Gregory (1999) Macroeconomics, Worth Publishers, fourth edition Chapters 10 and 11