1

1.1

The IS-LM Model

Derivation of the IS curve

From the national accounts identity Y C I = C +I +G = C (Y T ); where dC = C 0 and 0 < C 0 < 1 d(Y T )

= I (r); where

dI = I0 < 0 dr

When we substitute everything into one equation we get the IS curve Y = C (Y T ) + I (r) + G

In order to see what is the relationship between income Y and real interest rate r we need to take a derivative dY dr in this equation using the chain rule. dY dr dY dr dY dr dY (1 dr C 0) dY dr dC d(Y T ) dY dI dG + + d(Y T ) dY dr dr dr dY = C 01 + I0 + 0 dr dY = C0 + I0 dr = = I0 = I0 <0 (1 C 0 )

Since I 0 < 0 and 0 < C 0 < 1 dY dr < 0. It means that IS curve is downward sloping (check gure 10-9 from the textbook).

1.2

Derivation of the LM curve

On the other hand, we know that from the money market equilibrium M P dL where di = L(i; Y ) = L(r + = dL d(r +
e) e e

;Y ) = dL dL = L1 < 0 and = L2 > 0 dr dY

d(r + dr

This equation gives us the LM curve. To nd the slope of this curve we need to take dY dr derivative from this equation too. d(M=P ) dr d(r + dr dY 0 = L1 + L2 dr dY L1 = >0 dr L2 =
e)

dL d(r +

dL dY dY dr

Since L1 < 0 and L2 > 0 dY dr > 0. It means that LM curve is upward sloping (check gure 10-12 from the textbook).

1.3

Market equalibrium and curve shifts

IS LM

: Y = C (Y T ) + I (r) + G M : = L(r + e ; Y ) P

LM

IS Y

Shifts of the IS/LM curves: 1) Due to changes in exogenous variables (like G,T,Ms etc). 2) Due to changes in some functions (consumption function, money demand function etc). 1.3.1 Shifts in the IS curve

Suppose that G increases This shifts the IS curve out (check the gure 11-1 in the textbook). It leads to higher Y and higher r. Mathematically we can see why it happens by taking the derivative dY s dG from the IS equation. Let rst take the derivative dY holding r constant. Then dG Y = C (Y dY dG dY dG dY dG
dY dG

T ) + I (r) + G

dC d(Y T ) dY dI (r) dG + + d(Y T ) dY dG dG dG dY = C0 +0+1 dG 1 = > 1 because 0 < C 0 < 1 1 C0 =

= 1 1C 0 > 1 is called the multimplier eect (the eect of G on Y when r does not change). But r does change when IS shift out because the new equilibrium will be at a higher point on the LM curve. So, it is not only by how much IS shifts but also the slope of the LM curve that matters. To take that eect into consideration we need to take the derivative of both IS and LM. IS LM dY dG d(M=P ) dG Y = C (Y T ) + I (r) + G M = L(r + e ; Y ) : P dY dI (r) dr dI = C0 + +1 ( 6 0 any more) = dG dr dG dG dL dr dL dY = + dr dG dY dG dY dG 0 After some calculations 0 < dr dG = (1 dY = dG (1 1 C 0) +
I 0 L2 L1

= C0

dY dr + I0 +1 dG dG dY dr = L1 + L2 dG dG 1 1 C0

<

L2 =L1 C 0) +
I 0 L2 L1

>0

Example: Suppose that dL 0 (money demand is not responsive to dr = L1 changes in the interest rate). In this case LM curve will be very steep. To see this recall that the slope of the LM curve is dY = dr 3 L1 >0 L2

If L1 0 then dY 0 which correspond to almost vertical LM curve. If this dr is the case then any shifts in the IS curve will not change Y because all the changes in the aggregare demand will be absorbed by a much higher r. Suppose that T decreases Following the same steps as in the case of higher G we can conclude that dY dT < 0. When T decrease Y should increase. It is equivalent to the IS curve shifting out again(check gure 11-2 in the textbook). Suppose that there is an increase in consumer condence This can be modeled as a shift in C = C (Y T ). Ina formal way C = [(Y T ); X ] where dC dC = C1 > 0; = C2 > 0 d(Y T ) dX

where X is the consumer condence. Now we can dierentiate both IS and LM equations IS LM to nd that
dY dX

: Y = C [(Y T ); X ] + I (r) + G M : = L(r + e ; Y ) P

dr dX

> 0 and

> 0. It is equivalent to IS curve shifting out.

Suppose that there is a shift in I(r) Let s the availability of loans falls. Formally this can be modelled as I = I (r; Q) where dI dI = I1 < 0 and = I2 > 0 dr dQ

dI where Q is the availability of loans. dQ = I2 > 0 means that the more loans are available on the market the higher will be the investment. Taking the derivatives of the two equations

IS LM we can nd that dY dQ > 0.

: Y = C (Y T ) + I (r; Q) + G M : = L(r + e ; Y ) P