Y=C+I

2 SECTORS: HOUSEHOLD AND

FIRM

3 SECTORS: HOUSEHOLD, FIRM

Y=C+I+G Y=C+I+G+(X- AND GOVERNMENT
M)

4 SECTORS: HOUSEHOLD, FIRM,

GOVERNMENT AND FOREIGN
 Definition of IS = The Definition of LM = The
relationship between relationship between real
interest rate and aggregate income level (Y) and nominal
output for which the goods interest rate where money
market is in equilibrium. market is in equilibrium.

IS curve show negative IS-LM LM curve show positive

MODEL
relationship between relationship between interest
equilibrium aggregate rates and aggregate output for
output and the interest rate. which Md = Ms.

Concept

The LM curve shows the

The IS curve represents liquidity preference/money
investment and savings, supply equilibrium and the
and is a type of income- money available for
expenditure model. interesting.
 FACTORS IS SHIFT The IS will shift to the right as a
result of:

Changes in investment Changes in net exports

Changes in autonomous Changes in government
spending unrelated to the Changes in taxes unrelated to the interest
consumer expenditure spending
interest rate rate
An increase in autonomous An increase in planned An increase in government A decrease in taxes. An increase in net export
consumer spending. investment spending due to spending. A decline in taxes shift the unrelated to the interest
Refer to panel A, the business optimism. Increase in government aggregate demand function rate.
equilibrium output is at YA A rise in this factor shift spending will cause the by rising the consumer It will shift the aggregate
when interest rate is at IA. Yad1 to Yad2. aggregate demand function expenditure and shifting demand function upward
Panel B shows Yad1 at an In panel A , it cause IS1 to shift upward as in panel the aggregate demand and the IS curve shifts to
IA. shift to IS2. B. upward hence rising the the right.
When autonomous Any decrease in The equilibrium level of the equilibrium level of A declined in this factor will
consumer expenditure rise, investment spending will aggregate output rises and aggregate output and shift shift the aggregate demand
Yad1 shift to Yad2 and the shift the aggregate demand the IS curve shift to the the IS curve to the right. function downward and the
equilibrium output at panel function downward and the right. A rise in taxes lowers the equilibrium demand output
A rise to YA’ equilibrium level of Any decrease in aggregate demand function falls shifting the IS curve to
Rise in autonomous aggregate output falls, government spending will and reduces the the left.
expenditure shift IS1 to shifting the IS curve to the cause panel B shift equilibrium level of
IS2. left. downward and panel A aggregate output.
shift to the left.
 Panel B - Effect on goods market equilibrium
when the interest rate is at IA

Panel A - Shift of IS curve

 FACTORS LM SHIFT
The nominal return on The expected rate of
Nominal money supply M The price level P
money inflation

An increase in the supply An increase in aggregate An increase in nominal A increase in expected rate
of nominal money balances price level will shift the LM return on money, will shift of inflation, will shift the LM
will shift the LM curve to curve to the left (LM2 to the LM curve to the left curve to the right (LM1 to
the right (LM1 to LM2) LM1) (LM2 to LM1) LM2)
It is because the real It is due to the real interest It is due to the real interest It is because the real
interest rate falls, rate rises, reducing rate rises, reducing interest rate falls,
increasing demand for demand for money at any demand for money at any increasing demand for
money at any output level. output level. output level. money at any output level.
MS1 will shift to MS2, and MS2 will shift to MS1 and MS2 will shift to MS1 and MS1 will shift to MS2, and
this will cause IA move to this will cause the IA’ move this will cause the IA’ move this will cause IA move to
IA’ at a fixed income YA. to IA at a fixed income YA. to IA at a fixed income YA. IA’ at a fixed income YA.
 Simultaneous Determination of Output and the Interest Rate

At point E, aggregate output

equals aggregate demand (IS)
and the quantity of money
demanded equals the
quantity of money supplied
(LM).

At point A, economy is on IS curve.

Interest rate above its equilibrium level, At point B, economy is on LM curve.
so demand for money is less than the Output is higher than the equlibirum
supply. level and exceeds aggregate demand.
People have more money at hand, Firms unable to sell their output, and
therefore they try to get rid of buying unplanned inventory accumulates,
bonds. prompting them to cut production and
The resulting in bond prices cause a fall lower output.
in interest rate, investment and net Demand for money will fall, lowering the
exports rise, and thus aggregate output interest rates.
rises. The economy later on moves down along
The economy later on moves down along the LM curve until the economy is at
the IS curve until the economy is at equlibirum point E.
equlibirum point E.
Response to a Change in Monetary Policy
The Interest Rate to an Increase in the Money Supply

An increase in the money

Investment spending and net
supply creates an excess The interest rate declines
exports rise
supply of money.

The excess supply of money

Aggregate output rises Aggregate demand rises
is eliminated

Aggreagte output is
positively related to the
money supply
 Response to a Change in Fiscal Policy
The Interest Rate to an Expansionary Fiscal Policy

An increase in government
spending raises aggregate demand
directly; a decrease in taxes makes
more income available for
spending.
The increase in aggregate demand
cause aggregate output to rise.
A higher level of aggregate output
increases the demand for money.
The excess demand for money
pushes the interest rate higher.
The rise in the interest rate
eliminates the excess demand for
money.
Aggregate output and the interest
rate are positively related to
government spending and
negatively related to taxes.
 Effectiveness of Monetary and Fiscal Policy in the IS-LM Model

EFFECTIVENESS OF EFFECTIVENESS OF EFFECTIVENESS OF

MONETARY POLICY MONETARY POLICY FISCAL POLICY

i) The interest elasticity of the demand for i) The interest elasticity of the investment
money function

The more interest elastic the The more elastic the investment
demand function for money, function concerning the interest
the flatter the LM function. rate, the flatter the IS function.
The flatter the LM function, The flatter the IS function, the
the less effective monetary more effective monetary policy
policy will be in changing the will be in changing the equilibrium
equlibrium level of income. level of income.