IS-LM model

DFS ch 10 and 11
Introduction
• Why does output fluctuate around its potential level?
• In business cycle booms and recessions, output rises and falls relative
to the trend of potential output

• Model in this chapter assumes a mutual interaction between

output and spending: spending determines output and
income, but output and income also determine spending

• The Keynesian model develops the theory of AD

• Assume that prices do not change at all and that firms are willing to
sell any amount of output at the given level of prices  AS curve is
flat
• Key finding: increases in autonomous spending generate additional
increases in AD

DFS ch 10.
AD and Equilibrium Output
• AD is the total amount of goods demanded in the economy: (1)
AD = C + I + G + NX

• Output is at its equilibrium level when the quantity of output produced is

equal to the quantity demanded, or Y = C + I + G + NX (2)

• When AD is not equal to output there is unplanned inventory investment

or disinvestment: UI = Y - AD (3), where UI is unplanned additions to
inventory
• If UI > 0, firms cut back on production until output and AD are again in equilibrium
• Conversely, if output is below AD, inventories are drawn down until equilibrium is
restored.
The Consumption Function
• Consumption is the largest component of AD
• Consumption increases with income  the relationship between
consumption and income is described by the consumption function
• If C is consumption and Y is income, the consumption function is C  C  cY (4),
where C 0 and 0  c  1

• The intercept of equation (4) is the level of consumption when income

is zero  this is greater than zero since there is a subsistence level of
consumption

• The slope of equation (4) is known as the marginal propensity to consume

(MPC)  the increase in consumption per unit increase in income
The Consumption Function
Consumption and Savings
• Income is either spent or saved  a theory that explains consumption is
equivalently explaining the behavior of saving

• More formally, S  Y  C (5)  a budget constraint

• Combining (4) and (5) yields the savings function:
S  Y  C  Y  C  cY  C  (1  c)Y (6)

• Saving is an increasing function of the level of income because the marginal

propensity to save (MPS), s = 1-c, is positive
• Savings increases as income rises
• Ex. If MPS is 0.1, for every extra rupee of income, savings increases by Rs 0.10 OR consumers
save 10% of an extra rupee of income
Consumption, AD, and Autonomous Spending
• Now we incorporate the other components of AD: G, I, taxes, and foreign trade
(assume autonomous or independent of income)

• Consumption now depends on disposable income,

YD  Y  TA  TR (7) and
C  C  cYD  C  c(Y  TR  TA) (8)
YD: disposable
income, TA: tax, • AD then becomes: AD  C  I  G  NX
 C  c(Y  TA  TR )  I  G  NX
TR: transfer
payments.

C-bar is autonomous
consumption
 C  c(TA  TR )  I  G  NX   cY
 A  cY (9)
where A is independent of the level of income, or autonomous
Equilibrium Income and Output
• Equilibrium occurs where Y=AD, which is
illustrated by the 45° line  point E
• The arrows show how the economy
reaches equilibrium
• At any level of output below Y0, firms’
inventories decline, and they increase
production
• At any level of output above Y0, firms’
inventories increase, and they decrease
production

IU: unplanned additions to inventories

The Formula for Equilibrium Output
• Can solve for the equilibrium level of output, Y0, algebraically:
• The equilibrium condition is Y = AD (10)
• Substituting (9) into (10) yields Y  A  cY (11)
• Solve for Y to find the equilibrium level of output:

Y  cY  A
Y (1  c )  A
1 (12)
Y0  A
(1  c )
The Formula for Equilibrium Output
• Equation (12) shows the level of output as a function of the MPC and A

• Frequently we are interested in knowing how a change in some component of

autonomous spending would change output

• Relate changes in output to changes in autonomous spending through

1
Y  A (13)
(1  c)
• Ex. If the MPC = 0.9, then 1/(1-c) = 10  an increase in government spending by
Rs 1 billion results in an increase in output by Rs 10 billion

• Recipients of increased government spending increase their own spending, the

recipients of that spending increase their spending and so on
Saving and Investment
• In equilibrium, planned investment equals
saving in an economy with no government
or trade sector
• Vertical distance between the AD and
consumption schedules equal to planned
investment spending, I
• The vertical distance between the
consumption schedule and the 45° line
measures saving at each level of income
 at Y0 the two vertical distances are equal and S
=I
Saving and Investment
• The equality between planned investment and saving can be seen directly from national
income accounting
• Income is either spent or saved: Y  C  S
• Without G or trade, Y CI
• Putting the two together:
CS CI
SI
AD  C  I  G  NX
• With government and foreign trade in the model:
Y  C  S  TA  TR
• Income is either spent, saved, or paid in taxes:
C  I  G  NX  C  S  TA  TR
• Complete aggregate demand is I  S  (TA  TR  G )  NX
• Putting the two together: (14)
The Multiplier
By how much does a Re 1 increase in autonomous spending raise the equilibrium level of income?  The
answer is not Re 1

Out of an additional rupee in income, Rs c is consumed

Output increases to meet increased expenditure; change in output = (1+c)

Expansion in output and income results in further increases

The Multiplier
• If we write out the successive rounds of increased spending, starting with the
initial increase in autonomous demand, we have:

AD  A  cA  c 2 A  c 3A  ...

 A (1  c  c 2  c 3  ...) (15)
• This is a geometric series, where c < 1, that simplifies to:
1
AD  A  Y0 (16)
(1  c)
• Multiplier = amount by which equilibrium output changes
when autonomous aggregate demand increases by 1 unit

• The general definition of the multiplier is

Y 1 (17)
 
A (1  c )
Example of a budget multiplier
Definition: the increase in income resulting from a $1
increase in G.
In this model, the government
purchases multiplier equals Y 1

G 1  MPC

Example: If MPC = 0.8, then

An increase in G
Y 1
  5 causes income to
G 1  0.8 increase 5 times
as much!
Why is the multiplier >1 ?

• Initially, the increase in G causes an equal increase in Y: Y = G.

• But Y  C
 further Y
 further C
 further Y
• So, the final impact on income is much bigger than the initial G.
Why is the multiplier >1? An example

Suppose the government spends an additional Rs 100 crores on buying military jets.
Then, the revenues of defense firms increase by Rs 100 crores, all of which becomes
income to somebody: some of it is paid to the workers and engineers and managers, the
rest is profit paid as dividends to shareholders. Hence, income rises Rs 100 crores (Y =
Rs 100 crores = G ).

The people whose income just rose by Rs 100 crores are also consumers,
and they will spend the fraction MPC of this extra income.
Suppose MPC = 0.8, so C rises by Rs 80 crores. Multiplier is 5 (=1/(1-c)).
• To be concrete, suppose the defense firm people buy Rs 80 crores worth of Maruti
Altos. Then, Maruti sees its revenues increase by Rs 80 crores, all of which
becomes income to somebody - either Maruti’s workers, or its shareholders (Y =
Rs 80 crores).
• And what do these folks do with this extra income? They spend the fraction MPC
(0.8) of it, causing C = Rs 64 crores (8/10 of Rs 80 crores). Suppose they spend
all Rs 64 crores on Parle-G biscuits. Then, Parle company experiences a revenue
increase of Rs 64 crores, which becomes income to someone or the other (Y = Rs
64 crores).
• So far, the total impact on income is Rs 100 crores+ Rs 80 crores + Rs 64 crores,
which is much bigger than the government’s initial increase in spending. But this
process continues, and the final impact on Y is Rs 500 crores (because the
multiplier is 5).
The Multiplier
Effect of an increase in autonomous spending
on the equilibrium level of output:
1. The initial equilibrium is at point E, with
income at Y0
2. If autonomous spending increases, the
AD curve shifts up by ∆𝐴ҧ , and income
increases to Y’
3. The new equilibrium is at E’ with income
at ∆𝑌0 = 𝑌0′ − 𝑌0
The Government Sector
• The government affects the level of equilibrium output in two
ways:
1. Government expenditures (component of AD)
2. Taxes and transfers

• Fiscal policy is the policy of the government with regards to G,

TR, and TA

• Assume G and TR are constant, and that there is a

proportional income tax (t)

• The consumption function becomes: C  C  c(Y  TR  tY )

 C  cTR  c(1  t )Y (19)
The Government Sector
• Combining (19) with AD:
AD  C  I  G  NX
 C  cTR  c(1  t )Y   I  G  NX
 A  c(1  t )Y (20)
• Using the equilibrium condition, Y=AD, and equation (19), the
equilibrium level of output is:
Y  A  c(1  t )Y
Y  c(1  t )Y  A
Y 1  c(1  t )  A
A
Y0  (21)
1  c(1  t )
• The presence of the government sector flattens the AD curve
and reduces the multiplier to 1
(1  c(1  t ))
IS-LM model: Introduction
• Money plays a central role in the determination of income and
employment
• Interest rates are a significant determinant of aggregate spending 
the central bank controls the money supply
• The stock of money, interest rates, and the central bank were
noticeably absent from the model developed

• The IS-LM model:

─ Builds an explicit framework of analysis within which to study the
interaction of goods markets and money market in a closed economy
IS-LM model
IS-LM model is the core of short-run macroeconomics
–Maintains the details of earlier model, but adds the interest rate as an additional determinant of
aggregate demand
–Includes the goods market and the money market, and their link through interest rates and income

The IS-LM model translates the General Theory of John M. Keynes into neoclassical terms (often called the
neoclassical 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.
The Goods Market and the IS Curve
• The IS curve shows combinations of interest rates
and levels of output such that planned spending equals income

• Derived in two steps:

1. Link between interest rates and investment
2. Link between investment demand and AD

• Investment is no longer treated as exogenous, but dependent

upon interest rates (endogenous)

• Investment demand is lower, the higher are interest rates

• Interest rates are the cost of borrowing money
• Increased interest rates raise the price to firms of borrowing for capital
equipment  reduce the quantity of investment demand
Investment and the Interest Rate
• The investment spending function can
be specified as:
I  I  bi
(1) where b > 0
• i = rate of interest
• b = the responsiveness of investment
spending to the interest rate
• I = autonomous investment spending
• Negative slope reflects assumption that
a reduction in i increases the quantity
of I

•The position of the I schedule is determined by:

–The slope, b
–Level of autonomous spending
The Interest Rate and AD: The IS Curve
• Need to modify the AD function of the last chapter to reflect the new planned
investment spending schedule:

AD  C  I  G  NX
 C  cT R  c(1  t )Y   ( I  bi)  G  NX
 A  c(1  t )Y  bi

• An increase in i reduces AD for a given level of income

• At any given level of i, can determine the equilibrium level of income and output
[as in Ch. 10]

• A change in i will change the equilibrium

The Interest Rate and AD: The IS Curve
AD  A  c(1  t )Y  bi
• For a given interest rate, i1, the last term
in equation (2) is constant  can draw
the AD function with an intercept of
A  bi1
• Figure 11-5 shows the negative
relationship between i and Y 
Downward sloping IS curve

Derivation of the IS curve ->

The Interest Rate and AD: The IS Curve
• We can also derive the IS curve using the goods market equilibrium
condition:

Y  AD  A  c(1  t )Y  bi 
Y  c(1  t )Y  A  bi
Y (1  c(1  t ))  A  bi
Y  G ( A  bi)

1
where G  , the multiplier in presence of a proportional
(1  c(1  t ))
taxation system from session 7 (DFS ch 10)
The Slope of the IS Curve
• The steepness of the IS curve depends on:
• How sensitive investment spending is to changes in i
• The multiplier, G

• Suppose investment spending is very sensitive to i  the

slope, b, is large
• A given change in i produces a large change in AD (large shift)
• A large shift in AD produces a large change in Y
• A large change in Y resulting from a given change in i  IS curve is
relatively flat

• If investment spending is not very sensitive to i, the IS curve is

relatively steep
The Position (shift) of the IS Curve
• Figure 11-7 shows two different IS
curves  differ by levels of
autonomous spending
• The change in income as a result from a
change in autonomous spending is
∆𝑌 = 𝛼𝐺 ∆𝐴ҧ
The Money Market and the LM Curve
• The LM curve shows combinations of interest rates and levels
of output such that money demand equals money supply 
equilibrium in the money market

• The LM curve is derived in two steps:

1. Explain why money demand depends on interest rates and income
• Theory of real money balances, rather than nominal
2. Equate money demand with money supply, and find combinations of
income and interest rates that maintain equilibrium in the money
market
• (i, Y) pairs meeting this criteria are points on a given LM curve
Demand for Money
• The demand for money is a demand for real money balances
• People are concerned with how much their money can buy, rather
than the number of rupees in their pockets

• The demand for real balances depends on:

─ Real income: people hold money to pay for their purchases, which, in
turn, depend on income
─ Interest rate: the cost of holding money

• The demand for money is defined as: 𝐿 = 𝑘𝑌 − ℎ𝑖

The Liquidity Preference theory or the theory of money demand rests on three motives (transactions
motives, precautionary motive and speculative motives) behind holding or demanding money.
Demand for Money
𝐿 = 𝑘𝑌 − ℎ𝑖
• The parameters k and h reflect the
sensitivity of demand for real balances to
the level of Y and i.
• The demand function for real balances
implies that for a given level of income, the
quantity demanded is a decreasing function
of i.
• Figure 11-8 illustrates the inverse
relationship between money demand and i.
 money demand curve
The Supply of Money, Money Market Equilibrium, and the
LM Curve
𝑀ഥ
• The nominal quantity of money supplied, M, controlled by central bank (real money supply is , where M and P
𝑃ത
are assumed fixed)

• Starting at Y1, the corresponding demand curve for real balances is L1  shown in panel (a)
• Point E1 is the equilibrium point in the money market
The Supply of Money, Money Market Equilibrium, and the LM
Curve
• Point E1 is recorded in panel (b) as a point on the money market equilibrium schedule, or the LM curve
• (i1, Y1) pair is a point on LM curve
• If income increases to Y2, real money balances higher at every level of i  money demand shifts to L2
• The interest rate increases to i2 to maintain equilibrium in money market and the new equilibrium is
at point E2

Record E2 in panel (b) as another point on the LM curve

Pair (i2, Y2) is higher up the given LM curve
The Supply of Money, Money Market
Equilibrium, and the LM Curve
• The LM schedule shows all combinations of interest rates and levels of
income such that the demand for real balances is equal to the supply
 money market is in equilibrium

• LM curve is positively sloped because:

• An increase in the interest rate reduces the demand for real balances.
• To maintain the demand for real money balances equal to the fixed money supply, the
level of income has to rise.

• The LM curve can be obtained directly by combining the demand curve for real
balances and the fixed supply of real balances
The Supply of Money, Money Market
Equilibrium, and the LM Curve
• For the money market to be in equilibrium, supply must equal
demand: M
 kY  hi
P
• Solving for i: 1 M
i  kY  
h P 

• The steeper the LM curve:

• The greater the responsiveness of the demand for money to income,
as measured by k
• The lower the responsiveness of the demand for money to the
interest rate, h

• A given change in income has a larger effect on i, the larger is k and the smaller is h
The Position (shift) of the LM Curve
• Real money supply constant along the LM curve  a change in the real money
supply will shift the LM curve

• Figure 11-10 shows the effect of an increase in money supply

• Equilibrium occurs at point E1 with interest rate i1  corresponding
point E1 on the LM curve
The Position (shift) of the LM Curve
• If real money balances increases, money supply curve shifts to the right
• To restore equilibrium at the income level Y1, the i must decrease too
• In panel (b), the LM curve shifts to the down and to the right
The IS-LM Equilibrium (the Goods and Money Market Equilibrium)
• The IS and LM schedules summarize the
conditions that have to be satisfied for
the goods and money markets to be in
equilibrium
• Assumptions (Keynesian short run):
– Price level is constant
– Firms willing to supply whatever amount of
output is demanded at that price level

• The equilibrium levels of income and

the interest rate change when either
the IS or the LM curve shifts.
Applications of the closed economy IS-LM model
Changes in the Equilibrium
• Figure 11-12 shows effects of an
increase in autonomous spending
• Shifts IS curve out by 𝛼𝐺 ∆𝐼 if
autonomous investment is the source
of increased spending
• The resulting change in Y is smaller than
the change in autonomous spending
due to slope of LM curve

If rise in autonomous spending (A-bar) is due to rise in autonomous investment (I-bar), IS curve shifts to the right. The
resulting change in Y is smaller than the change in autonomous spending due to slope of the LM curve.
Y0 – Y’ < horizontal distance between IS and IS’ . ∆𝑌0 < 𝛼𝐺 ∆𝐼 .
If LM curve is horizontal, Y0 – Y’ = horizontal distance between IS and IS’ . ∆𝑌0 = 𝛼𝐺 ∆𝐼 . Because interest rate would not
change when IS curve shifts. Why is ∆𝑌0 < 𝛼𝐺 ∆𝐼 ? I-bar up, A-bar up, Y up, L down, as M/P is fixed interest rate increases
𝑀ഥ
to ensure L = . i up, I down. Accordingly, equilibrium change in Y < the horizontal shift of the IS curve, 𝛼𝐺 ∆𝐼 .
𝑃ത