Econ 312 - IS/LM Model Notes 1

Handout: IS/LM Model

IS Curve Derivation
Figure 4-4 in the textbook explains one derivation of the IS curve. This derivation uses the Induced
Savings Function from Chapter 3. Here, I describe an alternative derivation of the IS curve using
the 45◦ -line/Expenditure function model from Chapter 3. The results is the same but the graphs
differ.
IS Curve: All combinations of interest rates and GDP for which the spending balance model is in
equilibrium.
Derivation: The derivation begins with the “Keynes Cross” model developed in Chapter 3. Bear
in mind that Ip and Ca from this model both depend on the interest rate in the economy, r.
Graphically, the income determination model goes on the top set of axes and below it a set of axes
with GDP graphed on the horizontal axis and the interest rate graphed on the vertical axis.
E
6 E ≡Y

Ep = Ap + cY 1. Begin at the equilibrium point Eo in the

 spending balance model. Eo identifies

the equilibrium level of GDP (Yo∗ ) and
r
E0 
Epo

   planned expenditure (Epo ) in the model.

Apo  In turn, the equilibrium level of planned
expenditure depends on two factors, Ip
and Ca that depend on the interest rate.
45◦
r Yo∗
-
Y
To locate Apo , there must also be some
6 corresponding interest rate, ro , in the
economy.

2. Map the equilibrium level of GDP, Yo∗ ,

and the corresponding interest rate, ro ,
into the bottom panel (r × Y ). “Map”
ro q E0 means locate the equilibrium point Eo in
the lower graph, by locating Yo∗ and ro
in this space. Note that, by definition,
Eo is on the IS Curve.
-
Yo∗
Y
Econ 312 - IS/LM Model Notes 2

E
6 E ≡Y

3. Change the interest rate. Suppose that

Ep = Ap + cY interest rates rise from ro to r1 . An in-

 crease in interest rates reduces both Ip
E0

r
E0 
 p and Ca , which reduces Ap from Ap0 to
 



 Ap1 . This shifts the Ep line down and re-
?
 E  duces equilibrium GDP from Yo∗ to Y1∗
r
1 

Ep1
Ap1 
 and leads to a new equilibrium point,
E1 .
45◦ -
r Y1∗ Y 4. Map the new equilibrium point in the
6
spending balance model into the bot-
tom panel (r × Y ). The Y coordinate
can be found by extending the vertical
r1
qE1 dashed line straight down. The r coordi-
nate must be located somewhere above
q E0 the previous interest rate ro because the
interest rate was assumed to increase.
Note that the new equilibrium point E1
is also, by definition, on the IS Curve.
-
Y1∗
Y

r
6

@ qE
r1 @1
@ More points on the IS Curve could be found
@ q E0
ro
@ by repeating this procedure and finding addi-
@ tional equilibrium points. This would result in
@ a linear relationship between r and Y . Mov-
@
IS ing along the IS Curve interest rates move in
- the opposite direction as GDP.
Y1 Yo
Y
Econ 312 - IS/LM Model Notes 3

Strong and Weak Policy

Monetary Policy Fiscal Policy

r r
6 6
Old N ew LM

Q Q Q
Q - Qq E7
Q Q Q
Q r7
Qq E0 Qq E0 QqE5
Q Q Q
r0 r0
r1 Qq E1 Q Q
Q Q Q
Q Q Q
Q Q Q
Q Q Q
- IS Old N ew
- -
Y0 Y1 Y 0 Y7
Y Y
Strong Monetary Policy Strong Fiscal Policy

r r
6 6
Old N ew Original

Q Q Q
Q Q Q
Q Q -Q
Qq E0 q L Qq E0 QqE5 Horizontal LM
Q Q Q
r0 r0
Qq
r1
Qq E2
Q Q
r2 Q Q
Q Q Q
Q Q Q
Q Q Q
- IS Old N ew
- -
Y0 Y1Y2 Y0 Y5
Y Y
Weak Monetary Policy Weak Fiscal Policy

r r
6 6 LM

Q Old N ew Q Q qE
Q  
 r6 Q Q 6
Q  Q Q
Qq Eq0 Qq E0 QqE5
Q  Q Q
r0 r0
r4 Q E
 Q4
Q Q
   Q Q
-  Q Q Q
Q Q -Q
Q Q Q
IS Old N ew
- -
Y 0 Y4 Y0
Y Y
Econ 312 - IS/LM Model Notes 4

More on the Algebra of the IS/LM Model

The graphical presentation to the IS/LM model has a corresponding analytical representation. In
many ways, the model in equations provides more insight than the graphical version of the model.
The appendix to Chapter 5 contains a discussion of the algebraic solution to this model. Here, I
present a slightly different version of this material.
Recall from Chapter 3, the effect of changes in the exogenous variables of the model on GDP
depended on the multiplier
1
multiplier = (1)
marginal leakage rate
And also recall that the equilibrium condition from the Chapter 3 model of income determination
was

Y = kAp (2)
In a nutshell, the IS curve derivation in Chapter 4 simply makes Autonomous Planned Expenditure
depend on the interest rate.

Ap = A0p − br (3)
Here, the parameter b simply reflects how sensitive Ap is to changes in the interest rate. Recall
from the IS Curve derivation, when r changed, Ip and Ca changed, and the intercept of the Ep line
shifted around; when r ↑, the intercept fell and Y ↓. This equation simply shows this algebraically.
b is related to the effect of changes in the interest rate on Ip and Ca .
This also changes the equilibrium condition from the model. Simply substitute the expanded
equation for Ap into the equilibrium condition

Y = k(A0p − br) (4)

In fact, this new equilibrium condition is also an expression for the IS curve. To get this expression
in slope-intercept form, we need to solve it for the variable graphed on the vertical axis, r

Y = k(A0p − br)
Y = kA0p − kbr
kbr = kA0p − Y
k 0 1
r = kb Ap − kb Y
1 0 1
r = b Ap − kb Y
1
In this equation, − kb is the slope of the IS Curve. It is negative, so the IS curve slopes down. The
first term is the intercept of the IS curve. The exogenous factors in Ap shift this intercept - they
shift the IS curve left and right.
The LM curve emerges from the money market model. Interest rates move to equilibrate money
demand and money supply, so the equilibrium condition i the money market is
! !d
MS MS
= = hY − f r (5)
P P
The LM Curve emerges from this equilibrium condition. Again, simply solve the equilibrium
condition for r, the variable graphed on the vertical axis.
Econ 312 - IS/LM Model Notes 5

MS
hY − P
r= (6a)
f
Now we have a system of two equations (the IS Curve and the LM Curve) in two unknowns. These
two equations can be solved to get a reduced form equation for GDP. To recap, we have
IS Curve LM Curve
1 0 1 S
r = b Ap − kb Y r = fh Y − f1 MP
Spending Market Equilibrium Money
 S  Market Equilibrium
0
Y = k(Ap − br) M
= hY − f r
P

There are many ways to algebraically solve this system. For example, the IS Curve could be set
equal to the LM Curve, and the resulting equation solved for Y . The approach in the appendix is
to plug the expression for the LM Curve into the right hand side of the expression for the spending
balance model equilibrium, substituting for r [Note the typo in equation (7) in the text]
" !#
bhY b MS
Y = k(A0p − br) = k A0p + + (7)
f f P
Add kbhY /f to both sides and divide both sides by k to solve for Y
!
1 bh b MS
 
Y + = A0p +
k f f P

And divide both sides by the term in parentheses on the left hand side.
 
MS
A0p + b
f P
Y = 1 bh
(8)
k + f

This equation is a reduced form equation for GDP for the IS/LM Model. It shows the overall
impact on Y of changes in the exogenous variables in the model when both the money market and
the spending balance model are in equilibrium.
Chapter 5 is primarily concerned with the relative strength of monetary policy and fiscal policy.
How do ∆M S and ∆G affect Y in the model? Note that G is part of A0P . To make the analysis
easier, the reduced form equation can be rewritten a bit
 
MS
A0p + fb P
Y = 1
+ bh
k f
b  
MS
Y = 1
1
+ bh
A0p + 1
f
+ bh P
k f k f

In this equation, the policy variables of interest are M S and G which is part of A0p . The two messy
fractions in front of these terms can be simplified into two parameters
!
MS
Y = k1 A0p + k2 (9)
P
Where the parameters are simply
1
k1 = 1
(10)
k + bh
f
Econ 312 - IS/LM Model Notes 6

b/f b
 
k2 = 1 bh
= k1 (11)
k + f
f

And again, the simplified Reduced Form Equation For GDP from the IS/LM model is
!
MS
Y = k1 A0p + k2 (12)
P

Some Algebraic Insight

The graphical depictions of the conditions for strong and weak policy discussed in Chapter 5 and
shown above also have algebraic counterparts. Insight into the conditions under which monetary
and fiscal policy are relatively strong and weak can be seen from the reduced form solution for
GDP in the IS-LM Model.
 
MS
Reduced Form Solution: Y = k1 A0p + k2 P

Monetary Policy Fiscal Policy

   
∆MS MS
∆Y = k1 A0p + k2 P ∆Y = k1 ∆A0p + k2 P

Effect of ∆M on ∆Y depends on: Size of the effect of ∆G on ∆Y depends on:

 
b 1
k2 = f k1 k1 = 1
+ bh
k f

b ↑⇒ k2 ↑ b ↑⇒ k1 ↓

f ↑⇒ k2 ↓ f ↑⇒ k1 ↑

An Example: As the LM Curve gets steeper, fiscal policy gets weaker. Recall:

1 MS
LM Curve r = fh Y − f P Slope of the LM Curve = h
f

The strength of fiscal policy depends on k1 . When the LM curve gets steeper, fh gets larger. Note
that when fh gets larger, the denominator of k1 gets larger, and k1 gets smaller. That makes fiscal
policy (∆G) have a smaller effect on Y .
This concept is illustrated with a sample exam question on the following page. Answer this
question before looking at the solution on the next page.
Econ 312 - IS/LM Model Notes 7

Sample Exam Question: Suppose that money demand is not very sensitive to changes in the
interest rate. In this case, monetary policy is strong. (True/False/Uncertain)

-
Econ 312 - IS/LM Model Notes 8

Solution: True. If money demand is not sensitive to changes in the interest rate, then the param-
eter f is small. As f gets smaller, fh (the slope of the LM curve) gets bigger - the LM curve gets
steeper. The steeper the LM curve, the less effective is monetary policy.
r
6
h
LM with f small, f
large
@

@
h
@
LM with f large, f
small
@

r1 @q


@

@


@

@

@ IS


-
Y1 Y