ECN 302 602 5 The IS LM Model

Chapter 4 --

The IS-LM Model

 _{Fundamental inflexibility assumptions:}

W -- inflexible P -- inflexible i -- flexible

 _{Overriding theme -- The interest rate}

changes as a result of monetary policy (money supply) as well as other

The IS Curve

 _{Re-translation of Simple}

Keynesian model at equilibrium (Investment = Saving).

Properties of the IS Curve

 _{Downward sloping,} i  C, I  Y*

Shifting the IS Curve

 _{Increases in autonomous}

expenditure which shift the E_P curve upward, simultaneously shift the IS curve rightward.

 _{Decreases in autonomous}

Steepness or

Flatness of the IS Curve

 _{The steepness or flatness of the IS} curve describes the elasticity or

responsiveness of C and I to the nominal interest rate.

Considering Additional

Behavior (Curve #2)

 _{Extra behavior -- decisions to hold} money and financial assets.

 _{The Demand for Money -- The} decision of how much of total

wealth should be held as money (I.e. currency and checkable

Fundamental Aspects --

The Demand for Money

 _{Group all assets into two categories --}

money and “bonds”.

 _{Advantage of holding money --}

convenience for making desired transactions.

 _{Disadvantage of holding money --}

More Fundamentals:

The Demand for Money

 _{Major advantage of holding money}

implies that we demand money in real units.

 _{The Demand for Money (L) -- liquidity} preference.

 _{For a given level of real wealth, the} demand for money covers the entire

The Demand for Money in

Real Terms (L) -- Causes

 _{Output or Income (Y)}

Y  L

 _{The interest rate (i)}

i  L

 _{Financial Innovation (FI)}

The Supply of Real

Money (M

s

/P) -- Causes

 _{The Nominal Money Supply (M}S) -- the Federal Reserve’s variable for monetary policy.

MS  (MS/P)

The LM Curve

 _{Depicts equilibrium in the money}

market (L = M), as well as the Bond Market (by Walras Law).

 _{A plot of the equilibrium interest rate}

for various levels of output or income versus the interest rate, within the

Properties of the LM Curve

 _{Upward sloping,} Y  L  i*

 _{Shift variables consist of the shift} variables of the money demand

Shifting the LM Curve

 _{Increases in the real money supply} (MS or P) shift the LM curve

rightward.

 _{Decreases in the real money} supply (MS or P) shift the LM

Steepness or

Flatness of the LM Curve

 _{The steepness or flatness of the} LM curve describes the elasticity or responsiveness of money

demand (L) to the nominal interest rate.

Economic Policy:

IS-LM Model

 _{Equilibrium output (Y*) takes place}

where the IS and LM curves intersect (equilibrium interest rate, i*, as well).

 _{Keynesian property of model }

Y* < Y_N, (sluggish economy)

Y* > Y_N, (accelerating inflation)

Types of Policy:

IS-LM Model

 _{Fiscal Policy – Federal givernment}

changes G0, T0, t, or other components

of autonomous goods and services expenditure  Shift the IS curve.

 _{Monetary Policy – Federal Reserve}

Expansionary and

Contractionary Policy

 Expansionary (Y* < Y_N) -- shifts the appropriate curve rightward.

Policy Effectiveness

 _{An effective policy is one that}

obtains a large output response for a given change --