is-lm model: predictions are qualitative

Source: "Macroeconomics", Mankiw, Chapter 11: 4th edition, Chapter 11: 5th edition

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IS-LM Model: Predictions are Qualitative

• The IS-LM model shows how monetary and fiscal policy influence the equilibrium level of income.

• The predictions of the model are qualitative not quantitative – i.e. IS-LM model shows that increases in

government purchases raises GDP and that increases in taxes lowers GDP. So the model tells us the direction of the effect of a policy


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• But it doesn’t tell us the size of the effect i.e. the prediction of the model is qualitative not quantitative

• Example: if the government increases taxes by €100m, and monetary policy is not affected how much will GDP fall by

• The IS-LM model tells us that GDP will fall but it does not tell us by how much it will fall.


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• A macroeconometric model: describes the economy quantitatively

• A model is built using historical data and economists simulate the affects of different policies, using a computer


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IS-LM Model: Shocks

• We can use the IS-LM model to examine how various shocks (or economic disturbances) can affect income. – Shocks to the IS curve– Shocks to the LM curve

• Shocks to the IS curve:– Exogenous changes in the demand for goods and

services


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IS-LM Model: Shocks

• Shocks to the IS curve (cont’d):– Keynes emphasised: shocks can be as a

result of waves of pessimism or optimism about the future of he economy

– Example: if firms become pessimistic about the future of the economy: investment falls. The fall in investment reduces expenditure and the IS curve shifts to the left – reducing income and employment.

– This fall in income partly validates the firms’ pessimism


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IS-LM Model: Shocks

• Shocks to the IS curve (cont’d):– May also arise from changes in the demand for

consumer goods.– Example: an increase in consumer confidence in

the economy because of new government in office. Consumers will save less for the future and start to spend more. Consumption and thus expenditure rise. Therefore, the IS curve shifts to the right and this raises income in the economy.


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IS-LM Model: Shocks

• Shocks to the LM curve:– Arise from exogenous changes in the demand for

money– Example: new restrictions on credit-card

availability. Therefore, people will want to hold more money and there will be an increase in the demand for money. In the money market, interest rates rise. The LM curve shifts to the left, with higher interest rates and lower income


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IS-LM Model: Shocks

• Several kinds of events can cause shifts in the IS and/or LM curves that result in economic fluctuations.

• Policymakers can try to use the tools of monetary and fiscal policy to offset exogenous shocks.

• If policymakers are sufficiently quick and skillful, shocks to the IS or LM curves may not lead to changes in income or employment


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IS-LM as a Theory of Aggregate Demand

• The IS-LM model provides a theory to explain the position and slope of the aggregate demand curve.

• Recall: aggregate demand curve describes the relationship between the price level and the level of national income. A higher price level implies lower demand, lower level of income.


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IS-LM Model as a Theory of Aggregate Demand

• We use the IS-LM model to:– Show why the aggregate demand curve is

downward sloping– Examine what causes the aggregate

demand curve to shift

• In order to do this we have to relax the assumption that prices are fixed.


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• To show why the aggregate demand curve slopes downward:– We examine what happens to the IS-LM

model when the price level changes – For any given money supply, M, a higher price

level, P reduces the supply of real money balances, M/P.

– A lower supply or real money balances shifts the LM curve to the left with higher equilibrium interest rate and lower income (see graph a on next slide)


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• In graph b on the previous slide: the aggregate demand curve plots this negative relationship between national income and the price level.

• In summary: the aggregate demand curve shows the set of equilibrium points that arise in the IS-LM model as we vary the price level and see what happens to income.


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• To examine what causes the aggregate demand curve to shift:– At a given price, events that shift the IS curve and

LM curve cause the aggregate demand curve to shift.

– Example: an increase in the money supply, with prices fixed, causes interest rates to fall and income to rise. The LM curve shifts to the right (first slide of panel a on next slide).

– With constant prices and a rise in income this must mean that the aggregate demand curve shifts to the right (second graph of panel a on next slide)


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• To examine what causes the aggregate demand curve to shift :– Example: expansionary fiscal policy (i.e. an

increase in government purchases or a decrease in taxes) shifts the IS curve to the right and raises income in the IS-LM model.

– The price level has not changed but income has increased, therefore, the aggregate demand curve shifts to the right (see panel b in previous slide)


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• To examine what causes the aggregate demand curve to shift :– Contractionary fiscal or monetary policy will

cause the aggregate demand curve to shift to the left

is-lm model: predictions are qualitative

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