is lm model1

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IS-LM Model

IS Function

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Outline Introduction Assumptions Investment Function I= f(r) Deriving the IS Function: Income-

Expenditure Approach (Y = E) Deriving the IS Function: Injection-

Withdrawal Approach (I + G = S + T) 4-quadrant diagram

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Outline Simple Algebra of the IS function Slope of the IS function

Interest Elasticity of Investment b Marginal Propensity to Save s

Shift of the IS function T’ v.s. E’

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Introduction In the elementary Keynesian model,

investment I is independent of interest rate r. The Paradox of Thrift In a 2-sector model, at equilibrium, planned I = planned S I = I’ = S’ + sY = S if S’ OR s Y However, when S’ OR s r I’ I S Y uncertain

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Introduction Sometimes, investment depends on

income Y and is an endogenous function I = f(Y) e.g. I = I’ + iY Marginal Propensity to Invest MPI: I/Y= i

However, in the IS-LM model, investment depends on the interest rate I = f (r ) e.g. I = I’ - br Interest Elasticity to Invest: I/r = -b

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Introduction In the elementary Keynesian model, only

the goods market is considered. In the IS-LM model, both the goods market

and the money market are considered. In the goods market

Investment I = Saving S In the money market

Liquidity Preference L = Money Supply M

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Introduction In the elementary Keynesian model,

equilibrium is attained when income is equal to ex-ante

aggregate expenditure Y = C + I + G + (X - M)

OR ex-ante withdrawal is equal to ex-ante injection S + T + M = I + G + X

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Introduction In the IS-LM model, equilibrium is

attained when both the goods market and the money market are in equilibrium.

Yet, the labour market may not be in equilibrium at this moment.

There may be excess supply/ unemployment OR excess demand / labour shortage.

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Introduction There is a similar relationship between the

goods market and the labour market in the simple Keynesian model

Equilibrium is achieved but Ye can be less than, equal to OR greater than Yf

Equilibrium is achieved when planned output is enough to meet planned expenditure. Yet, planned expenditure may not guarantee full employment, especially in times of depression

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Assumptions Investment is assumed to be

negatively related / correlated to the interest rate I/r = -b

Money supply is determined by the monetary authority.

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Assumptions The level of employment Ye is far below the full

employment level Yf i.e. vast unemployment output can be raised by using currently idle

resources without bidding up prices price rigidity P’ no difference between nominal income and

real income national income is demand-side determined

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Investment Function I= f(r ) I = I’ - br b > 0 I/r = -b The coefficient b is the interest elasticity of

investment. It measures the responsiveness of investment I to a change in the interest rate r

c= i= s= m= t= kE = kT =

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Investment Function

I

Y

I1 = I’ - br1

I2 = I’ - br2

r I

The greater is the value of b,

the more interest elastic is the investment function

the greater will be the increase in investment Iin response to a fall in interest rate r

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Investment Functionv.s. the one on slide 13the independent variable here is r (y-axis) instead of Y

I

r

I’

Slope = r/I = -1/b flatter r I

r

I

I

r

I’

I = I’ - br

r= 0 I =I’

I= 0 r =I’/b

This is only like a mirror image

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IS Function The IS curve is the loci of all the

combinations of r and Y at which the goods market is in equilibrium, i.e.,

planned output equals planned expenditure / planned saving equals planned investment / planned withdrawal equals planned injection

You’ve learnt the method of deriving the relationship between 2 variables in Micro, like ICC, PCC, Demand Curve

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Deriving the IS FunctionOutput-Expenditure Approach

C = C’ + cYd I = I’ - br G = G’ T = T’ if there’s only a lump sum tax

E = C + I + G E = C’ + cYd + I’ – br + G’ E = C’ – cT’ + I’ + G’ – br + cY

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In equilibrium, Y = E Y = C’ – cT’ + I’ + G’ – br + cY Y = kE * E’

E = C’+I’+G’–br + cY- ctY if it’s a proportional tax system

In equilibrium, Y = E Y =kE * E’

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First of all, find out the planned aggregate expenditure function E which corresponds to a certain level of interest rate r1

Then, determine the equilibrium national income Y1.

This combination of r1 and Y1 constitutes the first locus of the IS function

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If r (from r1 r2) I E’ E Ye by a multiple k E(Y = k E E’)

It means that when r decreases (may be due to an increase in money supply)

Y will increase in order to restore equilibrium in the goods market.

What has happened before Y ? That’s why r and Y are negatively related.

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E1 = C’ - cT’ + I’ - br1 + G’ + cY

y-intercept = E’ =

slope = c

Y

E, C, I, G

Y1

when Y = planned E

If r I E’ E

If b is large, r I

E2 = C’ - cT’ + I’ - br2 + G’ + cY

Y2

Y= kE I’

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r

YIS

r1

r2

Y1 Y2

Slope of the IS curve depends on 2 factors

b : If investment is interest elastic r I

kE:If expenditure multiplier is large I Y*

*

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Deriving the IS FunctionInjection-Withdrawal Approach

C = C’ + cYd I = I’ - br G = G’ T = T’ if there’s only a lump sum tax

S = S’ + s( Y – T’) S = S’ – sT’ + sY

S = S’ + sY - stY If it’s a proportional tax system

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In equilibrium, S + T = I + G S’ – sT’ + sY + T’ = I’ – br + G’ sY = -S’ + sT’ – T’ + I’ + G’ – br (1-c)Y = C’ + (1-c)T’ – T’ + I’ + G’ – br (1-c)Y = C’ - cT’ + I’ + G’ – br Y = kE * E’ [same as slide 17]

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Y

I, G, S, T

T = T’G = G’

I1 = I’-b r1

S + T

I1 + GI2 = I’-b r2

I2 + G

Y1

when S+T=I+G

Y2

The IS function derived here is the same as the one on slide 21

S =S’–sT’+sY

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4-Quadrant Diagram Investment Function Government Expenditure Function The relationship between r & Injection J Saving Function Tax Function The relationship between Y & Withdrawal W J = W [45 - line] The IS Function

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Investment Functionrefer slide 14

r r

II

I/r = -b =

I’

I/r = -b = 0r

I

I/r = -b

Slope = r/I = -1/b

I’

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Government Expenditure Function

r

G G’

As G is independent of r

G = G’

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Injection = I + Gr

J, I, G

I= I’- brG = G’At each interest rate r,

J = I + G

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Saving Function

S

Y

S = S’ - sT’ + sY

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Tax Function

Y

T

T’

As tax is independent of Y

T = T’

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Withdrawal W = S + T

T = T’

At each income level Y,

W = S + T

S = S’ - sT’ + sY

Y

W, S, T

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Equilibrium J = W

J

W

J = W

45

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4-Quadrant diagram Quadrant 1 - IS function-

Equilibrium in goods market relationship between r & Y

Quadrant 2 (slide 28) relationship between r & J

Quadrant 3 (slide 32) Equilibrium condition: J = W

Quadrant 4 (slide 31) relationship between Y & W

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4 - Quadrant Diagram

r

Y

W

J

r1

J1

W1

Y1

*

r2 *Y2J2

W2

IS

I + G

I+G=S+T S + T

(r1, Y1)

(r2, Y2)

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Simple Algebra of the IS Curverefer slide 16 & 17

E = C’ - cT’ + I’ + G’ - br + cY In equilibrium, Y = E Y = [C’ - cT’ + I’ + G’ - br]

1

1 - c

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Simple Algebra of the IS Curverefer slide 21 & 34

r = - Y r/Y =

C = 100 + 0.8Yd I = 40 - 10r G = 20 T = 10

Y = Y =

C’ - cT’ + I’ + G’

b

S

b

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Slope of the IS Curveflatter = slope smaller

slope of the IS curve = the curve is negatively sloped The slope of the IS curve shows the

responsiveness of the equilibrium income Y to a change in interest rate r.

The greater the interest elasticity of investment b, the flatter the IS curve

The smaller the MPS OR the greater the MPC, I.e., the greater the kE the flatter the IS curve.

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Slope of the IS Curver I Y

When interest rate falls, investment will increase.

If investment is interest elastic b = I /r, the increase in investment will be great.

When investment increase, income will increase by a multiple.

If expenditure multiplier (s is small or c is

large) is great k E = Y /I , the increase in income will also be great.

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Slope of the IS Curveb =I/r is large IS flat slope = s/b small

If investment is interest elastic, given any reduction in interest rate, the increase in investment I is large.

This leads to a larger increase in income Y = k E I

That is, for any reduction in interest rate, the increase in income is larger

a flatter IS curve

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Slope of the IS Curveb =I/r is large IS flat slope = s/b small

r

YJ

r1

J1

W1

Y1

*

r2 *Y2J2

W2

Steeper ISJ = I + G

I+G=S+TW = S + T

(r1, Y1)

(r2, Y2)

* (r2, Y3)

Flatter IS

Y3

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Relationship between MPC & MPS

Increase in MPC

Will lead to a

Decrease in MPS

Y

Suppose T = T’

Otherwise MPC is not the slope of the consumption function

C, S

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Relationship between MPC & MPS

An Increase in MPC is the same as a Decrease in MPS

Y

S

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Slope of the IS Curvek E = 1/s = Y/E’ is large IS flat slope = s/b small MPS small

If MPS S/Y is small, given any increase in income, the increase in saving is small, i.e., the increase in consumption is large, leading to a larger multiplying effect on income.

When interest rate decreases, investment will increase.

If k E is larger, the increase in income is larger as well

a flatter IS curve

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Slope of the IS Curvek E = 1/s = Y/E’ is large

IS flat slope = s/b small MPS smallr

Y

W

J

r1

J1

W1

Y1

*

r2 *Y2J2

W2

Steeper ISJ = I + G

I+G=S+T W = S + T

(r1, Y1)

(r2, Y2)

Y3

* Flatter IS

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Slope of the IS Curvek E = 1/(1 - c) = Y/E’ is large

IS flat slope = (1– c )/b small MPC large

If MPC C/Y is large, given any increase in income, the increase in consumption is large, leading to a larger multiplying effect on income.

When interest rate decreases, investment will increase.

If k E is larger, the increase in income is larger as well

a flatter IS curve

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Slope of the IS Curve refer slide 44

k E = 1/(1- c ) = Y/E’ is large

IS flat slope= (1– c)/b small MPC large

r

Y

W

J

r1

J1

W1

Y1

*

r2 *Y2J2

W2

Steeper ISJ = I + G

I+G=S+T W = S + T

(r1, Y1)

(r2, Y2)

Y3

* Flatter IS

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Shift of the IS Curverefer slide 36

r = - Y

Y = - r

Y/C’ = Y/T’ = Y/I’ = Y/G’ = Y/r = r/Y =

C’ – cT’ + I’ + G’

b

s

bC’ – cT’ + I’ + G’

s

b

s

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Shift of the IS Curve The X-intercept of the IS curve = At each interest rate level, a rise in either one of

the autonomous expenditure E’ (i.e., C’, I’, G’) will shift the IS curve outward by

At each interest rate level, a fall in the autonomous tax T’ will shift the IS curve outward by

But this does not mean Y will ultimately increase by that amount. We have to consider the LM curve as well. What will be the shape of the LM curve if Y indeed increase by that amount?

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Shift of the IS CurveRelationship between C and S

Increase in Autonomous Consumption

will lead to a

Decrease in Autonomous Saving and vice versa Y

C, S

C’

-C’

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Shift of the IS CurveRelationship between C and S

S = S’ – sT + sYS

Y

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Shift of the IS Curve C’ S’

r

Y

W

J

r1

J1

W1

Y1

*

r2 *Y2J2

W2

ISI + G

I+G=S+TS + T

*

Y3

*

IS

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Shift of the IS Curve I’

r

J, I, G

I= I’- brG = G’

At each interest rate r,

J = I + G

I’

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Shift of the IS Curve I’

r

Y

W

J

r1

J1

W1

Y1

*

r2 *Y2J2

W2

ISI + G

I+G=S+T

S + T

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Shift of the IS Curve G’

r

J, I, G

I= I’- brG = G’

At each interest rate r,

J = I + G

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Shift of the IS Curve G’

r

Y

W

J

r1

J1

W1

Y1

*

r2 *Y2J2

W2

ISI + G

I+G=S+T

S + T

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Shift of the IS Curve T’ T by T’ S by -sT’ W by c T’

T = T’

At each income level Y,

W = S + T

S = S’ - sT’ + sY

Y

W, S, T

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Shift of the IS Curve T’

r

Y

W

J

r1

J1

W1

Y1

*

r2 *Y2J2

W2

ISI + G

I+G=S+T

S + T

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Shift of the IS Curve T’ G’

r

Y

W

J

r1

J1

W1

Y1

*

r2 *Y2J2

W2

ISI + G

I+G=S+T

S + T

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Disequilibrium in the goods market

r

Y

W

J

r1*

ISJ = I + G

I+G=S+TW = S + T

J is greater/ smaller than W

unplanned inventory

*

* *

* *

Y is greater / smaller than AD

unplanned inventory

Y will

G’

J = W

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Two Extreme Cases

rr

Y Y

Slope larger

IS steeper

Slope = -s/b =

tan 90 =

Either s =

Or b = 0

Vertical ISSlope smaller

IS flatter

Slope = -s/b = 0

tan 0 = 0

Either s = 0

Or b =

Horizontal IS

Remember a horizontal demand curve has a Ed of infinity

is lm model1

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