IS-LM Model Notes

Introduction to Economics and the IS-LM Model

  • Course: ECU11012 – Introduction to Economics B

  • Focus: IS-LM Model (Chapters 31 & 32, 4th Edition and Chapters 26 & 27, 5th Edition)

  • Instructor: Davide Romelli

Motivation for Economic Study

  • Study explores GDP across EU from 1960 to 2014 measured in current US dollars.

Policy Instruments in Macroeconomics

  • Main instruments analyzed:

  • Fiscal Policy: Government spending and taxation that influences the economy.

  • Monetary Policy: Central bank actions that manage the money supply and interest rates.

The Keynesian Cross

  • Keynes's Message: Recessions can arise from insufficient aggregate demand.

  • Critique of Classical Economics:

  • Classical theory focuses on long-run effects; Keynes emphasizes immediate impacts, saying: "In the long run we are all dead."

Inflationary Gaps

  • Equilibrium Condition: Occurs when the expenditure line intersects the 45-degree line.

  • Inflationary Gap: When equilibrium output exceeds full employment output, signaling overheating in the economy.

The Multiplier Effect

  • Definition: Government expenditure can yield a greater total increase in aggregate demand than the initial spending.

  • Example: €10 billion spent on building power stations leads to increased income and consumer spending.

  • Multiplier Formula:

  • Multiplier = 1 / (1 - MPC)

  • MPC (Marginal Propensity to Consume): Portion of extra income spent rather than saved.

Calculation of the Multiplier

  • Example Calculation:

  • If MPC = 3/4, then Multiplier = 1 / (1 - 3/4) = 4.

  • €10 billion increase in government spending generates €40 billion in increased demand.

Other Applications of the Multiplier Effect

  • The multiplier effect applies to:

  • Changes in government spending, consumer expenditure, investment, and net exports.

  • Smaller changes in these areas can lead to significant national income fluctuations, depending on the MPC.

The IS and LM Curves

  • The IS-LM model represents general equilibrium in both the goods and money markets.

  • IS Curve: Represents investment and saving; shows equilibrium in the goods market.

  • LM Curve: Represents liquidity and money; displays equilibrium in the money market.

  • Interest rate (i) links the two markets.

The IS Curve

  • Derived from: The Keynesian cross diagram.

  • Characteristics: Shows an inverse relationship between interest rates and output.

  • Factors Influencing Slope: Responsiveness of consumption/investment to interest rate changes and size of the multiplier.

  • Shifts in IS Curve:

  • Government spending increase shifts IS to the right.

  • Decrease in exports shifts IS to the left.

The LM Curve

  • Represents equilibrium in the money market, influenced by:

  • Money Supply: Determined by the central bank (fixed).

  • Money Demand: Depends on income (Y) and interest rates (i).

  • LM Curve Characteristics:

  • Positive slope; higher income leads to higher interest rates due to increased money demand.

  • Shifts in LM Curve: Can occur with changes in money supply by the central bank.

General Equilibrium in the IS-LM Model

  • Equilibrium occurs at the intersection of IS and LM curves, indicating balance in both markets.

  • Each point on the IS curve equates goods market equilibrium, while points on the LM curve equate money market equilibrium.

Effects of Fiscal and Monetary Policy

  • Fiscal Policy Effects:

  • Increase in government spending or tax decreases shifts IS curve to the right.

  • Monetary Policy Effects:

  • Increase in money supply shifts the LM curve to the right.

Maintaining Constant Interest Rates

  • When the IS curve rises:

  • Central banks may need to increase the money supply to keep interest rates constant.

Key Takeaways

  1. Keynes emphasized inadequate aggregate demand as a reason for recessions.

  2. Government intervention is crucial for boosting demand and stabilizing the economy.

  3. Key Equilibrium Concept: IS curve (goods) intersects with LM curve (money) determines overall economic equilibrium.

  4. IS Curve: Reflects investment-saving balance; influenced by interest rates.

  5. LM Curve: Reflects liquidity preferences and money supply; positively sloped.

  6. Shifts in Both Curves: Result from fiscal and monetary policies impacting overall economic activity.

  7. Aggregate Demand Curve: Can be derived from the interactions in the IS-LM model, underscoring the relationship between national income and price levels.

  8. The IS-LM model adapts to account for policy changes, emphasizing inflation targeting in its current form.

Summary

  • The IS-LM model serves as a critical framework for understanding the relationship between the goods and money markets and the effects of fiscal and monetary policy on overall economic equilibrium.