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IS-LM Model Notes

Summary of the IS-LM Model

  • IS Curve Overview

    • Represents the relationship between real interest rates and real GDP (Y).
    • Two main views of this relationship:
    • Investment-driven: High real interest rates reduce planned investments, leading to lower real GDP.
      • High real interest rate → Low planned investment → Low real GDP.
      • Low real interest rate → High planned investment → High real GDP.
    • Savings-driven: Higher GDP results in increased savings, lowering real interest rates.
      • Low GDP → Low savings → High real interest rates.
      • High GDP → Increased savings → Lower real interest rates.
    • The IS curve is downward sloping, indicating an inverse relationship between real interest rates and real GDP.

  • LM Curve Overview

    • Represents liquidity preference in relation to the money supply.
    • Definitions:
    • Real Money: Money supply adjusted for inflation (e.g., M0 or base money / CPI).
    • Liquidity Preference: Demand for money; higher economic activity increases demand for money, pushing up real interest rates.
    • Higher GDP leads to higher demand for currency, raising real interest rates.
      • High GDP → High demand for currency → High real interest rates.
      • Low GDP → Low demand for currency → Low real interest rates.
    • The LM curve slopes upward, indicating a direct relationship between real interest rates and GDP.

  • Equilibrium in the IS-LM Model

    • The intersection of the IS and LM curves signifies the equilibrium level of real interest rates and real GDP.
    • Both constraints (investment vs. liquidity preference) must be considered to find this equilibrium.

  • Impact of Monetary Policy

    • Printing more money by the Federal Reserve increases real money supply without immediate price changes (short-term assumption of sticky prices).
    • Increased real money supply leads to:
    • Reduced price of money (real interest rates lower) at constant GDP.
    • Shift of the LM curve downward.
    • Outcome of this shift:
    • Equilibrium real interest rates decrease.
    • GDP may expand as a result of lower interest rates encouraging investment.