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.