IS-LM Model
This topic is organised into 4 parts
1. Introduction
2. Goods Market Equilibrium
3. Asset Market Equilibrium
4. Synthesis and utility
MONEY, INTEREST, AND
INCOME
Our preceding topic must have given a general
impression that stock of money, interest rates, the
RBI, and the Government DO NOT matter in
income determination.
All these play a critical role in the economy. AD is
influenced by rate of interest, RBI faces challenge
when there is a recession.
So, we use Money and Monetary policy to build a
framework to analyse interaction of goods and
assets markets.
2
The Purpose of Extension
Helps to analyse working of monetary policy
Previous income determination can be called a
partial approach in the absence of asset market.
It treats as if economy consists merely of Goods
(& services) market.
Enables to visualise expansionary fiscal policy
effect on increasing the consumption through
multiplier; but reduces investment as high interest
rate discourages private investments
3
Nominal and Real Variables
Nominal variables are those, which are measured in
current years prices and cannot be directly
comparable over years.
Examples: price level (P), nominal wage rate (W),
inflation rate, and nominal interest rate (i).
Real variables are those which will be, expressed
either in physical units or will be expressed in
money terms on the basis of some constant (base
year) prices.
Examples for real variables include output,
Consumption, Investment, Saving, real wage rate,
population, etc.
4
The IS LM Model
Money, Interest, and Income are dealt here
The Classical Dichotomy
Keynes General Theory (published in 1936)
J.R. Hicks summarised (in 1937) Mr. Keynes
and the Classics: A Suggested Interpretation
This popularised the Keynesian Theory via
the ISLM Model
It provides a framework for integrating the
real and monetary sectors
5
The ISLM Mechanism
Monetary policy targets on Assets Markets
Interest rate affected; and it causes changes in
goods market
peoples income changes and it will affect both
markets
Fiscal Policy targets Goods Market and the
incomes are affected. The income allocation
influences Asset, Goods markets and interest
6
The Structure of the IS-LM Model
Meanings and Definitions
Money Market Equilibrium (LM Curve)
Goods Market Equilibrium (IS Curve)
LM Curve: Locus of pairs of interest rate and
income that give equilibrium in the money mkt.
for a fixed MS.
IS Curve: Locus of pairs of interest rate and
income that give equilibrium in the commodity
mkt. for a given level of autonomous spending.
LM= Liquidity preference for Money;
IS= Equality of Investment and Saving
8
Rate of interest
A sensitive variable not only in economics
but also equally sensitive politically
No single rate ( T-bill, CP, Bonds, Saving
Bank deposit rate, P.O. deposits, NSC,
Vikas Patras, EPF, etc). One rate for
convenience.
Determinants of r
default risk
expected inflation
time preference
9
The Investment Schedule
10
Derivation of IS Curve
At higher interest rate i1, equilibrium in the
goods market is at E1 in Fig (a). This is
recorded as E1 in the Fig (b) also.
A fall in interest rate to i2 increases AD, and a
new equilibrium is at E2 in Fig (a). The
corresponding point in Fig (b) is also noted as
E2.
In the Fig (b) join E1 and E2 to obtain IS
schedule
11
Derivation of the IS Curve
12
The IS Curve
Combination of interest rates and levels of
output such that planned spending equals
income (Equilibrium in goods market).
Slope of IS: Sensitiveness of the spending to
change in i, and size of the spending
multiplier (ratio of change in output to
change in autonomous spending)
13
Effect of the Multiplier on the Slope of the
IS Curve
14
A Shift in the IS Curve Caused by a
Change in Autonomous Spending
15
Demand for Real Balances as a
Function of r and Y
16
Money Supply -India
M3 is the widely used money supply variable
It comprises of (1 to 4):
1 Currency with Public
2 Deposit money of the public
3 Post office, savings bank deposits
4 Time Deposits
M1=1+2
M2= M1+3
M3 = 1 to 4
M4=M3+ TOTAL Post Office deposits
17
Supply of Money
Commercial Banks in India report to RBI every
Friday, which will be collated by RBI
The WSS is uplinked on every Friday by noon; and
can be obtained at www.rbi.org.in
The latest data as on Feb 28, 2014 are:
The Indian Scenario (Source: WSS)
Money Supply (As on Feb 07, 2014 ) Rs. 93,48,930 Cr
Currency With Public
Rs 12,37,010Cr
DD deposits with banks
Rs. 7,73,210 Cr
Time Dep with banks
Rs. 73,37,570 Cr
Other deposits with RBI
Rs
11,500 Cr
Assumption: RBI can determine MS with certainty
18
Rate of Interest
Nominal r: The interest rate charged by the lending
institutions
Real r: The difference between nominal int. rate and rate
of inflation.
Eg: If Nominal int. is 15% and expected inflation for the
next 12 months is 7%, the real int. rate is 15-7 = 8%
In India, though the nominal lending rate is high, high
inflation of 7-8% made the real interest rate still low
A 10% inflation rate, for example, makes the real interest
much lower (with same nominal lending rate)
19
Expansion & Contraction of MS
The exogenous MS is a vertical line in the
real int. rate and money balances space.
An increase in Supply will shift the MS
curve to the right; and a decrease will shift
it to the left.
We take r on Y axis and M/P on X axis.
20
Derivation of the LM Curve
Let the income vary to shift DD for money
Let Supply of money remain fixed (M/P)
Two eqbm points (E1 and E2) help locate
interest rates in the money market.
The corresponding points help us to identify
the equilibrium income & output
The line passing through the two points
gives us the LM Curve
21
Derivation of the LM Curve
22
Demand for Money
Classicals: Money is demanded only for
transaction motive; as peoples income
rises, they demand more money to buy
more and if inflation to rise, to offset costs.
Keynes added:
Precautionary Motive (unforeseeable needs)
Speculative Motive (comparison between
interest rates and liquidity preference)
23
Liquidity Trap
Derived from speculative DD for money
Normal Vs Expected interest rate
Plungers: Either hold all finances in the form
of Bonds or all in Money form (little
empirical validity for this behaviour).
Normally, people allocate between them
If r falls too low, increase in MS will be
retained, rather than being used to buy bonds.
It is called liquidity trap
24
Equilibrium in Money Mkt
Supply of money= Demand for money
Symbolically, MS/P = MD/P
Mo/P =L1 (Q) + L2 (r) , where L1 is transaction
DD and L2 speculative DD, r interest rate and
Q is Supply of money
Higher the interest rate over eqbm. rate, less is
the transaction demand (rise in Sp.DD) along
the same DD, and vice versa.
25
Rise in M3 Shifts the LM to the Right
26
Eqbm in Money and Goods Mkts
Interaction of the IS and LM
The two curves represent loci, points away
from the equilibrium cannot persist.
The money and goods markets reach
equilibrium at point E
This model is useful for policy changes
27
Eqbm in Money and Goods Mkts
28
Rise in Autonomous Spending Shifts
the IS Curve to the Right
29
Derivation of the Aggregate Demand
Schedule
30
Policy Implications
Idea about firms& individuals spending pattern
Fiscal Expansion, and Crowding out
Output increases to sub-optimal level of Q 1 only;
and pushes up interest rate. If IS were vertical,
Hence, Pvt. sector is forced to cut investment
plans. (shaded area in fig.b) (we will have a detailed
discussion on this during MFPOL)
Monetary Expansion: Increase in MS leads the
interest rates to fall from I0 to I1; output rises
from Q0 to Q1
31
Conclusions
Goods and Assets markets respond differently to
changes in interest rate
Both markets must reach a balance to keep
economy in equilibrium
IS and LM refer to loci of equilibriums of Goods
and Assets markets
The ISLM Model helps the RBI and Ministry of
Finance to take expansionary or contractionary
policies. Generally, a judicious Policy Mix is
adopted to keep economy in equilibrium.
Business firms tracking fiscal and monetary policy
variables help them to take appropriate and timely
decisions.
32
