The IS-LM model basically, is made up of two components: IS & LM curves. The IS curve represents a “[negative] relationship between the interest rate and the level of income that arises in the market for goods and services.” (Mankiw, 2010) IS stands for investment and saving. IS curve represents the market for goods and services, and any IS shocks are exogenous changes in the demand for goods and services. An IS shock could be a change in consumption or a change in investment, for example in an economic boom or bust.
Basically, the IS curve develops on from the Keynesian Cross. The IS curve slopes downward as I = I(r) is on the vertical axis and income (or on the investment function investment) is on the horizontal axis, meaning that between them there is an inverse relationship, as an increase in r reduces income (or in the investment function planed investment).
Source: (Mankiw, 2010)
We must show how a change in government spending or taxes, shifts the IS curve. “Because a decrease in taxes also expands expenditure and income, it, too shifts the IS curve outward [while a] decrease in government purchases or an increase in taxes reduces income; therefore, such a change in fiscal policy shifts the IS curve inward.” (Mankiw, 2010)
Source: (Mankiw, 2010).
The LM curve represents a “[positive] relationship between the interest rate and the level of income (while holding the price level fixed) that arises in the market for real money balances.” (Mankiw, 2010) LM stands for liquidity and money, in which the rate of interest can influence investment and demand for money. LM curve represents the supply and demand for money, and LM shocks are also exogenous changes only now for the demand of money. An LM shock could be a change in a change in reserve requirements, a change in accessibility to banks/ATMs.
The LM curves relationship assumes the interest rate as the liquidity theory of interest, like the Keynesian Cross is the building tool for the IS curve. Assuming a fixed supply of real money balances. Where the money supply M is exogenous because the central bank indirectly sets it in this model. The demand curve slopes downward as a higher interest rate would reduce the quantity of real money balances demanded. If the central bank decreases the money supply, M / P is reduced by M and P is fixed, shifting the money supply left. Raising the interest rate, while people hold less money balances. While, an increase in the money supply, decreases the interest rate, while people hold more money.
This model assumes greater income greater spending, equals greater money demand: (M / P)d = L(r, Y). “The quantity of real money balances demanded is negatively related to the interest rate and positively related to income.” (Mankiw, 2010) Higher income also leads, in this model to higher interest rates and shifts the money demand curve to the right. “The higher the level of income, the higher the demand for real money balances, and the higher the equilibrium.” (Mankiw, 2010) Therefore, the LM curve slopes upward.
Source: (Mankiw, 2010).
Now, the effects of changing the money supply on the LM curve are shifts. “Decreases in the supply of real money balances shift the LM curve upward [while, increases] in the supply of real money balances shift the LM curve downward.” (Mankiw, 2010)
Source: (Mankiw, 2010).
Which are then put together to get the IS-LM model. The two equations of the model are Y = C(Y – T) + I(r) + G or IS curve and then the M/P = L(r, Y) the LM curve. IS and LM are both effected by the rate of interest, of which alters investment and money demand. By now it might be clear that this model assumes a level of control that economists can use to manipulate through three exogenous variables: government spending, taxation, or monetary policy. “The model takes fiscal policy G and T, monetary policy M, and the price level P as exogenous.” (Mankiw, 2010) This assumption ignores micro-economics and any individual actors.
As prices are sticky the model shows the cause of a short-run change in income when the price level is fixed, or the causes for a shift in aggregate demand and changes in equilibrium, see figure below. “A model of aggregate demand that shows what determines aggregate income for a given price level by analyzing the interaction between the goods market and the money market.” (Mankiw, 2010)
Mankiw, G. (2010). Macroeconomics. (International 3rd ed.). New York, United States of America: Worth Publishers.
Featured image supplied from Pixabay (edited).
Copyright © 2016 Zoë-Marie Beesley
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