A Presentation on IS-LM Model

1. A Presentation on IS – LM Model (Graphical Approach)

2. A Presentation By : - Dhananjay Ghei 09HS2023 Abhishek Jadon 09HS2010

3. The Goods and The Money Market Equilibrium Equilibrium of the goods market is achieved when the goods market is cleared, i.e. , according to Keynes, planned saving is equal to planned investment. S = I OR Y = C + I Equilibrium of the money market requires equality between the supply of and the demand for money. M s = M d

4. Equilibrium in the Goods Market In developing the IS model, investment is considered as a function of rate of interest , consumption and saving as functions of income. Investment Function : I = I(r) Consumption Function : C = C(Y) Saving Function : S = S(Y) Equilibrium in the goods market is achieved when : - S(Y) = I(r) However, this relationship may be shown graphically as follows

5. IS Curve Re-translation of Simple Keynesian model at equilibrium (Investment = Saving). A plot of equilibrium output for various interest rates within the market for goods and services.

6. Determining Output Note two characteristics of ZZ: Because it’s assumed that the consumption and investment Relations are linear , ZZ is, in general, a curve rather than a line. ZZ is drawn flatter than a 45- degree line because it’s assumed that an increase in output leads to a less than one for-one increase in demand.

7. Deriving the IS Curve Deriving the IS Curve (a ) An increase in the interest rate decreases the demand for goods at any level of output , leading to a decrease in the equilibrium level of output. (b) Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output .

8. Properties of IS Curve Downward Sloping, i   C, I  Y* Increase/Decrease in autonomous expenditure will shift the IS curve Rightward/Leftward. The steepness or flatness of the IS curve describes the elasticity or responsiveness of C and I to the nominal interest rate. -- Steep IS curve: inelastic. -- Flat IS curve: elastic.

9. Shifts in IS Curve due to taxes An increase in taxes shifts the IS curve to the left.

10. Equilibrium in the Money Market Money Market Equilibrium is achieved when the supply of money and demand for money are equal. M s = M d Money Demand is made of two parts : - M sp : Speculative Demand for Money M t : Transactionary Demand for Money M d = M sp + M t

11. LM Curve Depicts equilibrium in the Money market (L = M), as well as the Bond Market (by Walras Law). A plot of the equilibrium interest rate for various levels of output or income, within the money market for a given level of the nominal money supply.

12. Deriving the LM Curve An increase in income leads, at a given interest rate, to an increase in the demand for money . Given the money supply, this increase in the demand for money leads to an increase in the equilibrium interest rate. Equilibrium in the financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is therefore upward sloping .

13. Deriving the LM Curve

14. Properties of LM Curve Upward sloping, Y   L  i * Increase/Decrease in the real money supply shift the LM curve Rightward/Leftward. The steepness or flatness of the LM curve describes the elasticity or responsiveness of money demand (L) to the nominal interest rate. -- Steep LM curve: inelastic. -- Flat LM curve: elastic.

15. Shifts in LM Curve due to change in Money Supply An increase in money causes the LM curve to shift down.

16. Two – Market Equilibrium The intersection point of the IS and LM curve denotes the equilibrium point between the two markets. There is only one combination of Y and r at which both the goods market and the money market are in equilibrium simultaneously.

17. The Equilibrium Curve

18. Fiscal and Monetary policies Fiscal contraction, refers to fiscal policy that reduces the budget deficit. An increase in the deficit is called a fiscal expansion. Taxes affect the IS curve, not the LM curve . Monetary contraction, refers to a decrease in the money supply. An increase in the money supply is called monetary expansion. Monetary policy does not affect the IS curve, only the LM curve. For example, an increase in the money supply shifts the LM curve down .

19. Effects of Fiscal and Monetary Policy

20. Quiz  In the IS side of the IS-LM model, the money market : a.) is implicit in the I curve b.)is completely absent c.) conditions equilibrium   The goods market side of the IS-LM model is : a.)flow model b.)stock model c.) neither If I is highly sensitive to r then, graphically : a.) IS curve will be close to vertical b.) IS Curve will be close to horizontal c.) IS Curve will be impossible to draw

21. Quiz  Equilibrium in the Goods Market occurs when : a.) I + G = S + T b.) G = T c.) S = T  Graphically, a fall in G would: a.) shift IS rightward b.) shift IS leftward c.) make IS vertical The money market side of the IS-LM model is : a.) flow model b.) stock model c.)neither

22. Quiz Speculative demand for money is a function of : a.) r b.) Y c.) G In IS-LM model, money supply is : a.) endogenous b.)exogenous c.)irrelevant Since the velocity of money increases as interest rates rise the: a.) LM curve is positively sloped b.)LM curve is negatively sloped c.)IS curve is negatively sloped

23. Quiz A change in the public's desire to hold money will: a.) shift the LM curve b.) change the slope and position of LM Curve c.) change the slope of LM Curve When the central bank sells government bonds on the open market we have: a.) contractionary monetary policy b.) expansionary monetary policy c.) contractionary fiscal policy d.) expansionary fiscal policy

24. Quiz If the Congress passes wage and price controls in response to increased inflation we have had: a.) contractionary monetary policy b.) expansionary monetary policy c.) contractionary fiscal policy d.) expansionary fiscal policy e.) none of the above The IS curve shows all combinations of income and: a.) interest rate for which the goods market is in equilibrium b.) interest rate for which the money market is in equilibrium c.)price level for which the goods market is in equilibrium d.)price level for which the money market is in equilibrium

25. Quiz In terms of the ISLM model, an increase in tax rates should move the: a.)IS curve left b.)IS curve right c.)LM curve right d.)LM curve left The LM curve depicts Y,r combinations at which : a.) transactions and speculative demands are equal b.)transaction demand does not exceed speculative demand c.)money demand equals money supply

26. U.S Recession of 2001 and the IS-LM Model

27. DECLINE IN REAL GDP US RECESSION 2001 INCREASE UNCERTAINTY STOCK MARKET CRASH INCREASE UNEMPLOYMENT

28. What happened in U.S. in 2001? The U.S. economy shrank in three quarters in the early 2000s (the 3 rd quarter of 2000), the first quarter of 2001, and the third quarter of 2001. The US economy was in recession from March 2001 to November 2001, a period of eight months. 2.1 million people lost their jobs as unemployment rose from 3.9% to 5.8% . GDP growth slowed to 0.8% ( compared to 3.9% annual average growth during 1994-2000)

29. Causes of U.S Recession Stock Market Decline 9/11 Attack on U.S. 300 600 900 1200 1500 1995 1996 1997 1998 1999 2000 2001 2002 2003 Index Standard & Poor’s 500

30. Outcome of the Recession Increased Uncertainty. Fall in Consumer and Business Confidence. This all resulted in : - Lower Spending, IS curve shifted towards left. Reduced Stock Prices, Discouraged Investment

31. Measures taken Fiscal Measure IS Curve shifts towards Right Tax cuts in 2001 and 2003 Spending Increases a. Airline industry bailout b. Afghanistan War Monetary Measure LM Curve shifts donwards towards Right. Rise in interest rate Depress Income

32. The U.S Recession with IS – LM Model The decrease in investment demand led to a sharp shift of the IS curve to the left, from IS to IS”. The increase in the money supply led to a downward shift of the LM curve, from LM to LM’. The decrease in tax rates and the increase in spending both led to a shift of the IS curve to the right, from IS’’ to IS’.

33. Conclusion IS Curve represents the equilibrium of the goods market. LM Curve represents the equilibrium of the money market. The point of intersection of the two curves is the point of equilibrium of both the markets simultaneously. By taking both fiscal and monetary measures using the IS – LM model recession can be checked out.

34. Refrences Books referred : - Macroeconomic Analysis : - E. Shapiro Macroeconomics : – N. Gregory Mankiw An Inquiry into the Nature and Causes of the Wealth of Nations : - Adam Smith Online References : - Wikipedia Authorstream IS – LM model by Dudley Cooke (Trinity College Dublin)

35. Thank You