Shifting of is and lm curves BY BHAWNA BHARDWAJ

PART-1

1. SHIFTING OF IS AND LM CURVES:-Any fiscal policy change (a
change in government expenditure or taxes) will shift the IS curve.
Similarly, any monetary policy change will shift the LM curve.
The conditions of asset (stock) and goods market (flow) equilibrium as presented
in the previous topic are, respectively
1. M/P = γ − θ ( r + τ ) + ε Y
and
2. Y = ( a + δ + ΦBT + DSB)/(s + m) − μ/(s + m) r + m* /(s + m) Y* −
σ/(s + m) Q

Shifts of the IS Curve:
As a result of changes in government spending, both income and
interest fate respond positively, increase in taxes or reduction in
government expenditure or both reduce the level of income and
thus shifts the aggregate expenditure curve downward.

2. Thus, an increase in taxes shifts toe IS curve to the left. National
income falls in the commodity market. The demand for money is
reduced in the money market and as a consequence toe rate of
interest falls. So, at the end the rate of interest and the level of
income both fall.
Conversely, a reduction in taxes or an increase in government
expenditure or both fall. Conversely, a reduction in taxes or an
increase in government expenditure or both shift the IS curve to the
right (Fig. 16) and raise both Y and r.
Shifts of the LM Curve: The label IS comes from the fact that in a closed
economy (one with no trade) the curve gives the combinations of income and the
interest rate for which desired savings equals desired investment. In an open
economy this curve gives the combinations of income and the interest rate for
which the desired net capital outflow, represented by savings minus investment,
equals the the desired current account balance---that is, for which
S − I = BT + DSB. When there is no international trade, this condition becomes
simply
S − I = 0 .

An increase in money supply shifts the LM curve to toe right and
reduces toe rate of interest. This raises investment in the
commodity market. Income consequently rises. Similarly an
increase in the demand for money, for instance, raises the rate of in-
terest by shifting the LM curve leftward (Fig.16); investment falls
and so income. To portray asset equilibrium in terms of the relationship it
implies between the real interest rate and the level of income, it is useful to
rearrange Equation 1 to put r on the left side:
1a. r = − (1/θ) M/P + γ/θ − τ + (ε/θ) Y
Since ε/θ in this equation is preceded by a positive sign, the equation defines a
positive relationship between the real interest rate and level of income, holding

3. everything else constant, and can be portrayed as the upward sloping curve LM
(portrayed as a straight line) in Figure 2. (The name LM, meaning liquidity-money,
is also traditional.) The LM curve gives the combinations of income and the
interest rate for which the demand for money (or desired liquidity) equals the
money supply and hence for which the domestic economy is in asset or stock
equilibrium.



All these shifts make it clear that the two markets — the commercial
market and money market of the economy are inter-related. And
the IS-LM model seeks to study the nature of this interdependence.
Shifts of Both the Curves:
ADVERTISEMENTS:
If both curves shift at the same time, the consequence is
unpredictable Consider Fig. 17. If IS curve shifts to the right and LM
curve to the left the rate of interest increases (from r0 to r1), but
income remains unchanged (at Ye). Alternatively, if both shift to the

4. right, the rate of interest remains unchanged (at r0), but the level of
income rises (from Y0 to Y1).



. with a full-employment situation where IS and LM cross, let us assume that
there is a decline in desired investment so that the IS curve shifts downward to
IS'. In the short run before the price level can adjust the real interest rate will fall
from r1 to r2 and output and income fall from their full-employment levels to
Y1 . As time passes the price level will fall, increasing the real money stock and
shifting the LM curve down to LM'. As a result, the real interest rate will fall from
r2 to r3 and income and employment will return to their full-employment levels.
with a full-employment situation where IS and LM cross, let us assume that there
is a decline in desired investment so that the IS curve shifts downward to IS'. In
the short run before the price level can adjust the real interest rate will fall from
r1 to r2 and output and income fall from their full-employment levels to Y1 . As
time passes the price level will fall, increasing the real money stock and shifting
the LM curve down to LM'. As a result, the real interest rate will fall from r2 to r3
and income and employment will return to their full-employment levels
with a full-employment situation where IS and LM cross, let us assume that there
is a decline in desired investment so that the IS curve shifts downward to IS'. In

5. the short run before the price level can adjust the real interest rate will fall from
r1 to r2 and output and income fall from their full-employment levels to Y1 . As
time passes the price level will fall, increasing the real money stock and shifting
the LM curve down to LM'. As a result, the real interest rate will fall from r2 to r3
and income and employment will return to their full-employment levels. with a
full-employment situation where IS and LM cross, let us assume that there is a
decline in desired investment so that the IS curve shifts downward to IS'. In the
short run before the price level can adjust the real interest rate will fall from r1 to
r2 and output and income fall from their full-employment levels to Y1 . As time
passes the price level will fall, increasing the real money stock and shifting the LM
curve down to LM'. As a result, the real interest rate will fall from r2 to r3 and
income and employment will return to their full-employment levels


.

6. The rZ line imposes on our small open economy the effect of world market
conditions on the determination of the domestic real interest rate. Since
domestic assets are owned world-wide and the domestic economy is small, the
interest rate on those assets will be determined by the willingness of world
residents to hold them. The domestic real interest rate will thus equal the foreign
real interest rate plus a premium that reflects the risk of holding domestic assets
rather than rest-or-world assets. The domestic interest rate will also differ from the
foreign interest rate by an amount to compensate for any expected capital gain or
loss on domestic assets resulting from expected future changes in the domestic real
exchange rate.
Overall full-employment equilibrium of the small open economy will occur, of
course, where the IS and LM curves cross at the point at which the vertical YF line
and the horizontal rZ also cross. But suppose now that the IS curve shifts down to
IS'.