The IS-LM model, or the Investment Saving-Liquidity preference Money supply model, is a macroeconomic model that shows the relationship between interest rates and real output in the goods and services market and the money market. The model is used to demonstrate how the economy’s aggregate demand is influenced by both monetary and fiscal policy. Here’s a brief overview:
- IS Curve: This represents the relationship between the interest rate and the level of income that brings the goods market into equilibrium. In this market, total spending equals total output. The curve is downward sloping, meaning that lower interest rates encourage higher investment spending, boosting income.
- LM Curve: This represents the equilibrium in the money market, where demand for money equals supply. The curve is upward sloping, indicating that higher income levels lead to greater demand for money, thus raising the interest rate.
- Equilibrium: The intersection of the IS and LM curves represents the simultaneous equilibrium in both the goods and money markets. Changes in fiscal policy (like government spending and taxes) shift the IS curve, while changes in monetary policy (like changing the money supply) shift the LM curve.
- Policy Analysis: The IS-LM model is particularly useful for understanding how changes in monetary and fiscal policy can impact income and interest rates. For example, an increase in government spending would shift the IS curve to the right, leading to higher income and higher interest rates, ceteris paribus.
- Limitations: While useful, the IS-LM model has limitations. It assumes a closed economy (no international trade), ignores price level changes, and assumes a fixed supply of money. Also, it’s more applicable in the short run than in the long run.
Overall, the IS-LM model is a foundational tool in macroeconomics, providing a basic framework for understanding how monetary and fiscal policy interact in an economy.
The simple chart above is illustrating the IS-LM model:
- The IS Curve (in blue) is downward sloping, representing the inverse relationship between the interest rate and real output in the goods market. A lower interest rate leads to higher investment and therefore higher income.
- The LM Curve (in green) is upward sloping, indicating the positive relationship between real output and the interest rate in the money market. Higher income levels lead to a greater demand for money, which raises interest rates.
The intersection of these two curves represents the equilibrium point in both the goods and money markets. This equilibrium point shows the level of income and interest rates where both markets are in balance.
Check a live demonstration here: https://demonstrations.wolfram.com/TheKeynesianISLMModel/
Exercise: Analyzing Fiscal and Monetary Policy using the IS-LM Model
Suppose the economy is initially at equilibrium with interest rate ( r_0 ) and income level ( Y_0 ). The government decides to implement a policy change. Your task is to analyze the impact of this policy change using the IS-LM framework.
- Fiscal Expansion: The government increases its spending significantly.
- Draw the initial IS and LM curves on a graph.
- Indicate the initial equilibrium point (( r_0, Y_0 )).
- Show the effect of increased government spending on the IS curve.
- Indicate the new equilibrium and label it as (( r_1, Y_1 )).
- Explain in words how and why the equilibrium income and interest rate change.
- Monetary Expansion: The central bank decides to increase the money supply.
- Starting again from the initial equilibrium (( r_0, Y_0 )), draw the IS and LM curves.
- Show the effect of an increase in the money supply on the LM curve.
- Indicate the new equilibrium and label it as (( r_2, Y_2 )).
- Describe how the equilibrium income and interest rate are affected and why.
- Combined Policy Action: Assume both fiscal expansion and monetary expansion happen simultaneously.
- Draw the IS and LM curves showing the initial equilibrium (( r_0, Y_0 )).
- Show the effects of both policies on the graph.
- Indicate the new equilibrium and label it as (( r_3, Y_3 )).
- Discuss the overall impact on income and interest rates compared to the individual policy actions.
Questions for Discussion:
- How do the effects of fiscal policy differ from those of monetary policy in terms of the IS-LM model?
- Can monetary policy offset the impact of fiscal policy on interest rates? How would this be represented in the model?
- Discuss the limitations of the IS-LM model in analyzing real-world economic scenarios.