Money, Interest and Income (IS-LM Model) - Exam Notes
Chapter 10: Money, Interest and Income (IS-LM Model)
1. Introduction
• IS-LM model = core model of short-run macroeconomics.
• Explains interaction between:
- Goods market
- Money market
• Determines:
- Income/Output (Y)
- Interest Rate (i)
Importance:
• Monetary policy affects output through interest rates.
• Fiscal policy also affects interest rates.
• IS-LM model helps derive Aggregate Demand (AD) curve.
2. Goods Market and IS Curve
Meaning of IS Curve:
IS curve shows combinations of interest rate (i) and income/output (Y)
such that planned spending = income.
Investment Function:
I = I■ - bi
Where:
• I = Planned investment
• I■ = Autonomous investment
• i = Interest rate
• b = responsiveness of investment to interest rate
Important Points:
• Higher interest rate → lower investment
• Lower interest rate → higher investment
Aggregate Demand:
AD = C + I + G + NX
AD = A■ + c(1-t)Y - bi
Autonomous Spending:
A■ = C■ + cTR■ + I■ + G■ + NX■
Goods Market Equilibrium:
Y = AD
Y = A■ + c(1-t)Y - bi
Multiplier:
αG = 1 / [1 - c(1-t)]
3. IS Curve
Why IS slopes downward:
Interest rate ↓ → investment ↑ → aggregate demand ↑ → income ↑
IS becomes flatter when:
• investment is highly sensitive to interest rate
• multiplier is large
IS becomes steeper when:
• investment sensitivity is low
• multiplier is small
• tax rate is high
Shift of IS Curve:
Rightward shift:
• Government spending ↑
• Transfers ↑
• Autonomous investment ↑
• Net exports ↑
Size of shift:
∆Y = αG ∆A■
4. Money Market and LM Curve
Meaning of LM Curve:
LM curve shows combinations of interest rate and income such that
money demand = money supply.
Demand for Money:
L = kY - hi
Where:
• L = demand for real balances
• k = sensitivity to income
• h = sensitivity to interest rate
Interpretation:
• Income ↑ → money demand ↑
• Interest rate ↑ → money demand ↓
Real Money Balances:
Real Balances = M/P
Money Market Equilibrium:
M■/P■ = kY - hi
LM Equation:
i = (1/h)(kY - M■/P■)
5. LM Curve
Why LM slopes upward:
Income ↑ → money demand ↑ → interest rate ↑
LM becomes steeper when:
• money demand strongly responds to income
• money demand weakly responds to interest rate
LM becomes flatter when:
• money demand strongly responds to interest rate
Shift of LM Curve:
Rightward shift:
• money supply increases
Effects:
• interest rate falls
• investment rises
• output rises
6. IS-LM Equilibrium
Occurs where IS intersects LM.
At equilibrium:
• Goods market is in equilibrium
• Money market is in equilibrium
Determines:
• Equilibrium income (Y■)
• Equilibrium interest rate (i■)
7. Changes in Equilibrium
Increase in autonomous investment:
• IS shifts right
• Income rises
• Interest rate rises
Crowding Out:
Higher income → higher money demand → higher interest rate
→ investment falls partially.
8. Aggregate Demand Curve
Higher price level:
→ lowers real money supply
→ shifts LM left
→ reduces income
Therefore:
Price level ↑ → Aggregate demand ↓
9. Important Equations
IS Equation:
Y = αG (A■ - bi)
LM Equation:
i = (1/h)(kY - M■/P■)
Equilibrium Income:
Y = [hαG / (h + kbαG)] A■
+ [bαG / (h + kbαG)] (M■/P■)
Equilibrium Interest Rate:
i = [kαG / (h + kbαG)] A■
- [1 / (h + kbαG)] (M■/P■)
Fiscal Policy Multiplier:
∆Y / ∆G■ = hαG / (h + kbαG)
Monetary Policy Multiplier:
∆Y / ∆(M■/P■) = bαG / (h + kbαG)
10. Important Graph Readings
IS Curve:
• Downward sloping
• Interest rate ↓ → investment ↑ → income ↑
LM Curve:
• Upward sloping
• Income ↑ → money demand ↑ → interest rate ↑
IS Shift:
• Autonomous spending ↑ → IS shifts right
LM Shift:
• Money supply ↑ → LM shifts right
AD Curve:
• Price level ↑ → real balances ↓ → LM left → output ↓
11. Key Terms
• IS Curve
• LM Curve
• Aggregate Demand Schedule
• Real Money Balances
• Fiscal Policy Multiplier
• Monetary Policy Multiplier
• Goods Market Equilibrium
• Money Market Equilibrium
• Central Bank
• IS-LM Model
12. Quick Revision
• IS = Goods market equilibrium
• LM = Money market equilibrium
• IS slopes downward
• LM slopes upward
• Fiscal policy shifts IS
• Monetary policy shifts LM
• Higher money supply lowers interest rates
• Higher government spending raises income and interest rates
• AD curve derived from IS-LM framework