Transcript IS curve - Augustana College

IS curve
The IS curve shows the relationship
between interest rates generated in
financial markets and the equilibrium level
of income the economy gravitates toward
given these rates.
 The IS curve is based on the Keynesian
model of chapter 20

Derivation of the IS curve

Yad,Y
Yad i=6%
Yad i=7%
Yad i=8%
6545
6605
6665
Plotting these same points in i
and Y space
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i
8
7
6
IS
6545 6605 6665
The IS curve’s position
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The IS curve’s position is determined by the
factors that determine Yad curve’s position .
Anything ,other than a drop in interest rates, that
would push Yad to the left (up) will be
represented by the IS curve shifting to the right.
And anything, other than a rise in interest rates,
that would push Yad to the right (down) will be
represented by the IS curve shifting to the left
An increase in real wealth for
example.

Yad
B
A
A
B
IS’
IS
Definition of the LM curve
The LM curve shows the relationship
between the equilibrium level of income
the economy and interest rates financial
markets gravitate toward given this level of
real income.
 The LM curve is based on the analysis of
the money market carried out in chapter 5.

Derivation of the LM curve
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Hold factors that affect MD (besides real
income) constant.
The higher real income is, the higher the
demand for money. The higher the demand for
money, the higher the equilibrium rate of interest
will be.
The lower real income is, the lower the demand
for money. The lower the demand for money,
the lower the equilibrium rate of interest will be.
The above is the basis of the
LM curve.

i
c
Ms
MD”
b
a
MD
MD’

Let’s say that points a, b and c correspond
to 6000 billion dollar, a 6500 billion and a
7000 billion levels of equilibrium income.
Putting these points together generates the LM
curve
i
LM
c
b
a
6000
6500
7000
The LM curve’s position
The LM curve’s position is determined by
the factors that determine MD and MS
curves’ positions .
 Anything, other than a drop in income, that
would push MD to the left (down) will be
represented by the LM curve shifting to the
right. (A drop in prices or ie falling.)

LM curve’s position (cont’d)
Anything other than a rise in income that
would push MD to the right (up) will be
represented by the LM curve shifting to the
left. (A rise in prices or an increase ie.)
 Anything, that would push the money
supply curve to the right (left) will cause
the LM to shift in the same direction.

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For example, the Fed on net buying
securities from the public will increase the
money supply, push the MS curve to the
right and be represented by the LM curve
shifting to the right as well.
Combining IS and LM
The IS curve shows the relationship
between interest rates generated in
financial markets and the equilibrium level
of income given these rates.
 The LM curve shows the relationship
between the level of income and the
interest rates that results in financial
market equilibrium


Therefore the point at which IS and LM
intersect represents equilibrium in BOTH
financial markets AND in the rest of the
economy and equilibrium i and Y (interest
LM
rates and real income).
i
IS
Y
A brief discussion of “methodology”
Key elements of any economic model
such as the ISLM model
 Exogenous variables.
 Endogenous variables.
 Behavioral equations and identities.
 Equilibrium conditions.

Exogenous
variables
Exogenous variables are determined outside the
model (and therefore assumed constant). If they
change, we do NOT ask why, we simply assess
the impact of their changing on the model’s
endogenous variables.
In the basic macromodel (the Keynesian cross of
chapter 23) think of that model’s exogenous
variables as guests seated around a table .
CC
Expected
profits(LT)
Real
wealth
i
mpc
Pk
I go here!
Endogenous
variables
Variables we DO want to explain. Their values
are determined by the model (like Y in the
basic macro model). Basically the model is
designed to show how the endogenous
variables are influenced by the exogenous
variables.
Behavioral equations and identities.
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Equations that describe how variables in the
model (both endogenous and exogenous) fit
together.
For example, the consumption function of
chapter 20 is an example of a behavioral
equation showing how consumer spending
relates to real income, interest rates, real wealth,
and consumer confidence.
The equation Yad = C+I is an example of an
identity, an equation that is true by definition.
Equilibrium conditions
Relationships that results once things
have settled down. In ISLM you have two
such relationships:
 (1) Y=Yad
 Equilibrium in the “goods” market.
 (2) Md=Ms
 Equilibrium in the money market.

Comparative statics
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Once we have defined equilibrium conditions we
are ready to show endogenous variables are
influenced by the exogenous variables.
In the context of ISLM this means asking such
important questions such as the impact of the
FED targeting a lower fed funds rate on other
market interest rates and the level of real
income.
Limits of models
Imitating the methods of the hard
sciences but “materials” we deal
with are inherently different.
Physics versus economics
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Physics:
Many general stable
relationships with reliable
constants (what is assumed
exogenous IS in reality
constant)
For example, the mass of two
objects as you derive
gravitational force are
assumed constant and in
reality ARE constant.
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Economics:
Many relatively unstable
relationships with few reliable
constants.
What is assumed constant in a
model often is in reality
anything but constant.
For example, both real income
and the velocity of money in
the traditional quantity “theory”
of money were assumed
constant but in reality both are
endogenous variables.
Models in economics nonetheless
incredibly useful
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These simplified versions of the real world allow us to
see workings of more complicated real world economies.
Elaborations and refinements possible. In chapter 22,for
example, we can and will make the price level
endogenous.
Many studies of learning and what is known as the
“transference” of knowledge indicate that understanding
of general principles are far more valuable than a lot of
specific detailed information.
In short, although it takes more time and effort, really
understanding something is vital. It is far more important
than simply committing to memory the “right answers”.
Economists should strive for what
Aristotle called for in his
Nichomedian Ethics:

“Our discussion will be adequate if it has
as much clearness as the subject matter
admits of.”