Transcript Topic 1: Introduction to Economics 1 (The Price System)

NUIG Macro
Lecture 18: The IS/LM Model
(continued)
Based Primarily on Mankiw Chapters 10, 11
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Review And Learning Objectives
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In the last lecture we derived the IS curve. In this
lecture we will derive the LM curve and present the
complete IS/LM model.
– IS/LM is the core macroeconomic model used to
explain the short-run behaviour of the economy.
We will explain how to derive the LM curve and look at
what determines its slope and position.
– In the next lecture we will go on to consider how the
IS/LM model can be used to understand the
business cycle, and how it can answer questions
about the effectiveness of fiscal and monetary
policy.
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The LM Curve (1)
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The LM curve shows all combinations of r and
Y that are consistent with equilibrium in the
money market.
To understand this relationship, we need to
begin by looking at a theory of interest rate
determination called the theory of liquidity
preference.
–

This is part of Keynes’ General Theory. It is a
theory of interest rate determination.
To develop the theory we need to re-examine
the supply of and demand for real money
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balances.
The Theory of Liquidity Preference

We assume that the supply of real money
balances (M/P) is fixed by the Central Bank.
–
–
Money Supply = M*/P* where M* is determined by
the Central Bank and P is fixed at P*. Remember
IS/LM is a short-run model and so we assume that
prices are fixed.
This assumption means that the supply of real
money balances does not depend on the interest
rate r. Thus, when we plot the supply of real money
balances against the interest rate we obtain a
vertical supply curve.
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Demand for Real Money Balances
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
The theory of liquidity preference posits that
the interest rate is one determinant of how
much money people wish to hold.
Why?
–
–
Remember that the interest rate is the opportunity
cost of holding money. It is what you forgo by
holding assets as money rather than as interestearning deposits.
When the interest rate rises people will hold less of
their wealth as money.
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The demand for real money balances is (M/P)d=L(r)
This relationship is shown in the next slide.
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What Equilibrates Supply and Demand?

According to the theory of liquidity preference,
the interest rate adjusts to equilibrate the
money market.
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–
At the equilibrium interest rate, the quantity of real
balances demanded equals the quantity supplied.
If there is an excess supply or demand of/for real
money balances then individuals try to adjust their
portfolio of assets, and, in the process, alter the
interest rate.
The interest rate stops adjusting when the demand
for real money balances equals the supply.
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Comparative Statics
–
Now that we have seen how the interest rate is
determined, we can use the theory of liquidity
preference to show how the interest rate
responds to changes in the supply of money.
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–
Imagine that the ECB suddenly reduces the money
supply. A fall in M reduces M*/P*, because we are
assuming that P is fixed in the model. The supply
of real balances shifts to the left, as in the next
slide.
The equilibrium interest rate rises from r1 to r2, and
the quantity of real money balances demanded and
supplied falls. The opposite would occur if there
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was an increase in the money supply.
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Constructing the LM Curve (1)

How does a change in the economy’s income,
Y, affect the market for real money balances?
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–
–
Recall from earlier lectures that the level of income
affects the demand for money.
When income is high expenditure is high, so people
engage in more transactions that require the use of
money. Thus, greater income implies greater
money demand.
Our simple demand function need to be augmented
to (M/P)d=L(r, Y). The quantity of real money
balances is negatively related to the interest rate
and positively related to income.
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Constructing the LM Curve (2)
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
If income increases, then the money demand
curve shifts to the right. With a fixed supply of
real money balances, the interest rate must
rise from r1 to r2 to equilibrate the money
market.
See the next slide.
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The LM Curve
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

The LM curve plots this relationship between
the level of income and the interest rate.
The higher the level of income, the higher the
demand for real money balances, and the
higher the equilibrium interest rate.
For this reason, the LM curve slopes upward,
as in panel (b) of the previous slide.
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Monetary Policy and the LM curve

As we have just seen, the LM curve is drawn
for a fixed supply of real money balances,
M/P.
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–
If real balances change - because there has been a
change in prices and/or because the Bank of
England has altered the money supply - then the
LM curve shifts.
Suppose that the Bank of England reduces the
money supply from M1 to M2, which causes the
supply of real balances to fall from M1/P to M2/P.
The level of income has remained constant but the
equilibrium interest rate has risen. Therefore, the
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LM curve has shifted upward.
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The Slope of the LM curve

As important issue in macroeconomics is the
slope of the LM curve.
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–
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The slope of the LM curve depends upon (a) the
income elasticity of money demand and (b) the
interest elasticity of money demand.
This should be intuitive given our construction of
the LM curve.
We can now use IS/LM to explain the short-run
equilibrium of the economy.
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The IS/LM Model

We now have all the pieces of the IS/LM model.
– IS curve: Y = C(Y-T) + I(r) + G
– LM curve: M/P = L(r, Y)
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The model takes fiscal policy, G and T, monetary policy M,
and the price level P as exogenous variables. Given
these exogenous variables, the IS curve provides the
combinations of r and Y that satisfy equilibrium in the
goods market, and the LM curve provides the
combinations of r and Y that satisfy equilibrium in the
money market.
The short-run equilibrium on the economy is the point at
which the IS curve and the LM curve cross. So in the
short-run both the goods market and the money market
simultaneously determine r and Y.
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