A QUICK REVIEW OF ISLM ANALYSIS

The analysis is based on two types of markets: asset markets and goods markets.

The Asset Market (The LM curve)

In the asset market, the demand for money can be written as a function of the interest rate (r) and the level of GNP (Y):

Demand for money = L(r , Y ). - +

Interest rates are thought to reduce the demand for money as people make deposits in banks rather than hold on to real balances. Similarly, Increases in GNP raise demand for money as people have a greater need to use money to make purchases.

In equilibrium the demand for money equals supply or

M = L(r , Y ) P - +

In class we used a simple version of money demand were

Y L(r , Y ) = – ar - + V or

Y M r = - aV aP

This equation defines the LM curve

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LM

Interest rate (r)

0

-M/aP

GNP (Y)

Above the LM curve there is an excess supply of money, i.e. interest rates are too high for a given level of output and people are unwilling to hold on to the total amount of money in the economy. Similarly, below the LM curve there is an excess demand for money because interest rates are so low that people would like to hold more cash than is available.

Note how money supply affects the position of the LM curve. An increase in money supply means that interest rates must fall or GNP must rise in order to induce the public to hold the additional cash. In terms of the equations, an increase in M, lowers the intercept, -M/aP, and shifts the curve to the right (see below). [dM simply means an increase in money supply]

LM

Interest rate (r) dM 0

-M/aP

GNP (Y)

The Goods Market (the IS Curve)

Equilibrium in the goods market is determined by the effect of interest rates on investment demand.Starting with the definition of GNP ( and ignoring the trade account),

Y = C + I + G - T

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High interest rates are thought to reduce investment because they make loans more expensive. A simple way to think about this is to assume that investment demand is determined by the following equation.

I = I0 - br

Substituting this into the equation for GNP produces

Y = C + G - T + I0 - br rearranging produces br = I0 + C - T - Y + G

And finally,

1 Y r = [I + C + G] - b 0 b

Graphically, the IS curve looks like the following.

[I o+ C + G]/b

Interest rate (r)

IS GNP (Y)

Above the IS curve, interest rates are too high and there is insufficient investment demand for a given level of GNP. In this region, interest rates must fall in order for the investment demand to be sufficiently high to absorb all of the output. Below the curve, interest rates are too low and there is excess investment demand in the economy. Here interest rates must rise in order for investment demand to be choked off.

An increase in government expenditure will increase the demand for goods. This increased demand can only be met by either increasing output (Y) or choking off investment by letting interest rates rise. This implies that a rise in government expenditure will shift the IS curve to the right. Algebraically, a rise in government expenditure, dg, will cause an upward shift in the vertical intercept that will shift the IS curve to the right. 4

[I o+ C + G]/b dg Interest rate (r)

IS GNP (Y)

Macroeconomic equilibrium is determined when both the assets and goods markets clear: at the intersection between the IS and LM curves:

LM Interest rate (r)

IS

GNP (Y)

At this point you should be able to answer the following by using the above graph and thinking about how different policies shift the two curves.

1) What is the effect on GNP and interest rates of an increase in government spending (expansionist fiscal policy?

2) What is the effect on GNP and interest rates of a decrease in government spending?

3) What is the effect on GNP and interest rates of an increase in money supply?

4) What is the effect on GNP and interest rates of a decrease in money supply (tight monetary policy)?

5) What effect will an increase of both money supply and government spending?

6) Review the policies of Takahashi in light of this model

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Answers

1) GNP up and interest rates up

2) GNP down and interest rates down

3) GNP up and interest rates down

4) GNP down and interest rates up

5) GNP up and and ambiguous effect on interest rates