JOINT EQUILIBRIUM IN THE MONEY AND GOODS MARKETS: THE IS-LM FRAMEWORK

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Introduction to Economics ECO401

UNIT - 14

Lesson 14

JOINT EQUILIBRIUM IN THE MONEY AND GOODS MARKETS: THE IS-LM FRAMEWORK

So far we have talked about macroeconomic equilibrium either in the context of the goods

market (AS-AD), the labour market, or the loan able funds market. We now enrich our notion

of equilibrium with the money market and see what the conditions are for an economy to strike

joint equilibrium in the goods and money markets. The framework within which this is done is

called the IS-LM framework. The exact meaning of the letters is perhaps not so important as

their meaning. IS actually refers to a curve drawn in i-Y space capturing all the points at which

the goods market is in equilibrium. LM is similarly, a curve also drawn in i-Y space, but

capturing all the points at which the money market is in equilibrium. We look at how these

curves are derived, in reverse order, i.e. staring with the LM curve.

MONEY MARKET EQUILIBRIUM: THE LM CURVE

We start from where we left our discussion of the monetary sector. We noted that money

demand increased with income and decreased with interest rates. Now plotting the money

demand function (we'll call it L) in i-M space (where M denotes real money), we get a

downward sloping line. The slope of L depends on the sensitivity of money demand to

changes in the interest rate, or the interest elasticity of money demand (iєL).

An increase in real income (Y) causes a rightward shift in the L curve while a fall in income

causes a leftward shift. The amount by which L shifts in response to a given change in income

depends on the sensitivity of money demand to income changes, or the income elasticity of

money demand (YєL).

By introducing money supply at this stage, we can develop a notion of money market

equilibrium. As mentioned earlier, the nominal money supply is controlled (directly or

indirectly) by the central bank. Given a certain level of prices (P), and sticking with the i-M

space, real money supply (i.e Ms/P) will plot as a vertical line intersecting the M axis at a finite

point determined by Ms (determined by the central bank) and the price level. Given constant

prices, an increase in Ms will cause Ms/P to shift to the right, and a decrease in Ms will cause

Ms/P to shift to the left. Similarly, given a constant Ms, an increase in P will shift Ms/P to the

left, while a decrease will have the opposite effect.

The intersection point of the L and Ms/P lines delivers money market. To see how this

equilibrium responds to changes in income (Y), we can see that with a fixed Ms/P, increases in

income will cause L to shift to the right, causing the equilibrium interest rate to rise. It is

obvious that if we were plotting the equilibrium relationship in the money market in i-Y space,

we would get an upward sloping line, since a rise in income causes a rise in interest rates.

Again, the slope of this line would depend on the two elasticize mentioned above. If YєL is

small then even a large change in Y will cause only a small change in money demand. Now if

iєL is large, only a small change in i will be required to bring money demand back to

equilibrium levels (i.e. equal to the fixed Ms/P). In this case, the LM curve will be relatively flat

(large changes in Y associated with small changes in i). LM will be steeper the bigger is YєL

and the smaller is iєL.

Shifts in the LM Curve:

It is also useful to think about factors that will cause shifts in the LM curve. Ms/P is one such

factor. How? Simulate the effect of an increase in Ms/P in i-M space. The vertical Ms/P curve

shifts to the right causing the equilibrium interest rate to fall. Thus for an unchanged income

level (since we have not assumed anything about income changes causing shifts in the L

curve), the interest rate falls. The way this translates in i-Y space is simple. Every point on the

LM curve will shift vertically downwards. Why vertically downwards, because income has not

changed. Thus, it is clear: an increase in real money supply (Ms/P) will cause LM to shift down

(or the right), while an decrease in Ms/P will cause in LM to shift up (or to the left).

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GOODS MARKET EQUILIBRIUM: THE IS CURVE

This is much simpler. We start with the loan able funds or (saving-investment) market (with i

on the vertical axis and S & I on the horizontal axis) where the investment schedule plots as a

downward sloping curve. Now consider what happens to investment demand (I) when there is

a fall in i (due, say to a rightward shift in the saving function). I will increase, as it is now

cheaper for firms to borrow money and invest. How would a higher I affect income Y in the

context of the 45 degree line diagram introduced earlier in the course. Clearly, the AD curve

would shift upwards by +ΔI (the increase in I induced by a fall in i). This would cause a

multiplied rise in income, raising the latter by k*ΔI, where k is the Keynesian multiplier.

Clearly then, a fall in interest rates is associated with a rise in equilibrium national income

Thus the IS curve, which captures goods market equilibrium is downward sloping in i-Y space.

The lower the interest rate, the higher the income; the higher is interest rate, the lower the

income.

The Slope of the IS Curve:

The slope of the IS curve, as you may have already guessed, depends on two factors:

a. The sensitivity of investment demand to the interest rate (i.e. how flat the investment

curve is in i-S,I space) or the interest elasticity of investment (iєI). The higher the iєI ,

the greater the increase in I for any given -Δi.

b. The Keynesian multiplier (k): the higher is k, the greater the increase in Y given a

certain increase in I.

Combining the two then, we can say, the higher is k and the higher is iєI, the flatter will be the

IS curve. Intuitively it makes sense as well. A flat IS curve relates a small decrease in i with a

large increase in Y. Now with a high iєI, a small -Δi will cause a large +ΔI, which, given a large

k, will cause a very high +ΔY. Conversely, the IS curve is steep when iєI and k are small.

Shifts in the IS Curve:

Shifts in the IS curve are also easy to understand. Any injection into the circular flow: e.g.

autonomous changes in C, G or X-M, which are not caused by an interest rate change, but

which do cause an increase in AD and Y, will cause the IS curve to shift to the right. Similarly,

IS shifts the left when there is a decrease in these injections.

THE IS-LM FRAMEWORK AND FISCAL-MONETARY POLICY INTERACTIONS

An upward sloping LM curve and a downward sloping IS curve are bound to provide an

intersection point which represents joint equilibrium in the money and goods markets. Since

the advent of the IS-LM framework in the 1940s, as an extension of Keynesian ideas,

macroeconomists have been interested in studying how this joint equilibrium can be affected

and brought in line with the full-employment equilibrium (remember the two may not

necessarily be the same in a Keynesian world). In particular, their interest has lay in what the

government can do, by way of fiscal and monetary policies to guide the economy towards

such equilibrium.

Expansionary monetary policy:

As mentioned earlier, a real money expansion [i.e. +Δ(Ms/P)] can be produced by either a

reduction in P or an increase in Ms (the nominal money supply). Let's assume for the time

being that P is fixed and the central bank increase Ms. Ms/P rises. This will cause the LM

curve to shift to the right with the effect that interest rates fall and equilibrium income or output

will rise. Should the economy operating below the full-employment level, such a policy can

clearly help. The reverse process would apply if the central bank reduced money supply in a

bid to relieve inflationary of excess demand pressures.

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Expansionary fiscal policy:

Similarly, an increase in government spending (G), will cause a rightward shift in the IS curve

causing both equilibrium interest rate and income to rise. There is an important intuition as well

behind why interest rates would rise in this case (apart from the fact that it is graphically the

case). The intuition is related the crowding out effect of government spending.

a. Crowding out of investment demand: When the government spends and finances

that spending through borrowing from banks or the general public (i.e. does not resort

to money-supply expanding means of financing the fiscal deficit), the demand for loan

able funds is driven up, causing interest rates to rise and private sector ability to borrow

funds to fall. This acts as a drag on AD and Y which consequently do not rise as much

as they would have in the absence of crowding out.

b. Crowding out of net exports demand: Given that higher government spending

causes interest rates to rise one can also see why net exports demand would suffer

from such high interest rates as well. As we discussed earlier, higher interest rates

would cause the exchange rate to appreciate (interest-parity condition), which in turn

would cause competitiveness to fall thus the negative effect on net exports. As such,

high interest rates induced by higher government spending can crowd out both net

exports and investment, thus preventing AD and Y to rise as much as they would have

had interest rates remained the same.

This takes us to the natural question: what if the government financed higher spending by

either asking the central bank to print more money for it, or by borrowing from abroad? This is

just another way of stating the question: "what if a government fiscal expansion and a

monetary expansion were implemented simultaneously, i.e. the IS and LM curves both shifted

to the right?" It is clear that in this case, the negative effects of higher interest rates can be

eliminated. Thus, if the economy is in deep recession, the policy prescription should naturally

be to simultaneously effectuate both fiscal and monetary expansions.

Fiscal Monetary Policy Interaction:

However, if the economy is not in recession and does not, per se, have excess capacity or

slack, the above prescribed simultaneous fiscal and monetary expansions cannot succeed in

increasing income or output. Why? The reason is prices, which we have so far assumed as

constant. However, in reality prices respond readily to demand pressures and as the economy

approaches the full employment level, expansionary monetary and fiscal policies will

increasingly put pressure on prices to rise (recall the AD-AD diagram).

Now assuming we are in such a situation, i.e. the economy is at its full-employment equilibrium

level and the government implements a joint fiscal- monetary expansion, we can trace the

effect of rising prices on equilibrium. An increase in P will cause real money supply (Ms/P) to

fall, which means the LM curve will shift back. In the goods market, on the other hand, rising

prices cause aggregate demand to fall due to wealth, interest-rate, and the international

purchasing power effects, we studied earlier. Thus, the effects of expansionary fiscal policy will

be reversed as well. The net result is that there is no positive impact on equilibrium income; in

fact there might even be a negative impact if inflation becomes very high and starts hurting

long-run business confidence and hence investment.

A final point about the comparison between the effectiveness of fiscal policy vs.

monetary policy is: Which is better and when?

Drawing the IS-LM curves, it is easy to see that when the LM curve is relatively flat, any given

fiscal expansion will cause a large effect on income and a relatively small effect on i. Thus,

fiscal policy is more effective (desirable) in this setting. On the other hand, when the IS curve

is relatively flat, any given monetary expansion will produce a larger impact on income.

Monetary policy is more effective in this situation.

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END OF UNIT 14 - EXERCISES

What would be the effect on interest rates of a contractionary monetary policy combined

with a contractionary fiscal policy (lower spending, lower borrowing from the central

bank)..

Both IS and LM would shift to the left. The impact on equilibrium income is obvious (it will fall),

but nothing immediately can be said about interest rates, as the two policy changes have

opposite effects on the interest rate. However, it should be ntoed that since the fiscal policy

contraction is also causing the monetary base (and henc emoney supply) to contract "credit to

government" and "M0" both fall on the central bank balance sheet due to the government

reducing its borrowing therefrom. There will be thus be an additional monetary contraction,

which makes a rise in interest rates more likely.

On an IS-LM diagram, trace through the effects of (a) a fall in investment and (b) a fall in

the money supply. On what does the size of the fall in national income depend?

a) The IS curve will shift to the left. There will be a resulting fall in the rate of interest and

a fall in national income. The fall in national income will be greater, (i) the flatter the LM

curve i.e. the less the rate of interest has to fall to bring equilibrium in the money

market; (ii) the steeper the IS curve i.e. the less will any fall in the rate of interest help

to boost investment again (after its initial fall).

b) The LM curve will shift to the left. There will be a resulting rise in the rate of interest

and fall in national income. The fall in national income will be greater,(i) the flatter the

IS curve i.e. the more investment is reduced by the rise in interest rates; (ii) the

steeper the LM curve i.e. the more interest rates will have to rise (and hence the

more investment and national income will fall) in order to restore equilibrium in the

money market..

Explain what could cause a downward shift in the LM curve and how this would affect

the AD curve.

The LM curve would shift downwards if either of the following occurred: (a) an increase in the

supply of money; (b) a fall in the demand for money, other than as a result of a rise in interest

rates (this could occur, for example, if people relied more on credit and less on cash).

The effect of the downward shift in the LM curve is a fall in the real rate of interest and a rise

in national income. The rise in national income causes an increase in aggregate demand at

any given price level: i.e. the AD curve shifts to the right. (Whether the price level will rise and

hence nominal interest rates, will depend on the shape of the AS curve.)

Why do `ever more rapid financial flows across the world that are unpredictable and

uncertain' make Keynesian discretionary fiscal (and monetary policy) less suitable?

Because the interest-rate and exchange-rate effects of fiscal policy changes will cause crowding

out. Also, the unpredictability of international financial flows makes the effects of fiscal (and

monetary policy) changes less predictable.

Show what will happen if there is (a) a rise in business confidence and a resulting

increase in investment; (b) a rise in the demand for money balances (say for

precautionary purposes).

a) The IS curve will shift to the right. The effect is the same as with an expansionary fiscal

policy.

b) A rise in the demand for money will shift the LM curve to the left. The effect will be the

same as with a contractionary monetary policy.

Compare the relative effectiveness of fiscal and monetary policies as means of

expanding aggregate demand under a system of floating exchange rates.

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Monetary policy would be relatively effective. An expansion of the money supply will reduce

interest rates. This will increase aggregate demand directly; lead to a depreciation in the

exchange rate, which will increase exports and reduce imports, thereby further stimulating

aggregate demand; cause initial exchange rate overshooting, reinforcing the boost to demand

from increased exports and reduced imports.

Fiscal policy will be relatively ineffective. A cut in taxes and/or an increase in government

expenditure will increase the transactions demand for money and thus increase interest rates.

The exchange rate will appreciate. This will have the effect of dampening the rise in aggregate

demand.

Under what circumstances would an expansionary fiscal policy have no effect at all on

national income?

(i) The greater the degree of capital mobility, the bigger will be the balance of payments surplus

resulting from the expansionary fiscal policy (and the higher interest rates it produces), and the

more the exchange rate will appreciate, and hence the more aggregate demand will be reduced

again through exports. (ii) The greater the price elasticity of demand for imports and exports, the

more the appreciation will reduce aggregate demand again. The bigger these two effects, the

more likely it is that fiscal policy will have no effect on national income under floating exchange

rates.

How would a monetarist answer the Keynesian criticisms given below?

1. `The time lag with monetary policy could be very long.' Monetarists do not claim that

monetary policy can be used to fine tune the economy. It is simply important to maintain

a stable growth in the money supply in line with long-term growth in output.

2. `Monetary and fiscal policy can work together.' onetarists would argue that it is the

monetary effects of fiscal policy that cause aggregate demand to change. Pure fiscal

policy will be ineffective, leading merely to crowding out.

3. `The velocity of money is not stable, thus making the predictions of the quantity theory of

money i.e. that monetary growth must necessarily lead to inflation is unreliable.'

Monetarists would accept that the velocity of money circulation fluctuates in the short

term, but they will argue that there is still a strong correlation between monetary growth

and inflation over the longer term.

4. `Changes in aggregate demand cause changes in money supply and not vice versa.'

Monetarists would argue that if governments respond to a rise in aggregate demand by

allowing money supply to increase, then that is their choice to expand money supply. If

they had chosen not to and had pursued a policy of higher interest rates, then money

supply would have thereby been controlled and aggregate demand would soon have

fallen back again.

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