The IS and LM Model
- Macroeconomics is a necessary discipline within the field of Economics which looks at the aggregate indicators of the economy such as national income, unemployment and the level of Inflation.
- As such, John Maynard Keynes is regarded as the father of Modern Macroeconomic analysis with his model of Income determination in the short run and his emphasis on the importance of aggregate demand.
- The economy may not be in a steady-state or equilibrium in the short run due to unchanging or sticky wages and prices, according to Keynes. This deviated from the position of the Classical Economists that markets clear out on their own due to adjustments of supply and demand and full employment is achieved.
- The IS-LM model borrows from the Keynesian Analysis and tries to show the determination of the equilibrium level of income.
The IS Curve and the LM Curve
- The IS (Investment-Saving) Curve is a generally downward-sloping curve which shows a negative relationship between the interest rate and the level of real income and represents the locus of points of equilibrium in the goods market.
- Each point on the IS curve represents equality between the level of Private Investment and actual saving.
- The LM (Liquidity-Money) Curve is an upward sloping curve which shows the locus of equilibrium points in the money market where demand for real Money Balances is equal to the money supply.
Analysis of the IS Curve
- If a point is taken above the IS curve, it is shown to represent a disequilibrium where the level of savings exceeds private investment and interest rates are lowered to encourage more investment.
- If it is taken below the IS curve, it is shown to represent an excess of investment over the savings level, and interest rates are raised to decrease investment, increase savings and restore equilibrium.
- The downward-sloping curve is due to the inverse relationship between the interest rate level and real income.
- If Interest rate increases, in the context of investment and savings market, then the investment decreases, leading to a fall in real income. The converse happens when interest rates fall.
- The IS Curve is derived from the negative relation of Autonomous Planned Spending (mainly Autonomous Consumption and Investment) with the level of interest rates, and the positive relationship between the level of Autonomous Spending with the level of real income.
- The rise in interest rates discourages investment and consumption and their level falls, which establishes the negative relationship between the interest rates and the Autonomous spending.
- The real output constitutes the level of Autonomous spending and has a positive relationship with it, which means real output increases as the level of Autonomous spending increases.
Analysis of the LM Curve
- The LM curve points show equality between the levels of Money Demand and Money supply.
- A point situated above the LM curve on the graph will represent an excess of the money supply over the money demand, a situation where interest rates have to be lowered to make money more attractive with respect to other assets and thus raise money demand and restore equilibrium,
- A point below the LM curve represents an excess of money demand over the money supply, and thus Interest rates are raised to discourage demand for money and restore equilibrium.
- The LM curve shows a positive relationship between the level of real income and interest rates, leading to an upward sloping curve.
There is a positive relationship between the level of income and the demand for money. In fact, Money demand is defined as a fixed proportion of Real Income. The Money supply is taken as fixed and the Money Demand as an inverse function of the Interest rate. The money market is in equilibrium, where the downward sloping Money Demand Line crosses the vertical Money supply line. When the increase in income increases money demand, the Money supply also increases, which causes the Interest rates to be raised upwards to restore equilibrium. Thus, a positive relationship is established between the level of real income and the interest rate in the money market, which leads to an upward sloping curve.
The IS curve meets the LM curve
If we plot the IS and the LM curves in the same graph with interest rates on the vertical axis and level of income on the horizontal axis, then we see that the equilibrium is determined at the point where the two curves cross each other, which denotes the equilibrium level of real income and interest rates. The equilibrium point denotes equality in both the Goods and the Money market.
Fig -The IS and the LM curves meet each other
Need for Fiscal and Monetary Policy
- Fiscal Policy is defined as increasing or decreasing Government spending to stabilize the economy. Monetary Policy is defined as raising or lowering interest rates by the Central Bank to change the level of the money supply to again restore equilibrium in the economy.
- In the IS-LM Model context, if the economy is at a point to the left of the equilibrium point, then that calls for a contractionary Fiscal policy or reducing Government spending, so that IS curve shifts leftwards, and equilibrium is restored, and contractionary monetary policy to reduce the money supply, shift the LM Curve upwards and restore equilibrium.
- If the economy is at a point to the right of the equilibrium point, then an expansionary fiscal policy is required, where an increase in Government spending shifts IS curve rightwards, boosts income, cuts interest rates and restores equilibrium, and an expansionary Monetary policy, which boosts money supply, raises income, shifts LM Curve downwards and restores equilibrium.
- If the economy is at a point right above the equilibrium point, then an expansionary fiscal policy and a contractionary monetary policy is required which shifts the IS curve rightwards, and the LM curve upwards raises interest rates and restores equilibrium.
- Finally, if the economy is at a point below the equilibrium point, then a contractionary fiscal policy and expansionary monetary policy is required, which shifts IS Curve leftwards, LM Curve downwards, lowers interest rates and restores equilibrium