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Gartner, Macroeconomics, 3rd
Edition © Manfred Gartner 2009
Lecture 2
IS-LM Model
Chapter 2 and 3

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Figure 3.2 Rising interest rates raise the opportunity costs of holding money.
Therefore they drive down the demand for money at given income levels (panel
(a)). Rising income raises transactions and shifts the money demand curve to
the right. The money supply curve is vertical. Changing supply shifts the curve
left or right
(panel (b))

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Figure 3.3 In 2001 Australian households’ assets (gross wealth) totaled 3,200 billion
Australian dollars. Wealth comprises non-financial assets, things like houses and
cars, and financial assets. About a fourth of all financial assets, some 11% of total
wealth, is held as money (currency and deposits with banks)

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Figure 3.4 Money demand and supply are equal at one interest rate i0. At higher
interest rates there is an excess supply. A lower interest rate generates an excess
demand

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Figure 3.5 Panel (a) shows a vertical money supply and a negatively sloped money-
demand curve. Rising income raises money demand at any interest rate, shifting
the money- demand curve right. To retain equilibrium, the interest rate must rise
to contain money demand at its old level. Transferring points A and B into panel
(b) gives two points on the LM curve, the money-market equilibrium line

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Figure 3.6 In panel (a) the money supply increase shifts the vertical money-supply
curve to the right. To retain equilibrium, money demand must be spurred by
lowering the interest rate from i0 to i1. Transferring points A and B to panel (b)
gives two money-market equilibrium points on two different LM curves, each one
drawn for a different money supply

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Figure 3.7 In order to keep the interest rate at i, the central bank must accommodate
an increase in the demand for money, caused by a rise in income from Y0 to Y1,
by raising the money supply from M0 to M1 (panel (a)). Transferring equilibrium
points A and B to panel (b) gives two money-market equilibrium points on two
different LM curves, each one drawn for a different money supply. Both points sit
on one lm curve, however, drawn for a given interest rate target

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Figure 3.8 The dark blue line shows a money market equilibrium line, an lm curve,
derived from a monetary policy rule such as (3.3) in which both the money supply
and the interest rate feature as targets. When only the money supply is targeted
(a = 0), the equilibrium line turns into the steeper, light blue LM curve. When only
the interest rate is targeted (a → ∞), the money market equilibrium line becomes
horizontal

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Figure 3.9

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Figure 3.10

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Figure 3.11 All goods market equilibria form a plane in R-i-Y space. It slopes up as
we move towards the rear (depreciation generates excess demand; to reverse
this, the interest rate must rise). The plane slopes down as we move to the right
(rising income leads to an excess supply; to eliminate this, the interest rate must
fall). Placing a vertical cut parallel to the income axis carves out an equilibrium
line (IS curve) for a given real exchange rate

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Figure 3.12 The IS curve shows all combinations of interest rates and income that
make aggregate spending equal to output. It is drawn for given government
expenditures, world income and a given exchange rate. As these variables rise,
the IS curve moves up (or to the right)

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Figure 3.13 This shows how what we learned in this chapter fits into the circular flow
diagram. If i falls, I goes up. I increases by the grey segment of the investment
injection. This demand rise adds to income. Since this stimulates consumption,
second-round effects set in. The fact that leakages also get larger (not shown in
graph) ensures that income does not continue to rise forever. Eventually, the
stream of income settles into a new width determined by the multiplier. Note that
changes of world income, the exchange rate or taxes affect the circular flow in a
similar way

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Figure 3.14 While points A, B and C indicate goods market equilibria and A, D and E
mark money market equilibria, only point A is an economy-wide equilibrium with
both markets being in equilibrium at the same time. At F there is disequilibrium in
both markets. The arrow indicates how such a disequilibrium might be removed.
Our IS-LM model does not really cover this. It only tells where the equilibrium is,
not how we get there

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Figure 3.15 When the money supply increases, the LM curve shifts to the right,
indicating that we need higher income or lower interest rates (or some
combination of these effects) to induce people to increase money demand. The
slope of the IS curve causes the macroeconomic equilibrium to move from A to B.
Only the indicated fall in the interest rate and the indicated rise in income will keep
the goods market in equilibrium while restoring money market equilibrium after the
money supply increase

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Figure 3.16

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Figure 3.17 The IS-LM model rests on the Keynesian cross, but extends this. In the
Keynesian cross, an increase in government spending moves the aggregate
expenditure line up, moving the economy from A to B. In the IS-LM diagram the
IS curve moves to the right. The same macroeconomic equilibrium B would only
obtain if the interest rate did not change. Since money market equilibrium requires
the interest rate to rise, investment is driven down and the new equilibrium is in C,
where LM and the new IS curve intersect. In the Keynesian cross this rise in i and
fall in I moves the AE line down and the new equilibrium is also at C

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Figure 3.18

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Figure 3.19 An increase in government spending shifts the IS curve to the right. If the
money supply was kept unchanged, this would move the economy up from A
along LM0, raising the interest rate and crowding out some private investment.
When the central bank wants to keep the interest rate unchanged at i instead, it
must increase the money supply appropriately and shift LM into LM1, moving the
economy into point B. Expansionary fiscal policy has a bigger income effect when
the central bank fixes the interest rate. Crowding out is prevented because the
central bank is forced to respond to an increase in government spending by
expanding the money supply

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Table 3.1

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Table 3.2

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Figure 3.20

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Table 3.3
Sources: IMF-IFS and Statistics Norway

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Table 3.4

M03 gart 7928_03_ppw_ch03

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