What do we learn when we combine the IS and the LM curves on
one graph?
Why is equilibrium achieved?
What is the IS-LM model’s biggest drawback?
The Keynesian cross diagram framework is great, as far as it
goes. Note that it has nothing to say about interest rates or
money, a major shortcoming for us students of money, banking, and
monetary policy! It does, however, help us to build a more powerful
model that examines equilibrium in the markets for goods and money,
the IS (investment-savings) and the LM (liquidity preference–money)
curves, respectively (hence the name of the model).
Interest rates are negatively related to I and to NX.
The reasoning here is straightforward. When interest rates
(i) are high, companies would rather invest in bonds than
in physical plant (because fewer projects are positive net
present value or +NPV) or inventory
(because it has a high opportunity cost), so I (investment) is low.
When rates are low, new physical plant and inventories look cheap
and many more projects are +NPV (i has come down in the
denominator of the present value formula), so I is high. Similarly,
when i is low the domestic currency will be weak, all else
equal. Exports will be facilitated and imports will decline because
foreign goods will look expensive. Thus, NX will be high (exports
> imports). When i is high, by contrast, the domestic
currency will be in demand and hence strong. That will hurt exports
and increase imports, so NX will drop and perhaps become negative
(exports < imports).
Now think of Yad on a Keynesian cross diagram. As we
saw above, aggregate output will rise as I and NX do. So we know
that as i increases, Yad decreases, ceteris
paribus. Plotting the interest rate on the vertical axis
against aggregate output on the horizontal axis, as below, gives us
a downward sloping curve. That’s the IS curve! For each
interest rate, it tells us at what point the market for goods (I
and NX, get it?) is in equilibrium—holding autonomous consumption,
fiscal policy, and other determinants of aggregate demand constant.
For all points to the right of the curve, there is an excess supply
of goods for that interest rate, which causes firms to decrease
inventories, leading to a fall in output toward the curve. For all
points to the left of the IS curve, an excess demand for goods
persists, which induces firms to increase inventories, leading to
increased output toward the curve.
Obviously, the IS curve alone is as insufficient to determine
i or Y as demand alone is to determine prices or
quantities in the standard supply and demand microeconomic price
model. We need another curve, one that slopes the other way, which
is to say, upward. That curve is called the LM curve and it
represents equilibrium points in the market for money. The
demand for money is positively related to income because more
income means more transactions and because more income means more
assets, and money is one of those assets. So we can immediately
plot an upward sloping LM curve, a curve that holds the money
supply constant. To the left of the LM curve there is an excess
supply of money given the interest rate and the amount of output.
That’ll cause people to use their money to buy bonds, thus driving
bond prices up, and hence i down to the LM curve. To the
right of the LM curve, there is an excess demand for money,
inducing people to sell bonds for cash, which drives bond prices
down and hence i up to the LM curve.
When we put the IS and LM curves on the graph at the same
time, asinFigure21.4
"IS-LM diagram: equilibrium in the markets for money and
goods", we immediately see that there is only one
point, their intersection, where the markets for both goods and
money are in equilibrium. Both the interest rate and aggregate
output are determined by that intersection. We can then shift the
IS and LM curves around to see how they affect interest rates and
output, i* and Y*. In the next chapter, we’ll see how policymakers
manipulate those curves to increase output. But we still won’t
be done because, as mentioned above, the IS-LM model has one major
drawback: it works only in the short term or when the price level
is otherwise fixed.
Stop and Think Box
Does Figure 21.5 make sense? Why or why
not? What does Figure 21.6 mean? Why is Figure 21.7 not a good
representation of G?
Source: U.S. Department of Commerce, Bureua of Economic
Analysis
Source: U.S. Department of Commerce, Bureua of Economic
Analysis
Source: U.S. Department of Commerce, Bureua of Economic
Analysis
Figure 21.5 makes perfectly good sense
because it depicts I in the equation Y = Yad = C + I + G
+ NX, and the shaded areas represent recessions, that is, decreases
in Y. Note that before almost every recession in the twentieth
century, I dropped.
Figure 21.6 means that NX in the United
States is considerably negative, that exports < imports by a
large margin, creating a significant drain on Y (GDP). Note that NX
improved (became less negative) during the crisis and resulting
recession but dipped downward again during the 2010 recovery.
Figure 21.7 is not a good
representation of G because it ignores state and local government
expenditures, which are significant in the United States, as Figure
21.8 shows.
Source: U.S. Department of Commerce, Bureua of Economic
Analysis
key takeaways
The IS curve shows the points at which the quantity of goods
supplied equals those demanded.
On a graph with interest (i) on the vertical axis and aggregate
output (Y) on the horizontal axis, the IS curve slopes downward
because, as the interest rate increases, key components of Y, I and
NX, decrease. That is because as i increases, the
opportunity cost of holding inventory increases, so inventory
levels fall and +NPV projects involving new physical plant become
rarer, and I decreases.
Also, high i means a strong domestic currency, all
else constant, which is bad news for exports and good news for
imports, which means NX also falls.
The LM curve traces the equilibrium points for different
interest rates where the quantity of money demanded equals the
quantity of money supplied.
It slopes upward because as Y increases, people want to hold
more money, thus driving i up.
The intersection of the IS and LM curves indicates the
macroeconomy’s equilibrium interest rate (i*) and output (Y*), the
point where the market for goods and the market for money are both
in equilibrium.
At all points to the left of the LM curve, an excess supply of
money exists, inducing people to give up money for bonds (to buy
bonds), thus driving bond prices up and interest rates down toward
equilibrium.
At all points to the right of the LM curve, an excess demand
for money exists, inducing people to give up bonds for money (to
sell bonds), thus driving bond prices down and interest rates up
toward equilibrium.
At all points to the left of the IS curve, there is an excess
demand for goods, causing inventory levels to fall and inducing
companies to increase production, thus leading to an increase in
output.
At all points to the right of the IS curve, there is an excess
supply of goods, creating an inventory glut that induces firms to
cut back on production, thus decreasing Y toward the
equilibrium.
The IS-LM model’s biggest drawback is that it doesn’t consider
changes in the price level, so in most modern situations, it’s
applicable in the short run only.