This post goes over some common economics problems
associated with the IS-LM model.
Remember that the IS-LM model shows the relationship between real income
(Y) and the real interest rate (i) using the IS (Investment and Saving
equilibrium) curve along with the LM (Liquidity Preference and Money supply
equilibrium) curve.
Four common policies the government can enact are:
1. Expansionary
fiscal policy (which will shift the IS curve right)
2. Contractionary
fiscal policy (which will shift the IS curve left)
3. Expansionary
monetary policy (which will shift the LM curve right)
4. Contractionary monetary policy (which will shift the LM
curve left)
Depending on the current state of the economy, the
government may want to fight high inflation (through contractionary policies)
or help lower unemployment (through expansionary policies). There is tradeoff between low inflation and
low unemployment so the government generally has to pick one strategy at a
time.
Let’s begin with the basic IS-LM graph, and go through each
of the examples above to see what the results on equilibrium real income and
the real interest rate will be.
We start with the downward sloping IS curve, and the upward
sloping LM curve. We can then add in the
fiscal policy choices by shifting the IS curve.
We can check to see how the IS curve will shift by reviewing the IS
equation:
Y = C(Y-T(Y))+I(r)+G+NX(Y)
We can see that G (government spending – fiscal policy) is
exogenous, and that an increase in G or expansionary fiscal policy will have a
positive impact on the equation or increase the IS curve (shift it right). Likewise, a decrease in G or contractionary
fiscal policy will have a negative impact on the equation or decrease the IS
curve (shift it left).
Looking at the graph, the ISi represents expansionary fiscal
policy. The new equilibrium point
results in a higher real GDP or income level Yi>Y and real interest rate
ii>i. Note that the LM curve did not
change.
Similarly, the ISd curve represents contractionary fiscal
policy and results in a lower equilibrium real interest rate and real GDP.
When the central bank enacts monetary policy, we will shift
the LM curve. We can figure out how the
LM curve will shift by looking at its equation:
M/P = L(i,Y)
If the central bank enacts expansionary monetary policy, we
will see M (the money supply) rise which has a positive impact on the equation. This causes the LM curve to shift right (to
LMi) which results in a lower real interest rate and higher real GDP. A decrease in the money supply causes the LM
curve to shift left (to LMd), which results in a higher interest rate and a
lower equilibrium level real GDP.
