The IS-LM model: Short-run
goods market and money market
equilibrium; monetary policy &
fiscal policy.
Topic 2
(Blanchard and Sheen, Chapters 3-5)
ECON5002 Macroeconomic Theory
(S2 2023)
1
Chapter 3
The Goods Market
2
The Composition of
Australian GDP, 2011
3-1
3
Section 3.1: The Composition of GDP
• Consumption (C) refers to the goods and services purchased by
consumers.
• Investment (I), sometimes called fixed investment, is the
purchase of capital goods. It is the sum of non-residential
investment and residential investment.
4
The Composition of GDP
• Government Spending (G) refers to the purchases of goods and
services by the federal, state, and local governments. It does not
include government transfers, nor interest payments on the
government debt.
• Imports (IM) are the purchases of foreign goods and services by
consumers, business firms, and the Australian government.
• Exports (X) are the purchases of Australian goods and services by
foreigners.
5
The Composition of GDP
 Net exports (X − IM) is the difference between
exports and imports, also called the trade balance.
Exports > imports trade surplus⇔
Exports < imports trade deficit⇔
Exports = imports trade balance⇔
 Inventory investment is the difference between
production and sales.
6
Australia’s GDP & expenditure share
(September Quarter (Q3), 2022)
7
Raw data source: ABS
U.S. GNP and Its Components
Source: Krugman, Obtsfeld, Melitz, International Economics, 10th edition
8
Z C I G X IM≡ + + + −
Z C I G≡ + +
Section 3.2: The Demand for Goods
• The total demand for goods is written as:
• The symbol “≡” means that this equation is an identity, or
definition.
• Under the assumption that the economy is closed, X = IM =
0, then:
9
Consumption (C)
• The function C(YD) is called the consumption function. It
is a behavioral equation, that is, it captures the behavior
of consumers.
• Disposable income, (YD), is the income that remains once
consumers have paid income taxes and received transfers
from the government.
C C YD= ( )
( )+
Y Y TD ≡ −
10
Consumption (C)
Consumption and
Disposable Income
Consumption increases
with disposable
income, but less than
one for one (0C C YD= ( )
Y Y TD ≡ −
C c c Y T= + −0 1 ( )
11
Investment (I)
• Investment is taken as given (until Chapter 5), or treated as an
exogenous variable:
I I=
12
Government Spending (G)
• Government spending, G, together with taxes, T, describes fiscal
policy—the choice of taxes and spending by the government.
• We shall assume that G and T are also exogenous.
13
Y c c Y T I G= + − + +0 1 ( )
Y Z=
Then (in a closed economy):
• The equilibrium condition is that, production, Y, be equal to
demand. Demand, Z, in turn depends on income, Y, which itself
is equal to production.
Section 3.3: The Determination of Equilibrium
Output
• Equilibrium in the goods market requires that production, Y, be
equal to the demand for goods, Z:
14
Using Algebra
• The equilibrium equation can be manipulated to derive some
important terms:
• Autonomous spending and the multiplier:
Y c c Y T I G= + − + +0 1 ( )
1 0 1(1 )c Y c I G c T− = + + −
Y
c
c I G c T=
−
+ + −
1
1 1
0 1[ ]
multiplier autonomous spending
15
Using a Graph
The Effects of an
Increase in
Autonomous
Spending on Output
An increase in
autonomous
spending has a
more than one-for-
one effect on
equilibrium output.
16
How Long Does It Take for Output to Adjust?
• In response to an increase in aggregate spending, output does not
jump to the new equilibrium immediately, but rather increases over
time. The adjustment depends on how and how often firms revise
their production schedule.
• Describing formally the adjustment of output over time is what
economists call the dynamics of adjustment.
17
S Y CD≡ −
S Y T C≡ − −
Y C I G= + +
Y T C I G T− − = + −
S I G T= + −
I S T G= + −( )
• If T > G, the
government is running a
budget surplus—public
saving is positive.
• If T < G, the
government is running a
budget deficit—public
saving is negative.
This equilibrium condition for the goods
market is called the IS relation.
Section 3.4: Investment = Saving: An Alternative
Approach to Goods-Market Equilibrium
• Saving is the sum of private plus public saving. Private
saving (S), is saving by consumers.
18
Chapter 4
Financial Markets
19
Section 4.1: The Demand for Money
• Money, which can be used for transactions, pays no
interest. There are two types of money:
* currency; and
* current account deposits (accessed by EFTPOS or
cheques).
• Bonds, pay a positive interest rate, i, but they cannot
be easily used for transactions. Term deposits are
equivalent – they pay interest and cannot be accessed
at any time.
20
The demand for money:
• increases in proportion to
nominal income ($Y), and
• depends negatively on the
interest rate (L(i)).
M YL id = $ ( )
Deriving the Demand for Money
21
The Demand for Money and the Interest Rate
The ratio of money (M1) to nominal income decreased from
1960 to 1985, & increased from 1985 to 2008. The interest rate
(ten-year Treasury bonds) moved in the opposite direction.
22
• In this section, we assume that only the central bank
supplies money, in an amount equal to M, so Ms= M. People
hold only currency as money.
• Equilibrium in financial markets requires that money supply
be equal to money demand:
M YL i= $ ( )
Section 4.2: Money Market Equilibrium and the
Interest Rate i
This equilibrium condition for the financial market is called the LM relation.
23
The interest rate
must be such that
the supply of money
(which is
independent of the
interest rate) be
equal to the demand
for money (which
does depend on the
interest rate).
The
Determination of
the Interest Rate
Money Demand, Money Supply and the Equilibrium
Interest Rate
24
Money Demand, Money Supply and the
Equilibrium Interest Rate
An increase in
nominal income
leads to an increase
in the interest rate,
if the central bank
keeps the money
supply constant.
The Effects of an
Increase in
Nominal Income
on the Interest
Rate
25
Monetary Policy and Open-Market Operations
An increase in the
supply of money
leads to a decrease
in the interest rate.
The Effects of an
Increase in the
Money Supply on
the Interest
Rate
Equivalently, if the
central bank wants
to lower the
interest rate, it
must increase the
supply of money
26
Monetary Policy and Open-Market Operations
How does a central bank increase/decrease money supply?
27
Monetary Policy and Open-Market Operations
• Open-market operations,
which take place in the “open
market” for bonds, are the
standard method central
banks use to change the
money stock in modern
economies.
28
The assets of the central bank are the bonds it holds. The
liabilities are the stock of money in the economy. An open-
market operation in which the central bank buys bonds and
issues money increases both assets and liabilities by the
same amount.
Monetary Policy and Expansionary
Open-Market Operations
29
Monetary Policy and Open-Market Operations
• In an expansionary open market operation, the central bank
buys $1 million worth of bonds, increasing the money supply by $1
million – the interest rate falls.
• In a contractionary open market operation, the central bank
sells $1 million worth of bonds, decreasing the money supply by $1
million – the interest rate rises.
30
Chapter 5
Goods + Financial Markets:
The IS-LM Model
31
Y C Y T I G= − + +( )
Section 5.1: The Goods Market and the IS
Relation
• Equilibrium in the goods market exists when production, Y,
is equal to the demand for goods, Z.
• In the simple model developed in chapter 3, the interest
rate did not directly affect the demand for goods. The
equilibrium condition was given by:
32
Investment, Sales and the Interest Rate
I I Y i= ( , )
In this chapter, we capture the effects
of two factors affecting investment:
• The level of sales (+)
• The interest rate (-)
33
I I Y i= ( , )
Y C Y T I Y i G= − + +( ) ( , )
The Determination of Output
• Taking into account the investment relation above, the
equilibrium condition in the goods market becomes:
34
Deriving the IS Curve
An increase in the
interest rate
decreases the
demand for goods
at any level of
output.
The Effects of
an Increase in
the Interest
Rate on Output
35
Deriving the IS Curve
Equilibrium in the
goods market
implies that an
increase in the
interest rate leads to
a decrease in
output. The IS
curve is downward
sloping.
36
Shifts of the IS Curve
An increase in
taxes shifts the IS
curve to the left.
37
Section 5.2: Financial Markets and the LM
Relation
The interest rate is determined by the equality of the supply of
and the demand for money:
M YL i= $ ( )
M = nominal money stock
$YL(i) = demand for money
$Y = nominal income
i = nominal interest rate
38
Real Money, Real Income and the Interest
Rate
M
P
YL i= ( )
The LM relation: In equilibrium, the real money
supply is equal to the real money demand, which
depends on real income, Y, and the interest rate, i:
Notes:
(1) real output, Y, is equal to $Y/P, i.e. nominal output divided by the
price level;
(2) P, the price level, is taken as given and constant for now.
39
Deriving the LM Curve
An increase in income
leads, at a given
interest rate, to an
increase in the demand
for money. Given the
money supply, this
leads to an increase in
the equilibrium interest
rate.
The Effects of an
Increase in
Income on the
Interest Rate
40
Deriving the LM Curve
Equilibrium in financial markets implies that an
increase in income leads to an increase in the
interest rate. The LM curve is upward-sloping.
41
Shifts of the LM Curve
An increase in
money supply
leads the LM
curve to shift
down.
42
Equilibrium in the goods
market implies that an
increase in the interest
rate leads to a decrease in
output.
Equilibrium in financial
markets implies that an
increase in output leads to
an increase in the interest
rate.
When the IS curve
intersects the LM curve,
both goods and financial
markets are in equilibrium.
IS relation: Y = − + +C Y T I Y i G( ) ( , )
LM relation:
M
P
= YL i( )
The IS-LM Model
Section 5.3: Putting the IS and the LM
Relations Together
43
Putting the IS and the
LM Relations Together
Practice question 1
Consider the IS-LM framework. Any point below the LM curve depicts a
situation of
(A) Excess demand in the goods market and excess supply in the money
market
(B) Excess supply in the money market
(C) Excess demand in the money market
(D) Excess demand in both the goods and money markets
(E) Excess supply in the money market but equilibrium in the goods market.
44
Putting the IS and the
LM Relations Together
Practice question 2
Consider the IS-LM framework. Any point above the IS curve depicts a
situation of
(A) Excess demand in the goods market and excess supply in the money
market
(B) Excess supply in the goods market
(C) Excess demand in the goods market
(D) Excess demand in both the goods and money markets
(E) Excess supply in the money market but equilibrium in the goods market.
45
Fiscal Policy, Activity and the Interest Rate
• Fiscal contraction, or fiscal consolidation, refers to
fiscal policy that reduces the budget deficit.
• An increase in the deficit is called a fiscal expansion.
• Taxes affect the IS curve, not the LM curve.
46
Fiscal Policy, Activity and the Interest Rate
An increase in
taxes shifts the
IS curve to the
left, and leads to
a decrease in
the equilibrium
level of output
and the
equilibrium
interest rate.
The Effects of
an Increase
in Taxes
47
Monetary Policy, Activity and the Interest
Rate
• Monetary contraction, or monetary tightening, here
refers to a decrease in the money supply.
• An increase in the money supply is called monetary
expansion.
• Monetary policy does not affect the IS curve, only the LM
curve. For example, an increase in the money supply shifts
the LM curve down.
48
Monetary
expansion leads
to higher output
and a lower
interest rate.
The Effects
of a
Monetary
Expansion
Monetary Policy, Activity and the Interest
Rate
49
In Summary
50
Section 5.4: Using a Policy Mix
• Monetary and fiscal policy is rarely conducted in
complete isolation.
• The combination of monetary and fiscal policies is
known as the monetary-fiscal policy mix, or
simply, the policy mix.
• To see the importance, consider fiscal contraction
(↓G or ↑T), with 2 alternative approaches to
monetary policy:
1. Central bank keeps M constant
2. Central bank keeps i constant at i0
(Most central banks use 2. They decide on i and allow M to
be determined endogenously in market equilibrium)
51
Using a Policy Mix
Fiscal contraction
leads to lower
output (Y´´central bank
keeps the interest
rate constant.
Using a Policy
Mix
52
Notable Australian Policy Mixes,
1986–2012
3. Howard–Macfarlane
Tight fiscal,
easy monetary.
2. Keating–Fraser
Easy fiscal,
easy monetary.
1. Hawke–
Johnston/Fraser
Tight fiscal,
tight monetary.
4. Howard–
Macfarlane/
Stevens
Tight fiscal,
tight monetary.
5. Rudd/Gillard–
Stevens
Easy fiscal,
easy monetary.
53
Tight fiscal and tight
monetary policy has
severe adverse effects on
output. Created the
1990-91 recession.
Equilibrium went from A
to A′ in the figure.
Deficit Reduction and
Monetary Contraction
1. The Hawke-Johnston/Fraser Policy Mix,
1986-1991
54
2. The Keating-Fraser Policy Mix,
1991-1996
Easy fiscal and easy
monetary policy helped
Australia out of the 1991
recession.
Equilibrium went from A′
back to A in the figure.
Deficit and Monetary
Expansion
55
3. The Howard-Macfarlane Policy Mix,
1996-2002
Tight fiscal and easy
monetary policy allowed
Australian output to
continue to grow
modestly.
Equilibrium went from A
to A′ in the figure.
Fiscal Contraction
and Monetary
Expansion
56
LM'
LM
IS’
With the global economy
growing pushing out the IS
curve, tight fiscal (pushing it
in a little) and monetary
policy allowed Australian
output to continue to grow
without hitting capacity
constraints.
Fiscal Contraction and
Monetary Contraction
Output, Y
In
te
re
st
R
at
e.
i
IS
i2
Y2
•
i1´
Y1´
•
4. The Howard-Macfarlane Policy Mix,
2002-2008
57
LM3
Y2
LM2
IS1
5. The Rudd/Gillard–Stevens Policy Mix,
2008–12
The global financial crisis
in 2008 lowered
household and firm
confidence in Australia,
pushing the IS curve to
the left. Monetary and
fiscal stimulus packages
lowered the interest rate
and shifted the IS curve
back to the right.
The mining boom to 2012
(driven by China), shifted
the IS curve further right,
to IS3.
LARGE Fiscal Deficit
and LARGE Monetary
Expansion
Output, Y
In
te
re
st
R
at
e,
i
IS3
Y3
i3
i2
•
•
IS2
58
More recent example: policy responses
during the COVID-19 pandemic?
• Large fiscal stimulus (deficit); overall fiscal support
since the onset of the pandemic up to Q2 2021: AU$ 311
billion (around 16% of GDP), e.g.
• $90 billion JobKeeper payment;
• $66 billion JobSeeker supplementary payment;
• $35 billion cash flow boost for small and medium sized
businesses.
• Large monetary expansion: RBA decreased the cash
rate target to 0.1% (practically 0%)
• Note: RBA also conducted an unconventional monetary
policy (quantitative easing (QE)), due to the zero
lower bound on the nominal interest rate)
• IS-LM diagram?
59
More recent example: policy responses
during the COVID-19 pandemic?
Fiscal policy
60
More recent example: policy responses
during the COVID-19 pandemic?
Monetary policy (conventional)
61
More recent example: policy responses
during the COVID-19 pandemic?
Monetary policy (unconventional)