IS–LM MODEL, EFFECTS OF MONETARY AND FISCAL POLICIES ON IS-LM MODEL

The IS and LM model (also known as the Hick-Hansen model) was developed in 1937 by John R Hicks in an attempt to properly interpret John Maynard Keynes' famous book "General Theory of Employment, Interest, and Money."

The IS and LM models attempt to explain the short-run movement of output and interest rates in the economy.

The IS-LM consists of two curves: the IS (short for investment and Savings) curve and LM (liquidity preference and money supply ) curve.

The IS curve shows the combination of interest rate and output for which the goods market is in equilibrium.

Stated differently, the IS curve depicts the relationship between interest rate and output such that demand for goods equals supply for goods

The Investment-Savings (IS) curve is drawn as a downward-sloping curve with the interest rate on the vertical axis while GDP is on the horizontal axis.

A downward sloping IS a curve implies that the interest rate and GDP have an inverse relationship. In other words, as the interest rate rises, GDP falls, and vice versa. This has a very clear logic to it. Lower interest rates encourage people to borrow and seek out investment opportunities, resulting in increased investment and GDP. A lower interest rate, meanwhile, leads to increased consumption since consumers would rather spend than save in order to take advantage of reduced interest rates.

The interest rate is the independent variable in the IS curve, while the level of income is the dependent variable.

The Liquidity preference-Money supply (LM) shows the combinations of interest rates and levels of real income for which the money market is in equilibrium. 

To put it another way, the LM curve shows the combination of interest rate and income that causes money demand to the equal money supply. 

The upward-sloping LM curve indicates that as income rises, so does the demand for money, resulting in rising interest rates. The reason for this is that as income rises, so does the demand for money at any given interest rate. Because the money supply is fixed, interest rates must rise to lower the demand for money and maintain equilibrium in the financial market.

The independent variable in the LM curve is income, and the dependent variable is the interest rate.

The IS curve represents equilibrium in the goods market while the LM curve represents equilibrium in the financial markets.

The short-run equilibrium in the monetary sectors is represented by the point where the IS curve intersects the LM curve.

In other words, the intersection of the IS curve and LM curve indicates that the money market and commodity market are in general equilibrium.

IS-LM intersection

Effect of changes in Monetary policy and Fiscal policy on IS-LM curve

Both fiscal and monetary policies are employed by governments to influence output and income.

Let's look at how each one affects the IS-LM curve.

Effect of Expansionary fiscal policy on IS-LM curve

An expansionary fiscal policy occurs when government increases expenditures or reduce tax.

The result of an expansionary fiscal policy is a shift in the IS curve to the right, indicating a higher level of output and higher interest rates. rates

The intuition for this is very simple. When the government cuts tax (or increase expenditure), disposable income and consumption increase.

As a result, total income/output would rise, and the LM curve would shift to the right.

Because the supply of money is fixed, increases in income increase the demand for money via the LM relationship, resulting in a high-interest rate.

It's important to remember that the company's increase in income is constrained by the negative impact of higher interest rates on investment.

That is, a high-interest rate reduces income by reducing investments, but, this is not enough to offset the positive effect of fiscal contraction on income.

Effect on contractionary fiscal policy on IS-LM curve

This is when the government either raises taxes or cuts spending.

The result is a shift of the IS curve to the left or a decrease in total income.

A shift in the IS curve

When the government raises taxes (or cuts spending), disposable income falls and consumption falls as well.

As a result, the national income/output will decrease.

Because the supply of money is fixed, a fall in income reduces the demand for money via the LM relationship, resulting in a low-interest rate

It is very to note that an increase in income is limited by the negative effect of an increase in the interest rates on investment.

That is, the lower interest rate, by increasing investments, increases income, but, not enough to offset the negative effect of fiscal contraction on income.

Note that a change in fiscal policy only affects the investment savings (IS) curve, not the liquidity-money (LM) curve.

Effect of Expansionary monetary policy on IS-LM curve

This is the central bank's use of money supply to increase the level of aggregate demand for goods and services  

The result of expansionary monetary policy is a downward shift in the LM curve, indicating a higher level of interest output and lower interest rates.

The Lower interest rate boosts demand and output by stimulating investment.

A shift in the LM curve

Effect of Contractionary monetary policy on IS-LM curve

This is the central bank's use of money supply to decrease the level of aggregate demand for goods and services  

The LM curve shifts upward as a result of contractionary monetary policy, indicating decreased output and higher interest rates.

By decreasing investment, a higher interest rate reduces demand and output.

Note that a change in monetary policy only affects the liquidity-money (LM) curve, not the investment savings (IS) curve

Final words

It's important to remember that any changes in demand for commodities at a particular interest rate will cause a shift in the IS curve.

Changes in consumer confidence, changes in government spending, and changes in taxes can all cause shifts in the IS curve.

Because fiscal policy affect government spending and taxes, a change in fiscal policy will also shift the IS curve

The IS curve shifts leftward whenever a decrease in government spending, decrease in consumer confidence and/or an increase in taxes at any given interest rate decreases the demand for goods.

Conversely, an increase in government spending, consumer confidence, and tax cuts that increase demand at any given interest rate will result in a rightward shift in the IS curve.

Finally, it should be noted that any changes in the demand and supply of money will result in a shift in the LM curve.

A change in monetary policy would shift the LM curve because monetary policy affects the supply of money.

Help us grow our readership by sharing this post

Related Posts

Post a Comment

Subscribe Our Newsletter