IS–LM model

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The IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y) Islm.svg
The IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y)

The IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market (also known as real output in goods and services market plus money market).[ citation needed ] The intersection of the "investmentsaving" (IS) and "liquidity preferencemoney supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. [1] Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift. [2] Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies. [3]

Money market type of financial market

The money market is a component of the economy which provides short-term funds. The money market deals in short-term loans, generally for a period of less than or equal to 365 days.

In macroeconomics, investment is the amount of goods purchased or accumulated per unit time which are not consumed at the present time. The types of investment are residential investment in housing that will provide a flow of housing services over an extended time, non-residential fixed investment in things such as new machinery or factories, human capital investment in workforce education, and inventory investment.

Contents

The model was developed by John Hicks in 1937, [4] and later extended by Alvin Hansen, [5] as a mathematical representation of Keynesian macroeconomic theory. Between the 1940s and mid-1970s, it was the leading framework of macroeconomic analysis. [6] While it has been largely absent from macroeconomic research ever since, it is still a backbone conceptual introductory tool in many macroeconomics textbooks. [7] By itself, the IS–LM model is used to study the short run when prices are fixed or sticky and no inflation is taken into consideration. But in practice the main role of the model is as a path to explain the AD–AS model. [2]

John Hicks British economist

Sir John Richard Hicks was a British economist. He was considered one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model (1937), which summarised a Keynesian view of macroeconomics. His book Value and Capital (1939) significantly extended general-equilibrium and value theory. The compensated demand function is named the Hicksian demand function in memory of him.

Alvin Harvey Hansen, often referred to as "the American Keynes", was a professor of economics at Harvard, a widely read author on current economic issues, and an influential advisor to the government who helped create the Council of Economic Advisors and the Social Security system. He is best known for introducing Keynesian economics in the United States in the 1930s.

Keynesian economics are various macroeconomic theories about how in the short run – and especially during recessions – economic output is strongly influenced by aggregate demand. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

History

The IS–LM model was first introduced at a conference of the Econometric Society held in Oxford during September 1936. Roy Harrod, John R. Hicks, and James Meade all presented papers describing mathematical models attempting to summarize John Maynard Keynes' General Theory of Employment, Interest, and Money . [4] [8] Hicks, who had seen a draft of Harrod's paper, invented the IS–LM model (originally using the abbreviation "LL", not "LM"). He later presented it in "Mr. Keynes and the Classics: A Suggested Interpretation". [4]

The Econometric Society is an international society of academic economists interested in applying statistical tools to their field. It is an independent organization with no connections to societies of professional mathematicians or statisticians. It was founded on December 29, 1930, at the Stalton Hotel in Cleveland, Ohio. As of 2014, there are about 700 Elected Fellows of the Econometric Society, making it one of the most prevalent research affiliations.

Roy Harrod English economist

Sir Henry Roy Forbes Harrod was an English economist. He is best known for writing The Life of John Maynard Keynes (1951) and for the development of the Harrod–Domar model, which he and Evsey Domar developed independently. He is also known for his International Economics, a former standard textbook, the first edition of which contained some observations and ruminations that would foreshadow theories developed independently by later scholars.

James Meade British economist

James Edward Meade, was a British economist and winner of the 1977 Nobel Memorial Prize in Economic Sciences jointly with the Swedish economist Bertil Ohlin for their "pathbreaking contribution to the theory of international trade and international capital movements."

Hicks later agreed that the model missed important points of Keynesian theory, criticizing it as having very limited use beyond "a classroom gadget", and criticizing equilibrium methods generally: "When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect." [9] The first problem was that it presents the real and monetary sectors as separate, something Keynes attempted to transcend. In addition, an equilibrium model ignores uncertainty—and that liquidity preference only makes sense in the presence of uncertainty "For there is no sense in liquidity, unless expectations are uncertain." [9] A shift in one of the IS or LM curves will cause a change in expectations, which shifts the other curve.

In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. According to Keynes, money is the most liquid asset. Liquidity is an attribute to an asset. The more quickly an asset is converted into money the more liquid it is said to be.

Although generally accepted as being imperfect, the model is seen as a useful pedagogical tool for imparting an understanding of the questions that macroeconomists today attempt to answer through more nuanced approaches. As such, it is included in most undergraduate macroeconomics textbooks, but omitted from most graduate texts due to the current dominance of real business cycle and new Keynesian theories. [10]

Formation

The model is presented as a graph of two intersecting lines in the first quadrant.

The horizontal axis represents national income or real gross domestic product and is labelled Y. The vertical axis represents the real interest rate, r (or sometimes i). Since this is a non-dynamic model, there is a fixed relationship between the nominal interest rate and the real interest rate (the former equals the latter plus the expected inflation rate which is exogenous in the short run); therefore variables such as money demand which actually depend on the nominal interest rate can equivalently be expressed as depending on the real interest rate.

Gross domestic product market value of goods and services produced within a country

Gross domestic products (GDP) is a monetary measure of the market value of all the final goods and services produced in a specific time period, often annually. GDP (nominal) per capita does not, however, reflect differences in the cost of living and the inflation rates of the countries; therefore using a basis of GDP per capita at purchasing power parity (PPP) is arguably more useful when comparing living standards between nations, while Nominal GDP is more useful comparing national economies on the international market.

Real interest rate

The real interest rate is the rate of interest an investor, saver or lender receives after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.

In finance and economics, the nominal interest rate or nominal rate of interest is either of two distinct things:

  1. the rate of interest before adjustment for inflation ; or,
  2. for interest rates "as stated" without adjustment for the full effect of compounding. An interest rate is called nominal if the frequency of compounding is not identical to the basic time unit in which the nominal rate is quoted.

The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors (though not necessarily in other sectors, such as labor markets): both the product market and the money market are in equilibrium. This equilibrium yields a unique combination of the interest rate and real GDP.

IS (Investment Saving) curve

IS curve represented by equilibrium in the money market and Keynesian cross diagram. I-S and Y=AD to IS NT Wiki.png
IS curve represented by equilibrium in the money market and Keynesian cross diagram.

For the investment-saving curve, the independent variable is the interest rate and the dependent variable is the level of income. (Note that economic graphs often place the independent variable—interest rate, in this example—on the vertical axis while the dependent variable is measured with the horizontal axis.) [11] The IS curve is drawn as downward-sloping with the interest rate r on the vertical axis and GDP (gross domestic product: Y) on the horizontal axis. The initials IS stand for "Investment and Saving equilibrium" but since 1937 have been used to represent the locus of all equilibria where total spending (consumer spending + planned private investment + government purchases + net exports) equals an economy's total output (equivalent to real income, Y, or GDP). To keep the link with the historical meaning, the IS curve can be said to represent the equilibria where total private investment equals total saving, where the latter equals consumer saving plus government saving (the budget surplus) plus foreign saving (the trade surplus). In equilibrium, all spending is desired or planned; there is no unplanned inventory accumulation. [12] The level of real GDP (Y) is determined along this line for each interest rate.

Thus the IS curve is a locus of points of equilibrium in the "real" (non-financial) economy. Each point on the curve represents the equilibrium between saving broadly defined and investment.

Given expectations about returns on fixed investment, every level of the real interest rate will generate a certain level of planned fixed investment and other interest-sensitive spending: lower interest rates encourage higher fixed investment and the like. Income is at the equilibrium level for a given interest rate when the saving that consumers and other economic participants choose to do out of this income equals investment (or, equivalently, when "leakages" from the circular flow equal "injections"). The multiplier effect of an increase in fixed investment resulting from a lower interest rate raises real GDP. This explains the downward slope of the IS curve. In summary, this line represents the causation from falling interest rates to rising planned fixed investment (etc.) to rising national income and output.

The IS curve is defined by the equation

where Y represents income, represents consumer spending as an increasing function of disposable income (income, Y, minus taxes, T(Y), which themselves depend positively on income), represents physical investment as a decreasing function of the real interest rate, G represents government spending, and NX(Y) represents net exports (exports minus imports) as a decreasing function of income (decreasing because imports are an increasing function of income).

LM curve

The money market equilibrium diagram. Money Market diagram.svg
The money market equilibrium diagram.

For the liquidity preference and money supply curve, the independent variable is "income" and the dependent variable is "the interest rate." The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium. It is an upward-sloping curve representing the role of finance and money.

The LM function is the set of equilibrium points between the liquidity preference (or demand for money) function and the money supply function (as determined by banks and central banks).

Each point on the LM curve reflects a particular equilibrium situation in the money market equilibrium diagram, based on a particular level of income. In the money market equilibrium diagram, the liquidity preference function is simply the willingness to hold cash balances instead of securities. For this function, the nominal interest rate (on the vertical axis) is plotted against the quantity of cash balances (or liquidity), on the horizontal. The liquidity preference function is downward sloping. Two basic elements determine the quantity of cash balances demanded (liquidity preference) and therefore the position and slope of the function:

The money supply function for this situation is plotted on the same graph as the liquidity preference function. The money supply is determined by the central bank decisions and willingness of commercial banks to loan money. Though the money supply is related indirectly to interest rates in the very short run, the money supply in effect is perfectly inelastic with respect to nominal interest rates (assuming the central bank chooses to control the money supply rather than focusing directly on the interest rate). Thus the money supply function is represented as a vertical line – money supply is a constant, independent of the interest rate, GDP, and other factors. Mathematically, the LM curve is defined by the equation , where the supply of money is represented as the real amount M/P (as opposed to the nominal amount M), with P representing the price level, and L being the real demand for money, which is some function of the interest rate and the level of real income. The LM curve shows the combinations of interest rates and levels of real income for which the money supply equals money demand – that is, for which the money market is in equilibrium.

For a given level of income, the intersection point between the liquidity preference and money supply functions implies a single point on the LM curve: specifically, the point giving the level of the interest rate which equilibrates the money market at the given level of income. Recalling that for the LM curve, the interest rate is plotted against real GDP (whereas the liquidity preference and money supply functions plot interest rates against the quantity of cash balances), an increase in GDP shifts the liquidity preference function rightward and hence increases the interest rate. Thus the LM function is positively sloped.

Shifts

One hypothesis is that a government's deficit spending ("fiscal policy") has an effect similar to that of a lower saving rate or increased private fixed investment, increasing the amount of demand for goods at each individual interest rate. An increased deficit by the national government shifts the IS curve to the right. This raises the equilibrium interest rate (from i1 to i2) and national income (from Y1 to Y2), as shown in the graph above. The equilibrium level of national income in the IS-LM diagram is referred to as aggregate demand.

Keynesians argue spending may actually "crowd in" (encourage) private fixed investment via the accelerator effect, which helps long-term growth. Further, if government deficits are spent on productive public investment (e.g., infrastructure or public health) that spending directly and eventually raises potential output, although not necessarily more (or less) than the lost private investment might have. The extent of any crowding out depends on the shape of the LM curve. A shift in the IS curve along a relatively flat LM curve can increase output substantially with little change in the interest rate. On the other hand, an rightward shift in the IS curve along a vertical LM curve will lead to higher interest rates, but no change in output (this case represents the "Treasury view").

Rightward shifts of the IS curve also result from exogenous increases in investment spending (i.e., for reasons other than interest rates or income), in consumer spending, and in export spending by people outside the economy being modelled, as well as by exogenous decreases in spending on imports. Thus these too raise both equilibrium income and the equilibrium interest rate. Of course, changes in these variables in the opposite direction shift the IS curve in the opposite direction.

The IS–LM model also allows for the role of monetary policy. If the money supply is increased, that shifts the LM curve downward or to the right, lowering interest rates and raising equilibrium national income. Further, exogenous decreases in liquidity preference, perhaps due to improved transactions technologies, lead to downward shifts of the LM curve and thus increases in income and decreases in interest rates. Changes in these variables in the opposite direction shift the LM curve in the opposite direction.

Incorporation into larger models

By itself, the IS–LM model is used to study the short run when prices are fixed or sticky and no inflation is taken into consideration. But in practice the main role of the model is as a sub-model of larger models (especially the Aggregate Demand-Aggregate Supply model – the AD–AS model) which allow for a flexible price level. In the aggregate demand-aggregate supply model, each point on the aggregate demand curve is an outcome of the IS–LM model for aggregate demand Y based on a particular price level. Starting from one point on the aggregate demand curve, at a particular price level and a quantity of aggregate demand implied by the IS–LM model for that price level, if one considers a higher potential price level, in the IS–LM model the real money supply M/P will be lower and hence the LM curve will be shifted higher, leading to lower aggregate demand as measured by the horizontal location of the IS–LM intersection; hence at the higher price level the level of aggregate demand is lower, so the aggregate demand curve is negatively sloped.

See also

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References

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  5. Hansen, A. H. (1953). A Guide to Keynes. New York: McGraw Hill.
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  8. Meade, J. E. (1937). "A Simplified Model of Mr. Keynes' System". Review of Economic Studies . 4 (2): 98–107. doi:10.2307/2967607. JSTOR   2967607.
  9. 1 2 Hicks, John (1981). "'IS-LM': An Explanation". Journal of Post Keynesian Economics. 3 (2): 139–154. doi:10.1080/01603477.1980.11489209. JSTOR   4537583.
  10. Mankiw, N. Gregory (May 2006). "The Macroeconomist as Scientist and Engineer" (PDF). p. 19. Retrieved 2014-11-17.
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Further reading