Determining the IS and LM curves
IS-LM model introduction
The IS-LM model, based on Keynesian is the original monetarist approach to policy making, which was mostly popular between 1940s and 1970s.
Demand Side
(Model 1.1 - shows the model from which the IS curve is determined. See effect of changes in variables on the equilibrium Y)
The demand side depends on the equilibrium-determining factors in the Keynesian Income-expenditure model. It uses the expenditure equation for calculation of GDP, while considering total investment to be endogenous, dependent on the interest rate.
In the mathematical model, this relationship defines the downward-sloping IS curve, plotted between the total output and interest rate.
Supply Side
(Model 1.2 - Shows the model from which the LM curve is determined. Play around with the M_s curve and observe effects on the interest rate)
Supply side is determined by the money market equilibrium, which is given by money demanded by the consumers at each interest rate and the money supply fully controlled by the central bank. The change in total output causes positive shifts in the demand. Assuming the money supply remains constant, these changes form a positive relationship between GDP and interest rate. Finally, the LM curve can be plotted and the IS-LM equilibrium found
Policy making
Shifts in IS curve are mainly caused by changes in national savings. The government is therefore able to form a demand-side policy by adjusting the level of government spending and changes in
taxes. Shifts in LM curve can be simply caused by central bank through regulation of the money supplies.
Through these interventions, the unemployment could be managed in some way through the consistently increasing output. Unfortunately, the effect of inflation was not exactly well incorporated in this model,
which is why it failed.
Although decisions were made based on this model in the past, they have been proven not to be efficient, mainly due to the crowding-in and crowding-out of public investment. For this reason, it failed and had to be replaced by a rather complex mechanism around the oil crisis of 1970s.
The next section of this chapter provides an example of this model with full mathematical formulae and dynamic determining factors. Play around and try to understand. For more details on how the formulae are determined, see appropriate macroeconomics textbook or google it.
To be reviewed