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Income Determination Model

including Money and Interest


Introduction
Hicks and Hansen developed a simple macro model of an open economy by synthesizing goods
market and the money market to determine the overall income of the economy. This short-run model
is popularly known as IS-LM model, where the price is exogenously determined and the model will
not show changes in the price levels over a period of time. IS curve represents goods market
equilibrium and LM curve represents the money market equilibrium.




The Structure of IS-LM Model
Income


Assets Markets Goods Markets
Money Market Bond Market Aggregate Demand Output
Demand Supply Demand Supply

Interest Rates

Monetary Policy Fiscal Policy

THE GOODS MARKET AND IS CURVE
The National Income identity of a closed economy: Y= AD= C+I+ G is the basic equation for the IS
curve.
Where Y in the equation is GDP, AD is the Aggregate Demand. The components of AD are C
consumption demand, I is the investment demand and G is the Government expenditure.
Consumption demand is referred to as desired consumption and investment demand is referred to as
desired investment.
Consumption: The level of consumption depends upon the income which can be secured or
unsecured and the Fiscal Policy of the government.
Example: Income: If the people have job security, there are assured of certain income and
there will not be reduction in the consumption and vice versa.
Example: Taxes: If more taxes are levied by the government, then less money is available in
hands of the people to spend and consumption will decrease and vice versa .
Investment: The sources of investment are savings and borrowings. The volume of savings
and borrowings are determined by the prevailing rate of interest. If the rate of interest is high,
it will encourage the people save money by postponing their present consumption and vice
versa. On the other hand, high rate of interest will discourage the firms to borrow money for
the purpose of investment and vice versa.
Government Purchases: The extent of government purchases are determined by the ideology
and beliefs of the political party that is in power. Therefore a government purchase is
independent of output or interest rates in the economy.
Derivation of IS Curve
Equilibrium in the Goods Market is achieved at a point where all goods and services produced are
purchased by consumers, firms and government.
Figure 1

The above figure represents, with the increase in the income from Y
0
to Y
2
, the desired savings are
increasing for every possible level of interest rate and results in the shift in curve S
0
(Y
0
)to S
2
(Y
2
).
In case if the rate of interest is fixed at r
0,
the equilibrium point in the economy will be established at
point A, where supply of funds is more than the demand for funds i.e., the desired savings is more
than the desired investment.

The outcome of this excess supply of funds is that it will reduce the rate
of interest, increase the output and shift the equilibrium of the economy from point A to point B.
Panel B of the figure is constructed by taking the combinations of output and interest rates for which
the demand and supply of goods are in equilibrium. The curve thus obtained is a downward sloping
curve indicating negative relationship between aggregate output and real interest rate and the curve
is referred to as IS curve, where (I) stands for Investment and (S) stands for savings.

Therefore, IS
curve shows different combination of interest rates and income levels at which Saving (S) is equal to
Investment (I).
IS curve is derived by taking into account the determinants of saving and investment and holding Y
and r as constant.

Movement along the IS curve
Change in the output because of change in the interest rate will result in the movement along the IS
curve. The rightward movement is referred to as extension and leftward movement is referred to as
contraction in income. The following figure 2 represents the movement along the IS curve:
Figure 2

Shift in the IS curve
IS curve might move to the right side or left side from the original position. This situation is referred
to as shift in the IS curve which is due to other factors (Consumption, Investment and Government
purchases etc.,) other than the rate of interest. For example, Increase in the government expenditure,
will increase the aggregate demand for goods and services in the economy as a result of this IS curve
will shift to right side.
Figure 3

Example: Suppose the government reduces the prevailing tax rate, this will enable the people to
have more disposable income in their hands. As a result of this, consumers will increase expenditure
on goods and service. This is reflected in terms of rightward shift in the IS curve.
The striking difference between the Movement and Shift in the IS curve is that, movement is due to
rate of interest, therefore it is the rate of interest which will determine the level of income. On the
other hand, shift in the IS curve is due to other factors other than the rate of interest. Therefore
interest is the determining factor in the movement along the IS curve and determined factor in case
of shift in the IS curve.
What does the points which are outside the IS curve indicate?
IS Curve by considering points off it that is points not on the IS Curve.
Figure 4

Now, in figure 4 points E
3
and E
4
are disequilibrium points because they do not lie on the IS Curve.
What are the properties of points E
3
and E
4
? Let us first consider point E
3
. Point E
3
has the same
level of income as point E
1
, but the interest rate is lower. Therefore, the demand for investment is
higher at E
3
than at E
1
. Consequently, the aggregate demand is higher at E
3
than at E
1
. Since at E
1
,
an equilibrium point, quantity demanded is equal to quantity produced, at E
3
quantity demanded will
have to be greater than quantity produced. Thus at E
3
, have excess demand for goods and services
over what is supplied. What applies to E
3
applies to all points below the IS Curve as well. A similar
reasoning can be used to show that at all points above the IS Curve, we have excess supply of goods,
that is, aggregate demand is less than output.
THE MONEY MARKET AND LM CURVE
Money is usually demanded for to meet day to day transactions (also includes precautionary demand
for money) and the speculative demand for money. The transactions demand for money (M
1
) is
interest inelastic and depends on the level of income. On the other hand speculative demand for
money is (M
2
) interest elastic and it is a function of the rate of interest. Therefore, Speculative
demand for money is expressed as follows:
M
2
= L
2
(r)
M = M
1
+ M
2
= L
1
(Y) + L
2
(r)
In reality demand for money balances is influenced by aggregate income and price level in the
economy. Money demand considered in this model is real money balances i.e M/P. The demand for
real balances will decrease with an increase in nominal interest rate. Therefore the demand for real
money balances is determined by aggregate income and nominal interest rate:
MD/P = L(Y, i)
The equation can be transformed into a linear functional form as :
MD/P =b
0
+ b
1
Y b
2
i
Where MD is the nominal money demand, Y is the output and i is nominal interest rate,b
1
and b
2
are
the positive parameters that are estimated form the past data and b
0
captures the impact of variables
other than the real income and nominal interest which may affect the demand for money.
The equilibrium condition in the monetary sector is at the point at which demand for money is equal
to the supply of money. In such market , money demand is the function of real interest rate (r). The
ex ante nominal interest rate can be further decomposed into real interest rate and expected rate of
inflation
I = r + E ()
Money demand function can be expressed as;
MD/P =b
0
+ b
1
Y b
2
-(r + E ())
This implies that money demand and real interest rate move in opposite direction. In other words
there is inverse relationship between the two. The model considers money supply as exogenous and
does not give the determinants of money supply. The determinants of supply of money are the
policies of the government and the central bank of the country at any given point of time.
Figure 5

In the above figure the vertical line is (MS/P) is the money supply which is assumed to be
independent of real interest rate. Initially the money market equilibrium is achieved at point A,
where the demand for money balances is equal to supply of money. Incase if the real aggregate
output decreases from Y2 to Y1, the immediate impact is that the money demand curve will shift to
the left side and the demand for money for transaction purpose will fall and there will no change in
the money supply as it is determined by the central bank. Shift in the demand curve associated with
no change in the rate of interest will result in a situation where the supply of money is more than the
demand for money. As a result of this the equilibrium position will be shifted from point C to point
A and the rate of interest will decrease from r2 to r1. Panel B of the figure is constructed by taking
the combinations output and real interest interest rates for which the demand and supply of money
are in equilibrium. The curve thus obtained thus is a positive slope indicating positive relationship
between aggregate output and real interest rate and the curve is referred to as LM curve, where L
stands for liquidity and M stands for Money Supply. Further the upward sloping LM curve
indicates that equilibrium in the money market can be achieved when higher level of aggregate
output is associate with higher rate of interest .
Movement along the LM curve
Change in the output because of change in the real interest rate will result in the movement along the
LM curve. The rightward movement is referred to as extension and leftward movement is referred to
as contraction in Output. The following figure 6 represents the movement along the LM curve:
Figure 6

Shift in the LM curve
LM curve might move to the right side or left side from the original position. This situation is
referred to as shift in the LM curve which is due to other factors (Changes in money supply, changes
in the price level or changes in exogenous money demand) other than the real rate of interest.
Figure 7

1. The RBI decreases the money supply (contractionary monetary policy). Other things
remaining constant, money supply decreases relative to money demand excess demand for
money.
2. An increase in the price level. Other things remaining constant money demand increases
relative to money supply excess demand for money.
3. An exogenous positive shock to money demand e.g. worry about bank failure. Other things
remaining constant money demand increases relative to money supply excess demand for
money.
Example 1: An Increase in the Money Supply (M).
An increase in the supply of money will bring about an excess supply of money. The
excess demand can only be cleared if the interest rate falls at each level of income. As a
result of this the LM curve shifts to the right (outward).
Example 2: An Increase in the Price Level.
An increase in the given price level will raise money demand and cause an excess demand
for money. Since money supply is unchanged, this excess money demand can only be
cleared if the interest rate rises at all levels of Y. As a result of this the LM curve shifts to
the left (inward).
Figure 8

Points on the LM curve indicate a situation of the supply of money being equal to the demand for
money. What do points which do not lie on the LM Curve indicate? Do they indicate excess demand
for money or excess supply of money?
Figure 9

In figure 9, point E
1
shows the equilibrium in the money market for income level Y
1
. If there is an
increase in income to Y
2
, the demand for real balances will rise as indicated by the Curve L
2
. At the
initial interest rate i
1
, the demand for real balances would be indicated by point E
4
in figure 9(b), and
we would have an excess demand for money equal to the distance E
1
E
4
. Accordingly, point E
4
in
figure 9(a) is a point of excess demand for money.
A similar reasoning shows that at point E
3
there is an excess supply of money. More generally, any
point to the right and below the LM schedule is a point of excess demand for money, and any point
to the left and above the LM Curve is a point of excess supply.
Adjustment towards Equilibrium
Points on the IS curve indicate equilibrium in the goods market. Points on the LM Curve indicate
equilibrium in the money market. For simultaneous equilibrium in both the goods market and the
money market, point indicating such equilibrium will have to lie on both the IS and the LM Curves.
Such a point exists only at the intersection of the IS and the LM Curves. At point E in figure10, we
have simultaneous equilibrium in the goods market and the money market. At any other point than
E, we have equilibrium only in the goods market, or equilibrium only in the money market, or
equilibrium in neither markets.
Figure 10

Figure 11 shows the characteristics of various points in the interest rate (i) income (Y) plane.
Figure 11

From our discussion on the characteristics of points which do not lie on the IS and the LM curves,
we have seen that points above the IS curve indicate Excess Supply of Goods (ESG) and below it
indicate excess demand for goods (EDG); points above the LM curve indicate Excess Supply of
Money (ESM) and below it indicate Excess Demand for Money (EDM). The intersection of the IS
and LM curves results in four regions with different characteristics. These are indicated in figure11
Except for point E, all other points are dis-equilibrium points.
Goods Market Money Market
Region Disequilibrium Output Disequilibrium Interest rate
I ESG Falls ESM Falls
II EDG Rises ESM Falls
III EDG Rises ESM Rises
IV ESG Falls EDM Rises
MONETARY AND FISCAL POLICIES
We now see how the IS-LM model can help us in understanding the working of monetary and fiscal
policy. These are two main macroeconomic policy tools the government uses to keep the economy
growing at a reasonable rate, with low inflation. Fiscal policy has its initial impact in the goods
market, and monetary policy has its initial impact mainly in the assets market. But, because the
goods and the assets markets are closely interconnected, both monetary and fiscal policies have
effects on both the level of output and interest rates.
Monetary Policy
Let us now see a bit more closely how monetary policy works. See Figure 12
Figure 12

The initial equilibrium at point E is on the initial LM schedule that corresponds to a real money
supply LM. Suppose now that the nominal quantity of money is increased, for example by open
market operations. Given a constant price level, the real quantity of money increases as the nominal
quantity of money increases. As a result of the increase in the real quantity of money, the LM
schedule shifts to LM
1
.
For the new schedule LM
1
, the equilibrium will be at point E
1
with a lower rate of interest and a
higher level of income.
Let us see a bit more closely how with an expansion in real money supply the economy moves from
the original equilibrium at E to the new equilibrium at E
1
. At the initial equilibrium point, E, the
increase in money creates an excess supply of money. The public tries to adjust to the excess supply
of money by buying financial assets. As a result of the increase in demand, the price of financial
assets rises, and thus the yields decline. The adjustment process in the assets markets is much more
rapid than that in the goods market and, therefore, we move immediately to point E
l
when the money
supply increases. At E
1
the money market clears and the public is holding larger quantity of real
money because the interest rate has declined sufficiently. At point E
1
, however, there is an excess
demand for goods. The decline in the interest rate, given the initial income level Y
0
, raises aggregate
demand and thus causes inventories to run down. In response, the output expands and we start
moving up the LM
l
schedule. As output expands, the interest rate rises (after the immediate decline
in interest rate when money supply is increased) because increase in output raises the demand for
money and the increase in demand for money has to be checked by higher interest rates.
The Transmission Mechanism
The mechanism by which the changes in monetary policy affect aggregate demand is called
transmission mechanism. Two stages in transmission mechanism are important. First is that an
increase in real money supply causes a portfolio disequilibrium at the prevailing interest rate and
level of income, i.e., people are holding more money than they want. They try to get rid of the
excess money they are holding by buying financial assets. This action of theirs pushes up the price
of financial assets and thus causes the interest rate to fall.
The second stage of the transmission process occurs when the change in interest rate affects
aggregate demand. The fall in interest rates induces an increase in investment expenditure, and also
possibly consumption expenditure, thereby increasing the aggregate demand and ultimately the
income.
Fiscal Policy
An Increase in Government Spending:
Figure 13

Let us examine how an increase in government spending affects the interest rate and the level of
income. When government spending increases, at unchanged interest rates, the level of aggregate
demand increases. To meet the increased demand for goods, output must rise as shown by a shift in
the IS schedule in
figure 13.
If the economy is initially at point E, an increase in government spending would shift the economy
to point E
ll
if the interest rate remained constant. At E
ll
, the goods market is in equilibrium but the
money market is no longer in equilibrium. Because of the increase in income, the quantity of money
demanded goes up, which in turn pushes up the interest rate. With interest rate rising, firms planned
investment spending declines and the aggregate demand begins to fall from the high level it reaches
immediately on increase in the government spending. The economy finally reaches its new
equilibrium at point E
1
where both the goods market and the money market are in equilibrium. As
compared to point E, at point E
1
the level of income is higher and so is the interest rate. Thus, an
increase in government spending results in an increase in the level of income and an increase in the
interest rate.
Crowding Out
See figure 12 again. Point E
ll
corresponds to the equilibrium when we neglect the impact of interest
rates on the economy. In comparing E
ll
and E
1
, it becomes clear that the interest rates and their
impact on aggregate demand dampen the expansionary affect of government spending.
Income, instead of increasing to the level of Y
ll
, rises only to
1
0
Y . This happens because the increase
in interest rate from i
0
to i
1
reduces the level of investment spending. We say that the increase in
government spending crowds out investment spending. Crowding out occurs when expansionary
fiscal policy causes interest rates to rise, thereby reducing private spending, particularly investment.
Is there a way to avoid crowding out of private investment as a result of expansionary fiscal policy?
Yes, there is. The key is to prevent the interest rates from rising when government spending is
increased. This can be done by an increase in the money supply. The monetary authorities can
accommodate the fiscal expansion by an increase in the money supply. Monetary policy is
accommodating when, in the course of a fiscal expansion, the money supply is increased in order to
prevent the interest rates from increasing.
See figure 14. A fiscal expansion shifts the IS curve to IS
l
and moves the equilibrium of the
economy from E to E
ll
. At E
ll
, though the income is higher than at E, the IS interest rate is also
higher than at E and rises from i
0
to i
ll
, thereby crowding out investment spending. But an increase in
the money supply shifts the LM curve to LM and the equilibrium of the economy to E
1
. The
interest rate remains at i
0
, thereby avoiding crowding out of investment, and the level of output rises
to Y
l
.
Figure 14