IS-LM Model

The IS LM Model explained

The best way to revise a concept is to write about it! Paul Krugman has this description of the IS (investment-savings)-LM (liquidity preference-money supply) model that examines the interaction between the market for goods and services and the money market,

My favorite approach is to think of IS-LM as a way to reconcile two seemingly incompatible views about what determines interest rates. One view says that the interest rate is determined by the supply of and demand for savings – the “loanable funds” approach. The other says that the interest rate is determined by the tradeoff between bonds, which pay interest, and money, which doesn’t, but which you can use for transactions and therefore has special value due to its liquidity – the “liquidity preference” approach...

loanable funds or liquidity preference doesn’t determine the interest rate per se; they determine a set of possible combinations of the interest rate and GDP, with lower rates corresponding to higher GDP... the adjustment of GDP is what makes both loanable funds and liquidity preference hold at the same time.

Let us analayze both models. Consider the loanable funds first. As interest rates fall (for whatever reason), investment increases, economy expands, and income levels increase. Atleast some portion of increased income will be saved, thereby expanding the savings pool available. A new interest rate equilibrium develops at this lower rate level between investment demand and savings available. The IS curve "determines a set of possible combinations of the interest rate and GDP, with lower rates corresponding to higher GDP" (therefore downward slope for the IS curve).

Now for the liquidity preference model. People make trade-offs (assuming the same risk, between returns and liquidity) when they take decisions to allocate their wealth between different investment and savings options (specifically between money and bonds). For a particular instrument, if its returns rise, people become willing to settle for lower liquidity. If the central bank wants to increase the money supply (cash balances with people), it must lower interest rates so as to induce people to increase their preference for liquidity.  The liquidity preference curve is thererefore downward sloping.

In the market for money supply (from central banks and passed on through commercial banks) and money demand (or liquidity preference), the former is vertical (in the short run, central banks can hold the money supply constant, even without changing the interest rate) while the latter is downward sloping. An increase in GDP, as indicated in the graphic above, will result in greater number of spending transactions, higher demand for money, and therefore a shift in the liquidity preference function outward. If the real money supply (supply adjusted for inflation) is held constant and the market has to equilibriate, the higher demand for money will have to be accompanied by an increase in interest rates. The LM curve, which is the set of all possible combinations of the interest rate and GDP where the money supply and demand matches, therefore slopes upward.

At the equilibrium of IS-LM graph, the loanable funds (goods/services market) and liquidity preference (money market) are in balance. Now let us examine the effects of fiscal and monetary policy on the economy by using the IS-LM model. Fiscal Policy first. Anything which causes a change in consumption, government spending, or investments, will shift the IS curve. A rise in Government investment spending, by increasing the demand for goods at the same interest rate, has the effect of pushing the IS curve to the right. This in turn increases the aggregate demand and therefore the GDP. However, interest rates have to increase so as to equilibriate between the loanable funds and liquidity preferences.

The classical economists refute this and argue that the resulting higher interest rates will eventually crowd-out private consumption and investment, thereby putting downward pressure on the growth of economic output. Further, the higher government spending will trigger inflationary pressures, which in turn will shift the LM curve inwards, thereby raising interest rates. These twin dangers, they contend, will invariably strangulate growth. 

Similarly with monetary policy, as the money supply is increased, the LM curve shifts outward or downward. This in turn will lower interest rates, spur investments and consumption, and raise national income.

In both cases, exogenous shocks/events can lead to changes in liquidity preference and demand for savings, which in turn can shift the LM or IS curves respectively. However, in the long-run, prices/wages adjust to return the real money supply curve (and thereby the LM curve) backwards to its original position. It is therefore argued that the long-run impact of any change in monetary policy is minimal. But the fine print of the debate is about the magnitude of the adjustment in prices/wages and the time taken for this adjustment (or what constitutes long-term). Classicists claim that prices adjust quickly whereas Keynesians argue that prices are sticky.

Similarly, when the economy faces conditions like the present situation - frozen credit markets, reduced investment and consumption apetite, very high unemployment rate, and zero interest rate bound - many of the standard assumptions of classical economics breaks down. In the circumstances, government is the only agent with the ability to pull the economy. Further, since the economy is operating way below its potential output frontier, large pool of labour unemployed, and aggregate demand heavily constrained by lack of purchasing power, an increase in money supply is not going to lead to inflationary pressures. Also, at the zero-bound, since cash and bonds become interchangeable, at the margins, money is just being held as a store of value, and changes in the money supply have no effect.

See this excellent presentation of the IS-LM model and also thisnice description.

The above is from here - an excellent blog to follow

Of course if you would like to get complicated and look at modern macroeconomic phenomena...

Here are some notes you may wish to print out on the IS-LM curve...

Lastly...a video

Liquidity Preference Theory

According to Keynes interest is purely a monetary phenomenon because rate of interest is calculated in terms of money. 

It is a monetary phenomenon in the sense that rate of interest is determined by the supply of and demand for money, Keynes defined interest as the reward for parting with liquidity for specified time. 

What is liquidity preference:- 

Liquidity means shift ability without loss. It refers to easy convertibility. Money is the most liquid assets. Money commands universal acceptability. Everybody likes to hold assets in form of cash money. If at all they surrender this liquidity they must be paid interest. As water is liquid and it can be used for anything at will, so also money can be converted to anything immediately.  

Other costly assets like gold and landed property may be valuable but they cannot be shifted at will. 

Thus they lack liquidity. 

As money are highly liquid people to hold money with than in form of Cash. This preference according to Keynes is popularly called liquidity preference. 

Thus according to Keynes interest is the price paid for surrendering their liquid assets. Greater the liquidity preference higher shall be the rate of interest. The liquidity preference constitutes the demand for money. According Keynes rate of interest is demand by the supply of and demand for money. The rate of interest on the demand side is governed by the liquidity preference of the community arises due to the necessity of keeping cash for meeting certain requirements. 

The demand for liquidity arises due to three motives. 

Demand for money: 

(a) The transaction motive:- An individual for his day to day transaction demand money. A man has to buy food and medicines in his day to day life. For this purpose people want to keep some cash with them. The amount of cash which an individual will require to keep in his possession depends on two factors (i) the size of personal income and (ii) the length of the time between pay-days. The richer a community the greater the demand for transaction motive.

(b) The precautionary motive: People demand to hold money with them to meet the unforeseen contingencies. An individual may become unemployed; he may fall sick or may meet serious accident. For all these misfortune, he demands money to hold with him. The amount of money under the precautionary motive depends on the individual's condition, economic as well as political which he lives. Thus the demand for money under this motive depends on size of income, nature of the person and farsightedness. 

(c) Speculative motive: Under speculative motive people want to keep each with them to take advantage of the charges in the price of bonds and securities. People under speculative motive hold money in order to secure profit from the future speculation of the bond market. If the prices of bonds and securities are expected to rise speculative will like to buy them. In such a situation the demand to hold cash diminishes. Thus liquidity preference will be more at lower interest rates. 

Money under the above three motives constitute the demand for money. 

An increase in the demand for money leads to a rise in the late of interest, a decrease in the demand for money leads to a fall in the rate of interest. According to Keynes the first two motives for liquidity preference namely the transaction and precautionary are interest inelastic. That is why the speculative motive is important in the sense that speculative motive is interest elastic. 

Supply money: The supply of money is different from the supply of ordinary commodity. The supply of commodity is a flow whereas the supply of money is a stock. The aggregate supply of money in a community at any time is the sum of money stock of all the members of the society. The supply of money is controlled by the govt. The supply of money in existence consists of legal tender money, bank money and credit money. The supply of money is determined by the central bank of a country. The total supply of money is fixed at a particular point of time. The supply of money is not influenced by the rate of interest. 

Equilibrium rate of interest: The rate of interest is determined by the demand for money and supply of money. The equilibrium rate of interest is fixed at that point where supply of and demands for money are equal. If the rate of interest is high peoples demand for money (liquidity preference) is low. The liquidity preference function or demand curve states that when interest rate falls, the demand to hold money increases and when interest rate raises the demand for money, diminishes. The determination of the rate of interest can be better explained in the shop. 

Now here's a practical part - draw your own diagram for the details below!

 In the above figure OX-axis measures the supply of money and OY-axis represents the rate of interest. The LP curve represents liquidity preference curve. This curve represents the demand for money at various rate of interest. The total supply of money is represented by a vertical line Ms. The equilibrium rate of interest is determined at that level. Where the demand for money is equal to supply of money. Given the demand for money when supply of money rises, rate of interest falls to OR. With a fall in money supply rate of interest rises. Similarly the liquidity preference may change given the supply of money. When liquidity preference shifts upward, given the supply money at the level on the rate of interest rises to the level OQ. Thus according to Keynes interact is purely a monetary phenomenon.

Source is here

Now watch a video....


 

Now read some more notes... 

KEYNES’ LIQUIDITY PREFERENCE THEORY OF INTEREST 

Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time. According to him, the rate of interest is determined by the demand for and supply of money. 

Demand for money: Liquidity preference means the desire of the public to hold cash. According to Keynes, there are three motives behind the desire of the public to hold liquid cash: (1) the transaction motive, (2) the precautionary motive, and (3) the speculative motive. Transactions Motive: The transactions motive relates to the demand for money or the need of cash for the current transactions of individual and business exchanges. Individuals hold cash in order to bridge the gap between the receipt of income and its expenditure. This is called the income motive. The businessmen also need to hold ready cash in order to meet their current needs like payments for raw materials, transport, wages etc. This is called the business motive.  

Precautionary motive: Precautionary motive for holding money refers to the desire to hold cash balances for unforeseen contingencies. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. Keynes holds that the transaction and precautionary motives are relatively interest inelastic, but are highly income elastic. 

The amount of money held under these two motives (M1) is a function (L1) of the level of income (Y) and is expressed as M1 = L1 (Y) Speculative Motive: The speculative motive relates to the desire to hold one’s resources in liquid form to take advantage of future changes in the rate of interest or bond prices. Bond prices and the rate of interest are inversely related to each other. If bond prices are expected to rise, i.e., the rate of interest is expected to fall, people will buy bonds to sell when the price later actually rises. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, people will sell bonds to avoid losses. 

According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for money as M2 = L2 (r) Where, L2 is the speculative demand for money, and r is the rate of interest. Geometrically, it is a smooth curve which slopes downward from left to right. Now, if the total liquid money is denoted by M, the transactions plus precautionary motives by M1 and the speculative motive by M2, then M = M1 + M2. Since M1 = L1 (Y) and M2 = L2 (r), the total liquidity preference function is expressed as M = L (Y, r). 

Supply of Money: The supply of money refers to the total quantity of money in the country. Though the supply of money is a function of the rate of interest to a certain degree, yet it is considered to be fixed by the monetary authorities. Hence the supply curve of money is taken as perfectly inelastic represented by a vertical straight line. Determination of the Rate of Interest: Like the price of any product, the rate of interest is determined at the level where the demand for money equals the supply of money. In the following figure, the vertical line QM represents the supply of money and L the total demand for money curve. Both the curve intersect at E2 where the equilibrium rate of interest OR is established. 

 If there is any deviation from this equilibrium position an adjustment will take place through the rate of interest, and equilibrium E2 will be re-established. At the point E1 the supply of money OM is greater than the demand for money OM1. Consequently, the rate of interest will start declining from OR1 till the equilibrium rate of interest OR is reached. 

Similarly at OR2 level of interest rate, the demand for money OM2 is greater than the supply of money OM. As a result, the rate of interest OR2 will start rising till it reaches the equilibrium rate OR. It may be noted that, if the supply of money is increased by the monetary authorities, but the liquidity preference curve L remains the same, the rate of interest will fall. If the demand for money increases and the liquidity preference curve sifts upward, given the supply of money, the rate of interest will rise. 

Criticisms: Keynes theory of interest has been criticized on the following grounds: 

1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest. 

2. Liquidity preference is not the only factor governing the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of investible funds. 

3. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time. 

4. Keynes ignores saving or waiting as a means or source of investible fund. To part with liquidity without there being any saving is meaningless. 

5. The Keynesian theory only explains interest in the short-run. It gives no clue to the rates of interest in the long run. 

6. Keynes theory of interest, like the classical and loanable funds theories, is indeterminate. We cannot know how much money will be available for the speculative demand for money unless we know how much the transaction demand for money is.

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