The IS-LM model is also known as investment-savings and liquidity-money. In Keynesian economics, the model represents how the market for economic goods (IS) interacts with the money market (LM). Both lines intersect and that represented the short-run equilibrium between interest rates and output.
In 1937, the IS-LM model was introduced by economist, John Hicks. This was one year after economist, John Keynes, published “The General Theory of Empowerment, Interest and Money” (Kenton, 2019). Hicks model was formed as a graphical representation of Keynes theories. The IS-LM graph, examines the relationship between real output, or GDP, and nominal interest rates. All in all, the economy is based on markets, output and money, and their respective supply and demand characteristics push the economy towards an equilibrium point.
If the IS-LM graph displays the IS curve slope downward and to the right. This represents that the level of investment and consumption is negatively correlated with the interest rate, but positively correlated with gross output. When the LM curve is sloped upwards it represents that the quantity of money demanded is positively correlated with the interest rate and it increases the overall total spending or income. “Gross domestic product (GDP), or (Y), is placed on the horizontal axis, increasing as it stretches to the right. The nominal interest rate, or (i or R), makes up the vertical axis.” DSGE stands for dynamic stochastic general equilibrium models. IS-LM curves are made up of all the same components as DSGE.
There are a few pros of the IS-LM curve, it is very easy to understand and explain. It is used to explain Keynesian macroeconomics at a simple level, so someone who is not familiar with the subject can understand. It is also a good way to introduce monetary policy-making. A few cons of IS-LM curve are there are several factors that are not taken into account. Such as, international trade, demand, and capital flows. IS-LM is a simple curve, which could be a con because Central banks prefer to control interest rates on the open market. This is done through the securities and bonds and the IS-LM curve does not measure those aspects. Another con is the IS-LM represents little information about international trade and does not provide advice or recommendations on government spending.
The Federal Reserve moves the LM curve by printing more money. When the Federal Reserve prints more money, the less aggressive banks are recommended to raise interest rates. By doing this, the LM curve will shift outward. When the LM curve shifts, a new point is formed where the interest rate is lower and the economy has more money. The Federal Reserve has the power to control GDP level. There are both pros and cons to the Fed printing more money. A negative impact of printing more money is that inflation rates will increase and cause the IS curve to shift inwards. The result is that when the interest rates rise, the economy is prone to slowing down (MasterClass, 2018). In some cases, this can also result in high rates of inflation and minimal GDP growth in the economy.
The effectiveness of monetary and fiscal policy is different depending on what economist is being researched. “The monetarists regard monetary policy more effective than fiscal policy for the economic stabilisation” (MasterClass, 2018). However, under Keynesian macroeconomics the economists have different views. The monetary policy is when the government influences investments, employment, output and income. Monetary supply is done by increasing or decreasing the money supply by the monetary authority (Federal Reserve). Expansionary monetary policy is when the money supply is increased (shown by shifting the LM curve to the right). Contractionary monetary policy is when the monetary supply is decreased (shown by shifting the LM curve to the left). **insert figure**
Source: (Chand, 2014).
The effectiveness of monetary policy is dependent on the shape of the LM curve and the IS curve. “Monetary policy is more effective if the LM curve is steeper” (source). Which means the demand for money is not dependent on the interest elastic. The less interest elastic, the larger the fall in interest rate is when the money supply is increased (source). “When the demand for money is less elastic to a change in interest rate, an increase in the money supply is more powerful in the bringing about a large fall in the interest rate” (Chand, 2014).
If the LM curve is horizontal the monetary policy is completely ineffective because the demand for money is perfectly interest elastic. Which can cause a liquidity trap, a liquidity tap is when the increase in money supply has no effect on the interest rate or income level.
The fiscal policy is also when the government influences investment, employment, output and income in the economy. When expansionary fiscal policy occurs, the government increase its expenditure and reduces taxes. This results in shifting the IS curve to the right. Contractionary fiscal policy occurs by reducing its expenditure and increases taxes (Chand, 2014). This results in shifting the IS curve to the left. The effectiveness of fiscal policy depends on the slope of the IS and LM curve. When the LM curve is flatter, fiscal policy is more effective and less effective when the curve is steeper. Government expenditures increase when the IS curve shifts upwards to IS1 and its impact occurs when the LM curve is flatter than with the steeper LM curve.
According to Bloomberg.com, “Typically, during an economic expansion, central governments try to restrain spending and raise taxes to pay down debt accumulated during recessions — at least that’s the theory” (Cowen & Smith, 2018). Tyler Cowen stated, “With support from Congress, [Trump Administration] has plans to raise the federal debt and deficit. I’ve seen the estimates that the tax-cut bill will add at least $1 trillion to the debt over a 10-year period, and for over the next two years Congress just approved about $500 billion in new spending” (Cowen & Smith, 2018). From this it is evident that Republicans and conservatives are more sympathetic to deficits than they used to be. Noah stated,
“Fiscal policy is always going to be political. I think of it like a game-theory equilibrium — as long as everyone believes that deficits raise growth in the short-term, anyone with a partisan slant is going to push for deficits while their party is in power and push for austerity when their party is out of power. Of course, this means the debt will tend to rise over time.”
It is possible that if debt gets high over a short period of time, it will start undermining businesses confidence and will impact the economy.
According to Fortune.com, “In Trump’s first three full quarters in the White House, GDP clocked growth just shy of his vaunted goal of 3%, a performance that by recent standards looks stellar. The stock market has added a quarter to its value since the election, a $5 trillion vote of confidence” (Tully, 2018). Based on statistics, under the Trumpian era the economy has been somewhat stable. However, “By 2028, America’s government debt burden could explode from this year’s $15.5 trillion to a staggering $33 trillion—more than 20% bigger than it would have been had Trump’s agenda not passed” (Tully, 2018). This would mean that federal revenue would absorb $1 in $5. The economy is not able to grow fast enough to not take a giant hit by US debt. A high debt will limit our economy even more and will prevent the US from focusing on other aspects of the economy.
“If the U.S. slips into recession, we’ll lack the option of lowering taxes or increasing spending on infrastructure, for example, as tools to revive growth. And as the debt load grows, efforts by the Federal Reserve to stimulate the economy with lower rates would be more likely to feed runaway inflation” (Tully, 2018).
In this quote it says, the U.S. will have a hard time lowering taxes and improved infrastructure because they will have to focus on the interest rates and inflation and try to stimulate the economy as a whole.
According to Powell, he told Congress in his testimony, that lawmakers should address “unsustainable” debt and find ways to get more Americans working again. Although the economy is growing at a solid pace, there have been crosscurrents and conflicting signals in the past year. “The Fed expects the U.S. economy to grow 2.3 percent in 2019. The Fed estimated that it grew just shy of 3 percent last year, the fasted annual pace in more than a decade but below President Trump’s goal” (Long, 2019). Trump’s goal was to grow the economy 4% a year. When Powell met with the Congress, they questioned him on how to get higher wages and how to get more Americans working. Powell said it is a troubling concern that the U.S labor force participation is so low compared to other countries. He has mentioned not being happy with Trump for raising the interest rates four times last year. However, he said that now is a “good time to be patient and watch and wait” (Long, 2019). The Fed is watching the economy closely with future impacts of the European and Chinese economies.
Mr. Powell’s main focus is the monetary policy and the course of action if a recession were to hit the U.S. His biggest challenge is, “Powell’s biggest challenge, then, is planning now to avoid any serious policy mistakes that could lead to a recession or leave the Fed badly positioned to control the money supply if one hit” (Lawler & Kaster, 2018). Another challenge is the management of the Fed’s regulations and supervision of central banks. Powell said in a statement, “supports the basic framework for regulation put in place by the 2010 Dodd-Frank financial reform law and other post-crisis rules” (Lawler & Kaster, 2018). He has given no signs that he will substantially repeal Dodd-Frank through regulation. Instead his plans are to make minor adjustments to lower regulatory burdens and small and mid-sized banks.
Overall, the IS-LM curves give economists information about the economy. However, it is not enough information to predict if a recession will occur. There are several different factors and economists should look at all inputs and outputs. Economists should not replace the Keynesian monetary theory.
2019-2-26-1551219720