Shift in IS Curve, LM Curve and Their Effect on Equilibrium Income

Shift in IS curve and effect on equilibrium income

The IS curve shows the real interest rate which clears the goods market for any level of output. With output held constant, any economic fluctuations or policy change that change the value of goods market clearing interest rate will cause IS curve to shift. More precisely, with output constant, any economic changes that reduce desired national saving relative to desired investment will increase the interest rate that clears good market and thus shift the IS curve up. On the other hand, with constant output, any change in the economy that increase desired national saving relative to desired investment will reduce good market clearing interest rate thereby shifting the IS curve down.

Factors that shift the IS curve are described below:

Expected future output: An increase in expected future income causes an increase in desired consumption which causes a decrease in desired saving. Reduce in desired saving result in an increase in real interest rate which shifts the IS curve up. Decrease in expected future output, on the other hand, shifts the IS curve down.

Wealth: An increase in wealth causes an increase in desired consumption which causes a decrease in desired saving. Reduce in desired saving result in an increase in real interest rate which shifts the IS curve up. The decrease in wealth, on the other hand, shifts the IS curve down.

Government purchases: An increase in government purchases result and increase in demand of goods. As a result desired saving falls which rise the goods market clearing real interest rate causing the IS curve to shift up. In contrast, a decrease in government purchases shifts the IS curve down.

Taxes: When tax increases, the desired consumption decreases and saving increases causing the real interest rate to decline. This shifts the IS curve down.

Expected future marginal product of capital: Increase in expected future marginal product of capital increase desired investment raising the real interest rate. As a result IS curve shifts up. When expected the future marginal product of capital decreases, the IS curve shifts down.

Effective tax rate on capital: Increase in the effective tax rate on capital increase desired investment raising the real interest rate. As a result, IS curve shifts up. When effective tax rate on capital decreases, the IS curve shifts down.

Graphical representation of shift in IS curve

The shift in IS schedule is caused by the shift in investment schedule. Let us suppose that the investment schedule shifts from I₁ to I₂ as shown in the figure. The shift in investment schedule implies an increase in investment. For interest rate i₂ the I-schedule shifts upward i.e. the investment increases from OI₁ to OI₂. Similarly, at interest rate i₂, investment increases for OI₂ to OI₃.

With the increase in investment, the saving increases from OS₁ to OS₂ at interest rate i₂ and OS₂ to OS₃ at interest rate i₁. This rise in investment and saving will increase equilibrium level of output from OY₁ to OY₂. By linking new level of income and corresponding rates of interest, we get a new IS curve IS₂.

Shift in general equilibrium

At the initial condition, the products, as well as money market, were in equilibrium at point E where IS₁ and LM curve intersected. At point E, the rate of interest is i₁, equilibrium income is Y₁, with I = S and M_d = M_s. Now let the IS curve shift upward causing a shift in general equilibrium from E to A. The interest rate increases from i₁ to i₂ and income from Y₁ to Y₂ at equilibrium A. The upward shift in IS indicates the increase in investment and hence income also increase. As a result saving increase and transaction demand for money also increases.

The reverse case applies when IS curve shift downward from IS₁ to IS₀ moving the equilibrium point from E to B.

Shift in LM curve and effect on equilibrium income

In deriving LM curve the output was varied but the other factors such, price level that affects the money market-clearing real interest rate, were held constant. Change in any of these factors causes the shift in LM curve. More specifically, with output held constant, any change that reduces real money supply relative to real money demand will increase the real interest that clears money market and the LM curve shifts up. On contrary, with output held constant, rise in real money supply in relative to real money demand will decrease interest rate and LM curve shifts down.

Factors that shift the LM curve are described below:

Nominal money supply: Increase in nominal money supply increases real money supply lowering the real interest rate that clears the money market. As a result, LM curve shifts down. Similarly, the LM curve shifts up when nominal money supply decreases.

Price level: An increase in price level lowers the real money supply rate raising the interest rate that clears money market. As a result, LM curve shifts up. Similarly, decrease in price level shifts LM down.

Expected inflation: An increase in expected inflation will decrease the demand for money lowering real interest rate that clears money market. The IS curve shifts down.

Nominal interest rate on money: An increase in nominal interest rate on money will increase the demand for money raising real interest rate that clears money market. The IS curve shifts up.

Shift in LM curve

Let us examine the upward shift in LM curve. The LM curve shifts upward due to following reasons: increase in demand for money, decrease in the supply of money, decrease in transaction demand for money.

The shift in LM curve due to shift in M_sp curve is illustrated below. At the initial condition the M_Sp1 is given at interest rate i₂, demand for money OL and transaction demand for money OR. Suppose interest remain stable at i2 and demand for money increases from OL to OK. This causes a shift of M_sp1 to M_sp2. Therefore at given money supply, transaction demand decreases by same amount i.e. when speculative cash balance increases by LK, the transaction demand for money decreases by RQ.

Similarly, change in money supply also shifts the LM curve. If the money supply decreases, remaining all other things constant, TV line shifts inward. As a result, M_t decrease and M_sp remains constant. This will cause the LM curve to shift upward from LM₁ to LM₂. In the same case, increase in money supply cause LM curve to shift downward.

Change in M_t also results in a shift of LM curve. Since M_t = kY. A change in k changes M_t. Increase in k shifts LM rightward and vice-versa.

Shift in general equilibrium

Initially the product market and money market are in equilibrium at point A, where interest rate is i₀, Y = Y₀, I = S, M_d = M_s. Due to increase in money supply the LM curve shifts from LM₀ to LM₁. When money supply increases it leads to excess liquidity. The excess liquidity finds its way into bond and security market. As a result, bond and security price goes up and interest rate falls down. This induces new investment and increase in income which leads to increase in transaction demand for money. New equilibrium point is formed at point B. The interest rate decreases to i₁ and income increase to y₂.

Similarly when money supply decrease, LM curve shifts leftward from LM₀ to LM₂ forming new equilibrium at point C.

Shift in IS and LM curves and simultaneous effect on equilibrium income

For simplicity, let us assume the both LM and IS curve shift in the same direction. Suppose the initial IS and LM curve are IS₁ and LM₁ respectively. These curves intersect at equilibrium E₁ at interest rate i₁ and income Y₁. Now, let the IS curve shift from IS₁ to IS₂ and LM curve from LM₁ to LM₂ which intersects at point E₂. The general equilibrium shifts from E₁ to E₂, income from Y₁ to Y₂ interest rate remaining the same. The magnitude of shift in IS and LM curve is same and hence the interest rate did not change. But in reality, the magnitude of shift of these curves is not same and hence there will be different interest rates. For instance, the LM curve shifts from LM₁ to LM₂ and IS curve shifts from IS₁ and IS₂, where equilibrium shifts to E₄ rising interest rate from i₁ to i₂ with new level of income Y₃. For the interest rate to be same i.e. i₁, the LM curve needs to shift to LM₃ and intersect with IS₃ at point E₃.

If the IS and LM shift in opposite direction, the interest rate and income depend on both the direction and magnitude of the shift. For instance, if IS₂ shifts to IS₃ and LM₂ shifts to LM₁, the new equilibrium will be formed at point E₅ which indicates a high increase in interest rate and fall in income below Y₂.

References

Dwivedi, D. N. (2010). Macroeconomic theory and policy. New Delhi: Tata McGraw-Hill Education.

Bernake and Abel , Macroeconomics, Singapore, Pearson Education latest edition