Economics Web Institute - Essay: A graph representation of IS-LM model

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A GRAPH REPRESENTATION OF A BASIC MACROECONOMIC SCHEME: THE IS-LM MODEL

by Valentino Piana (1998-2001)


	Contents
	1. Introduction to our graph representation
	2. The rules
	3. The scheme
	4. Reading the scheme: two examples
	4.1. Export-led growth
	4.2. Fiscal cuts
	5. The advantages of this representation
	Appendix 1. Justification for signs in relationships
	Appendix 2. Introduction for absolute beginners
	If you have never heard of IS-LM model click here. Freely modifiable MS Word version of the graph. Data for all the variables in IS-LM model
	*Appendix 1.* *Justification for signs in relationships* The IS-LM model relies on positive and negative relationships between macroeconomic variables. In order to describe the subsequent changes provoked by an initial shock, you just read the graph representation, following the arrows. You formally do not need to know the reason why two variables go in the same or in the opposite direction. The formal model and its graph representation works without justifications. Still, to economically understand what is happening, it is useful to know the justifications, also in order to judge the strength and the speed of the relationship. Here we present a standard and simplified (sometimes simplistic) justification for those relationships that are considered within the IS-LM model. Sign "plus" on the arrow: a movement in a direction in the first variable provokes a movement in the same direction in the second one. Sign "minus" on the arrow: a movement in the first variable provokes a movement in the opposite direction in the second one. All comments take the starting point of an increase in the first variable. If you starts from the opposite point of view (a fall), the same considerations will bring you to opposite conclusions.

	Income		Consumption
	Higher income means that people are richer, thus they will additionally spend a part of this new income.
	Consumption		Income
	Income (GDP) is equal to the sum of consumption, investment, public expenditure and net export (exports less imports, also known as "trade balance"). Any increase in one in its components, the others being equal, will raise GDP by the same amount.
	Income		Savings
	Higher income means that people are richer, thus they additionally save the part of this new income that has not been spent in consumption. In IS-LM model, the households can use their income only for consumption or savings by definition. Income = Consumption + Savings.
	Income		Tax revenue
	Higher income means wider tax base for direct tax on people's income. At the same tax rates, this improves the tax revenue.
	Public expenditure		Income
	Income (GDP) is equal to the sum of consumption, investment, public expenditure and net export (exports less imports, also known as "trade balance"). Any increase in one in its components, the others being equal, will raise GDP by the same amount.
	Investment		Income
	Income (GDP) is equal to the sum of consumption, investment, public expenditure and net export (exports less imports, also known as "trade balance"). Any increase in one in its components, the others being equal, will raise GDP by the same amount.
	Income		Real interest rate
	The increase of income brings together an increase in volume of transactions. Money, the means of payments settlement, is more and more demanded. But if the supply of money (to which the demand must be equal) is unchanged, something should counteract the growth in demand: the interest rate should rise, in order to "tame" demand for money. In fact, in a simplified world where people can choose only between money and bonds, an increase of the interest rate on bonds will make them more attractive, reducing the demand for money.
	Income		Imports
	Higher income means more purchasing power for foreign goods. People are richer and demand more foreign consumption goods.
	Exports		Income
	Income (GDP) is equal to the sum of consumption, investment, public expenditure and net export (exports less imports, also known as "trade balance"). Any increase in one in its components, the others being equal, will raise GDP by the same amount.
	Income		Employment
	The higher the production, the higher the number of people required for productive processes.
	Employment		Unemployment
	The more people find a job, the fewer the jobless.
	Unemployment		Wages
	If unemployment increases, the workers will accept lower wages, both in individual negotiations and in collective bargains.
	Wages		Price level
	The higher the wages, the higher the cost for firms to produce. Firms will increase their prices, hence the general price level.
	Price level		Real exchange rate
	Given a certain price level abroad and a certain nominal exchange rate, an increase in domestic price level will make more expensive for foreigners to buy our goods.
	Real exchange rate		Exports
	A higher real exchange rate means that domestic goods are more and more expensive. Thus foreign buyers will more and more renounce to domestic goods.
	Real exchange rate		Imports
	A higher real exchange rate means that domestic goods are more and more expensive. Thus domestic buyers will more and more prefer foreign "cheaper" goods. The same is true both whether the increase in real exchange rate is due to an increase of domestic general price level or to the nominal exchange rate.
	Nominal money supply		Real money supply
	Real money supply is computed as the nominal one divided by the price level. Thus, any increase of nominal supply will increase the real one, given a certain level of prices.
	Real interest rate		Nominal exchange rate
	In a free-floating system, the exchange rate will be determined by demand and supply of domestic currency. An increase in real interest rate makes domestic bonds more attractive for foreigners (since they are more profitable than before). Accordingly, there will be an inflow of foreign capital directed to domestic bonds. This means an increased demand for domestic currency, which will increase its "price": the nominal exchange rate.
	Nominal exchange rate		Real exchange rate
	Real exchange rate is computed as the nominal one divided by the price level. Thus, any increase of nominal exchange rate will increase the real one, given a certain level of prices.
	Imports		Income
	The larger the imports, the less the domestic production finds a buyer, other things equal.
	Price level		Real money supply
	Real money supply is computed as the nominal one divided by the price level. Thus, any increase of prices will reduce the real money supply, given a certain level of nominal one.
	Real money supply		Real interest rate
	An increase in supply always reduce the price, if demand stay at the same level. Employing this quite general rule, an increase of real money supply reduces the "price" of money, i.e. the real interest rate.
	Real interest rate		Investment
	Firms decide their investments looking at perspective profits and discounting their future values to present one. Higher interest rate means a lower present value of future profits. Moreover, the higher interest increases the cost of capital. Thus, lower profitability and higher costs depress investment.

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