Since we know the rate of interest which produced the aggregate demands curves AD0, AD1 and AD2, we also know the rates of interest which produced the incomes E0, E1 and E2. We can therefore plot rates of interest against income, which will give us the IS schedule shown below.
The LM curve is similarly derived, beginning from a graph of the money demand schedule. We know that for any given level of income there will be a certain amount of money demand, which will depend on the interest rate. A change in the level of income will lead to a change in height of the money demand schedule. If income rises, money demand will be higher. If income falls, money demand will be lower. Money demand depends to a large extent on the interest rate; if interest rates are low, then more money is demanded. The graph below shows several money demand curves.
Since we know the level of income which generated curves L0, L1 and L2, we also know the level of income which is associated with each of the equilibrium rates of interest, r0, r1 and r2. Therefore, it is possible to plot income against interest ratesfor the money market, giving an LM schedule like the one below.
The IS and LM schedules can then be plotted on the same axes to show the levels of income and interest which will lead to equilibrium in both the money market and the goods market. On this graph, an example of which is shown below, it is shown that the goods market is in equilibrium at any point on the IS schedule and the money market is in equilibrium at any point on the LM schedule, but there is only one point, E, where both are in equilibrium.
What are the mechanisms for controlling these variables by fiscal and monetary policy?
Government has several ways to control income and interest rates, which can be divided into two broad groups, fiscal policy and monetary policy. Fiscal policy involves managing demand on the goods market, and includes the raising or lowering of government expenditure and the raising or lowering of taxes. By raising the amount of government expenditure or lowering taxes, governments increase the circular flow and therefore aggregate demand. In relation to the IS/LM model, since anything (other than interest rates) which affects aggregate demand has a similar effect on the IS curve, we would expect a rise in government expenditure or a cut in taxes to move the IS curve to a higher position.
Some have criticised this use of fiscal policy on practical grounds. The main difficulty with it is the time lags involved. If government reacts to counter the effects of a recession by increasing government expenditure and therefore raising demand, it is quite possible that by the time this policy has been implemented and has worked its way through the system the recession will have ended, and therefore the increase in demand caused by the spending will come at an undesirable time. This is one of the reasons why fiscal policy is no longer widely used in the UK as a tool for controlling interest rates and income.
We can show the effect of fiscal policy in terms of the IS/LM analysis. The graph below shows the effect of an increase in government expenditure, assuming that the money supply is kept constant.
Here an expansionary fiscal policy, accompanied by a constant and unchanged money supply, has led to an increase in income from Y0 to Y1. However, there has also been a rise in interest rates, from r0 to r1, because of the upward shift in the equilibrium point.
At this point, it becomes important to consider monetary policy. In the example above, a tight monetary policy has been exercised, and the money supply has been kept constant. However, an expansionary fiscal policy undertaken under this monetary policy will inevitable lead to higher demand for money (because of the higher income), and therefore rises in interest rates. Rises in interest rates will in turn lead to the phenomenon of crowding out, whereby investment demand is reduced. From this two things are apparent. Firstly, fiscal policy is not a very efficient tool for stimulating demand, because of crowding out, and secondly, fiscal policy cannot be considered in isolation from monetary policy.
Monetary policy aims to increase income, and therefore aggregate demand, by controlling the money supply and interest rates. An increase in the money supply will naturally lead to less demand for money, and therefore a lower LM curve. This means lower interest rates, because lower interest rates are needed to encourage people to hold this real money supply rather than less liquid assets. Lower interest rates make assets less attractive and liquidity more attractive. The effect of increasing the real money supply whilst maintaining a strict fiscal policy is shown on the graph below.
However, it is often desirable to maintain interest rates at a fairly constant level, so this use of monetary policy would be less than useful.
It is clear that monetary and fiscal policy can be used to compliment each other, with the rise in interest rates caused by an easy fiscal policy being offset by the falls in interest rates associated with an increase in the money supply. An increase in income can be achieved either by having a tight fiscal policy and an easy monetary policy or an easy fiscal policy and a tight monetary policy, but is best achieved by a careful combination of fiscal and monetary policy.
How useful is this representation of the macro economy?
Although the IS/LM model provides a very useful way of looking at the determination of interest rates and incomes, it has several weaknesses. Firstly, the model does not provide a complete picture of the macro economy. For example, inflation is not considered in this model, but it is inflation which is a major influence on policy makers when they are considering what monetary policy to pursue. It is generally feared that an easy monetary policy, which would increase the real money supply, would lead to inflation, and therefore this is avoided.
Secondly, IS/LM does not provide an error-free analysis of the economy. Very often it is difficult to see what exact effect a fiscal policy might have, for example. It might be difficult to estimate the extent of crowding out. Also, the time lags involved mean that the model can only be used as a rough guide for what will happen in the real economy in relation to a specific fiscal or monetary policy.
