- IS-LM model
- The IS-LM model finds the real GDP and the interest rate at which the goods market and the money market are both in equilibrium, with prices held fixed.
- Crowding out
- Crowding out is the fall in private investment that follows when higher government spending pushes up the interest rate.
Two curves and one special case
Can you name the two curves of IS-LM and the special case where one of them goes flat?
The Keynesian cross holds the interest rate fixed. IS-LM lets it move, so the A-level story of monetary policy and the multiplier sits in one diagram.
The IS curve is every combination of interest rate and real GDP at which planned spending equals output, sloping down because a lower rate raises investment.
Can you think of an example?
Rates fall and firms borrow to build warehouses they had shelved. Investment rises and, through the multiplier, so does equilibrium output: a lower rate goes with a higher GDP.
The LM curve is every combination of interest rate and real GDP at which the demand for money equals its fixed supply, sloping up because higher income raises money demand.
Can you think of an example?
Incomes rise and people want more money in their accounts for bigger weekly spending. With the money supply fixed, they sell bonds to get it, bond prices fall and the interest rate rises.
A liquidity trap is a situation where interest rates are so low that people hold any extra money rather than bonds, so the LM curve is flat.
Can you think of an example?
After the financial crisis the Bank of England held Bank Rate at half a per cent for over seven years. With rates that low, more money could barely push them lower, so many economists argued fiscal policy was the stronger tool.