Basic Concepts

• IS-LM represents the goods (IS) and money (LM) market
• IS-LM focuses on the equilibrium behaviour of the economy in the short run
• Changes in consumer behaviour (income/consumption/savings/fiscal policy) shift IS
• Changes in money supply (monetary policy) shift LM
• The IS curve represents all possible combinations of (RGDP, r) for which the goods market (AD and AS) is in equilibrium
• IS is downward-sloping because lower r → Increased Investment → Increased RGDP [Investment-Driven Derivation]
• IS is downward-sloping because Lower RGDP → Lower Savings → Higher r (Demand for money is higher) [Savings-Driven Derivation]
• Real Money = Money Supply / CPI
• On the LM curve, real money is assumed to be constant
• LM is upward-sloping because higher RGDP → higher animal spirits → higher demand for Money/Liquidity → higher r
• LM shifts when real money is adjusted
• IS shifts when savings or investments change
• The final increase in AD and income is greater than the initial government spending because consumer spending leads to further economic reinvestment (Keynesian Multiplier).
• The increase in income induces excess demand for money, hence r increases. This decreases investment spending and partially offsets the increase in AD, aka crowding out.
• The long-run Phillips Curve is vertical, where unemployment is fixed at the natural unemployment rate.