Monetary Theory Course Notes After Mid-Term

CH#20 IS/LM Model

Background:
Classicals inability to explain and address the crisis of 1929’s Great Depression gave birth to new school
of thought, known as, Keynesians economics. Its founder, John Maynard Keynes, argued that insufficient
demand in the economy has led to persistent unemployment and stagnation, therefore, advocating for
active government intervention through fiscal policy. This contrasted with classical economists who
favored minimal government involvement. They rather insisted to wait for the long run where the
market forces will itself adjust, reach equilibrium, and will ultimately solve the crisis. Keynes in response
commented, “In long run, we all are dead”. The U.S. government, led by President Franklin D. Roosevelt,
implemented Keynesian policies through the New Deal, involving significant public spending on
infrastructure and social programs. These measures, along with other factors like World War II
mobilization, played a crucial role in the U.S. recovery from the Great Depression and established
Keynesian economics as a dominant paradigm in the post-war period.

Origin of IS/LM Framework Model:

The IS/LM framework model has its roots in the work of John Maynard Keynes, a British economist, in
the book, “The General Theory of Employment, Interest, and Money” that was published in 1936.
IS/LM is a macroeconomic model that illustrates the simultaneous equilibrium in the goods and
services market (the IS curve) and the money market (the LM curve). The model is a key part of
Keynesian economics and is named after the two main components: "IS" stands for Investment-Saving,
and "LM" stands for Liquidity preference-Money supply.

IS Curve: The IS curve represents the equilibrium in the goods and services market. It shows the
combinations of interest rates and levels of real output where total spending (consumption plus
investment) equals total income. The equation for the IS curve is typically written as;

Y = C + I(r) + G + (X - M)

Where Y is income, C is consumption, I(r) is investment dependent on the interest rate r, G is

government spending, X is exports, and M is imports. The IS curve slopes downward because, as the
interest rate decreases, investment increases, leading to higher overall output

LM Curve: The LM curve represents the equilibrium in the money market. It shows the combinations of
interest rates and levels of income where the demand for money equals the money supply. The term
"LM" stands for Liquidity Preference (L) and Money Supply (M). The equation for the LM curve is
typically written as:

M/P=L(r,Y)

Where, M is the money supply, P is the price level, and L(r,Y) is the demand for real money balances,
assumed to be positively related to income Y and negatively related to the interest rate r. The LM curve is
typically drawn as an upward-sloping curve because, at higher levels of income, people want to hold
more money for transactions, increasing the demand for money.
Equilibrium in the IS/LM Model: The equilibrium in the IS/LM model is determined by the intersection
of the IS and LM curves. At this point, the goods market is in equilibrium (total spending equals total
income), and the money market is in equilibrium (the demand for money equals the money supply).

The interest rate and level of income at this equilibrium point provide insights into the overall state of
the economy.

Keynesians use the IS/LM framework to support their policy recommendations i-e;

1) Role of Government: Keynesians argue for active government intervention in the form of fiscal
policies (government spending and taxation) to stabilize the economy and promote full employment.

2) Importance of Demand: Keynesians stress the importance of managing aggregate demand to prevent
economic downturns and high unemployment.

Policy Implications:
The IS/LM framework is often used to analyze the impact of various policy measures on the economy:
Monetary Policy: Changes in the money supply or interest rates can shift the LM curve.
Fiscal Policy: Changes in government spending or taxes can shift the IS curve.
Combined Policies: The combined effect of monetary and fiscal policies can be analyzed by considering
simultaneous shifts in both curves.

Let's delve into how changes in government spending or the money supply can impact the IS/LM
equilibrium, focusing on the shifts in the IS and LM curves and their effects on interest rates and income.
Example: Increase in Government Spending

Initial Equilibrium:
Imagine an economy in equilibrium where the IS and LM curves intersect at a certain level of income (Y1)
and interest rate (r1).

Change: Increase in Government Spending (G):

Impact on the IS Curve:

An increase in government spending (G) directly contributes to total spending in the economy. This shifts
the IS curve to the right.

The new equation becomes Y=C+I(r)+G2+(X−M), where G2>G1 (initial government spending).

New Equilibrium:
The new intersection point of the shifted IS curve and the unchanged LM curve determines the new
equilibrium (Y2,r2). With increased government spending, total spending (Y) is now higher than before.

Effects on the Economy:

Higher government spending boosts economic activity. As a result, businesses may increase production
to meet the higher demand, leading to an increase in income (Y2).
Impact on Interest Rates:

The interest rate (r2) may change depending on the specific factors affecting investment. If the increase
in income leads to higher investment, it could put upward pressure on interest rates.

Example: Increase in the Money Supply (M)

Initial Equilibrium:
Start again with the initial equilibrium where the IS and LM curves intersect at (Y1,r1).

Change: Increase in the Money Supply (M):

Impact on the LM Curve:

An increase in the money supply (M) means there is more money available in the economy. This shifts
the LM curve to the right. The LM curve equation is M2/P=L(r,Y), where M2>M1 (initial money supply).

New Equilibrium:
The new intersection point of the unchanged IS curve and the shifted LM curve determines the new
equilibrium (Y2,r2). With more money available, the economy may experience lower interest rates (r2).

Effects on the Economy:

Lower interest rates can encourage borrowing and spending, potentially leading to an increase in
investment and consumption. This, in turn, can contribute to higher income (Y2).
Impact on Interest Rates:
The decrease in interest rates (r2) can make borrowing more attractive, stimulating economic activity.

Summary:
1) Changes in government spending or the money supply can shift the IS and LM curves, leading to a
new equilibrium in the IS/LM model.

2) The impact on interest rates and income depends on specific factors influencing investment,
consumption, and other components of the economy.

3) These shifts and changes are essential for policymakers to understand how their decisions affect the
overall economic activity.

In both examples, the key takeaway is that changes in fiscal policy (government spending) or monetary
policy (money supply) can influence the equilibrium in the economy, impacting interest rates and income
levels.

Components of Aggregate Demand:

Aggregate Demand is the total amount of output demanded in the economy which is sum of the
following 4 types of spending:

1) Consumer Expenditure (C): Refers to the total demand for consumer goods and services. In
Keynesian’s view, the consumption expenditure is positively related to disposable income (denoted by
YD), the total amount of income available for spending, equal to aggregate output Y minus taxes T (Y-T).

𝑌D = 𝑌 − 𝑇

The consumption function can be expressed as 𝐶

C = 𝐶 dash + 𝑚𝑝𝑐 × 𝑌D = C dash + 𝑚𝑝𝑐(𝑌 − 𝑇)

Where C dash is autonomous consumption expenditure and mpc is marginal propensity to consume,
which is a constant between 0 and 1.

The term C dash stands for autonomous consumption expenditure, the amount of consumption
expenditure that is exogenous (independent of variables in the model, such as disposable income).
Autonomous consumption is related to consumers’ optimism about their future income and household
wealth, both of which are positively related to consumer spending.

The term mpc, the marginal propensity to consume, reflects the change in consumption expenditure
that results from an additional dollar of disposable income. Keynes assumed that mpc was a constant
between the values of 0 and 1. If, for example, a $1.00 increase in disposable income leads to an
increase in consumption expenditure of $0.60, then mpc = 0.6.

2) Planned Investment Spending (I): Refers to the total planned spending by businesses on new physical
capital (e.g., machines, computers, factories), plus planned spending on new homes.
There are two types of investment spending: fixed and inventory.
I. Fixed Investment: Fixed investment is planned spending by firms on equipment (machines,
computers, airplanes) and structures (factories, office buildings, shopping centers), plus planned
spending on new residential housing.
II. Inventory Investment: Inventory investment is spending by firms on additional holdings of raw
materials, parts, and finished goods, calculated as the change in holdings of these items in a
given time period—say, a year.

Fixed investment are always planned while Inventory investment can be unplanned.
Inventory investment is a much smaller component of investment than fixed investment.

Planned Investment Spending depends on interest rate and expectations

Keynes believed that planned investment spending is heavily influenced by business expectations
about the future. Businesses that are optimistic about future profit opportunities are willing to spend
more, whereas pessimistic businesses cut back their spending. Thus Keynes posited a component of
planned investment spending, which he called autonomous investment, I, that is completely exogenous
and so is unexplained by variables in his model, such as output or interest rates. Keynes believed that
changes in autonomous spending are dominated by these unstable exogenous fluctuations in planned
investment spending, which are influenced by emotional waves of optimism and pessimism—factors he
labeled “animal spirits.” His view was colored by the collapse in investment spending during the Great
Depression, which he saw as the primary reason for the economic contraction.

By combining the two factors that Keynes theorized drive investment, we can derive an investment
function that describes how planned investment spending is related to autonomous investment and the
real interest rate for investments. We write this function as follows:

I = I dash – dri

Where d is a parameter reflecting the responsiveness of investment to the real interest rate for
investments, which is denoted by ri .

The real interest rate for investments includes not only the central bank-controlled real interest rate (r)
on secure, short-term debt instruments but also financial frictions (denoted by f). These financial
frictions, arise from asymmetric information problems like adverse selection and moral hazard. They
introduce obstacles to the efficient functioning of financial markets by making it challenging for lenders
to assess a borrower's creditworthiness. As a result, lenders may charge higher interest rates to mitigate
the risk of non-repayment, leading to an increased credit spread— the difference between the interest
rate on loans to businesses and the interest rate on completely safe assets that are sure to be paid back.
Hence financial frictions add to the real interest rate for investments, and we can write:

ri = r + f dash
Substituting in Equation 4 the real cost of borrowing from Equation 5 yields:

I = I dash - d(r + f dash)

Equation 6 states that investment is positively related to business optimism as represented by

autonomous investment and negatively related to the real interest rate and financial frictions.

3) Government Purchases (G): Refers to the spending by all levels of government on goods and services
(e.g., aircraft carriers, salaries of government employees, red tape), not including transfer payments
(which redistribute income from one person to another).

The government affects aggregate demand in two ways: through its purchases and taxes

Government purchases 𝐺 = G dash

Here we assume that government purchases are exogenous. Equation 7 states that government
purchases are set at a fixed amount G.

The government affects spending through taxes because, as discussed earlier, disposable income is equal
to income minus taxes, Y - T, and disposable income affects consumption expenditure. Higher taxes T
reduce disposable income for a given level of income and hence cause consumption expenditure to fall.
The tax laws in a country like the United States are very complicated, so to keep the model simple, we
assume that government taxes are exogenous and are set at a fixed amount T dash:

Government taxes: 𝑇 = T dash

4) Net Exports (NX): Refers to the net foreign spending on domestic goods and services, equal to exports
minus imports.
Two components:
autonomous net exports and the part of net exports that is affected by changes in real interest rates •
Net export function:
𝑁𝑋 = 𝑁𝑋 whole dash – 𝑥r

Where x is a parameter that indicates how net exports respond to the real interest rate. This equation
tells us that net exports are positively related to autonomous net exports and are negatively related to
the level of real interest rates.

Goods Market Equilibrium:

Keynes recognized that equilibrium occurs in the economy when the total quantity of output is equal to
the total amount of aggregate demand (planned expenditure). That is,

Y = Yad

When this equilibrium condition is satisfied, planned spending for goods and services is equal to the
amount that is produced. Producers are able to sell all of their output and have no reason to change
their production levels, because there is no unplanned inventory investment.
Solving for Goods Market:
Y = C + I + G + NX
aggregate output = consumption expenditure + planned investment spending + government purchases
+ net exports.
Now we can use our consumption, investment, and net export functions in Equations 3, 6, and 7, along
with Equations 8 and 9, to determine aggregate output. Substituting all of these equations into the
equilibrium condition given by Equation 11 yields the following:

Deriving IS Curve:
We refer to Equation 12 as the IS curve, and it shows the relationship between aggregate output and
the real interest rate when the goods market is in equilibrium. Equation 12 is made up of two terms.
Since mpc is between 0 and 1, 1/1 - mpc is positive, so the first term tells us that an increase in
autonomous consumption, investment, government purchases, or net exports, or a decrease in taxes
or financial frictions, leads to an increase in output at any given real interest rate. In other words, the
first term tells us about shifts in the IS curve. The second term tells us that an increase in real interest
rates results in a decrease in output, which can be shown as a movement along the IS curve.

We can now use what we have learned about the relationship of interest rates to planned investment
spending and net exports in panels (a) and (b) to examine the relationship between interest rates and
the equilibrium level of aggregate output (holding government spending and autonomous consumer
expenditure constant). The three levels of planned investment spending and net exports in panels (a)
and (b) are represented in the three aggregate demand functions in the Keynesian cross diagram of
panel (c).
The lowest interest rate i 1 has the highest level of both planned investment spending I 1 and net
exports NX1 , and hence the highest aggregate demand function Y1 ad. Point 1 in panel (d) shows the
resulting equilibrium level of output Y1 , which corresponds to interest rate i 1 . As the interest rate rises
to i 2 , both planned investment spending and net exports fall, to I 2 and NX2 , respectively, so
equilibrium output falls to Y2 . Point 2 in panel (d) shows the lower level of output Y2 , which
corresponds to interest rate i 2 . Finally, the highest interest rate i 3 leads to the lowest level of planned
investment spending and net exports, and hence the lowest level of equilibrium output, which is plotted
as point 3.

The line connecting the three points in panel (d), the IS curve, shows the combinations of interest rates
and equilibrium aggregate output for which aggregate output produced equals aggregate demand. The
negative slope indicates that higher interest rates result in lower planned investment spending and net
exports, and hence lower equilibrium output.

The IS curve represents the equilibrium points where total goods produced match total goods
demanded in an economy. It illustrates the relationship between the interest rate and the level of
aggregate output needed for goods market equilibrium. As the interest rate increases, planned
investment spending and net exports decline, reducing aggregate demand. The IS curve is significant
because the economy tends to move toward equilibrium points on the curve. If the economy is to the
right of the IS curve, there's an excess supply of goods, leading to a decrease in output. Conversely, if
it's to the left, there's an excess demand, causing output to rise. However, achieving equilibrium output
requires considering the interest rate, introducing the need for another market—the market for money
represented by the LM curve. The combination of the IS and LM curves allows for the determination of
a unique equilibrium, establishing both aggregate output and the interest rate.

Why the Economy Heads Toward Equilibrium:

The concept of equilibrium is useful only if there is a tendency for the economy to settle there. Let’s first
consider what happens if the economy is located to the right of the IS curve (the orange shaded area),
where an excess supply of goods exists. In Figure 1 at point G, actual output is above aggregate
demand, and firms are saddled with unsold inventory. To keep from accumulating unsold goods, firms
will continue cutting production. As long as production is above the equilibrium level, output will exceed
aggregate demand and firms will continue cutting production, sending aggregate output toward the
equilibrium level, as indicated by the leftward arrow from point G to point A. Only when the economy
moves to point A on the IS curve will there be no further tendency for output to change. What happens
if aggregate output is below the equilibrium level of output (the blue shaded area to the left of the IS
curve), where an excess demand for goods exists? At point H in Figure 1, actual output is below
aggregate demand, so firms will want to increase production because inventories are declining more
than they desire, and aggregate output will increase, as shown by the rightward arrow. When the
economy has moved to point B on the IS curve, there will again be no further tendency for output to
change.

Equilibrium in the market for money; the LM curve:

Just as the IS curve is derived from the equilibrium condition in the goods market (aggregate output
equals aggregate demand), the LM curve is derived from the equilibrium condition in the market for
money, which requires that the quantity of money demanded equal the quantity of money supplied.
The main building block in Keynes’s analysis of the market for money is the demand for money he called
liquidity preference. It states that the demand for money in real terms Md /P depends on income Y
(aggregate output) and interest rates i. The demand for money is positively related to income for two
reasons.
• First, a rise in income raises the level of transactions in the economy, which in turn raises the
demand for money because it is used to carry out these transactions.
• Second, a rise in income increases the demand for money because it increases the wealth of
individuals who want to hold more assets, one of which is money.

The opportunity cost of holding money is the interest sacrificed by not holding other assets (such as
bonds) instead. As interest rates rise, the opportunity cost of holding money rises and the demand for
money falls. According to the liquidity preference theory, the demand for real money is positively related
to aggregate output/income and negatively related to interest rates. Mathematically;
Md/P = f (+Y, -i)
Deriving the LM Curve:
In Keynes's analysis, the equilibrium in the money market where qty of money demanded equals qty of
money supplied determines the level of interest rates. The LM curve, depicted in Figure 20.8, illustrates
the impact of changes in output on this equilibrium.

The real money supply is fixed at M/P in panel (a). Each level of aggregate output corresponds to its
own money demand curve, as changes in output influence transaction levels and, consequently, the
demand for money. When output is at Y1, the money demand curve is Md(Y1), sloping downward
because lower interest rates increase the quantity of money demanded. Equilibrium in the money
market occurs at point 1 with interest rate i1. As output increases to Y2, the money demand curve shifts
right to Md(Y2), and equilibrium shifts to point 2 with a higher interest rate, i2. This pattern continues
with even higher output Y3 leading to a higher equilibrium interest rate i3. Panel (b) shows the LM curve
connecting these equilibrium points, demonstrating the positive relationship between output and the
equilibrium interest rate. Higher output raises money demand, resulting in a higher equilibrium interest
rate along the LM curve.

What the LM Curve Tells Us:

The LM curve traces out the points that satisfy the equilibrium condition that the quantity of money
demanded equals the quantity of money supplied. For each given level of aggregate output, the LM
curve tells us what the interest rate must be for there to be equilibrium in the market for money. As
aggregate output rises, the demand for money increases and the interest rate rises, so that money
demanded equals money supplied and the market for money is in equilibrium.
Just as the economy tends to move toward the equilibrium points represented by the IS curve, it also
moves toward the equilibrium points on the LM curve. If the economy is located in the area to the left
of the LM curve, there is an excess supply of money. At point A, for example, the interest rate is i 3 and
aggregate output is Y1 . The interest rate is above the equilibrium level and people are holding more
money than they want to. To eliminate their excess money balances, they will purchase bonds, which
causes the price of the bonds to rise and their interest rate to fall. (The inverse relationship between the
price of a bond and its interest rate is discussed in Chapter 4.) As long as an excess supply of money
exists, the interest rate will fall until it comes to rest on the LM curve.

If the economy is located in the area to the right of the LM curve, there is an excess demand for money.
At point B, for example, the interest rate i 1 is below the equilibrium level, and people want to hold
more money than they currently do. To acquire this money, they will sell bonds and drive down bond
prices, and the interest rate will rise. This process will stop only when the interest rate rises to an
equilibrium point on the LM curve.

IS-LM Approach to Aggregate Output and Interest Rate:

The ISLM model combines the IS and LM curves in Figure 20.9 to determine both aggregate output (Y)
and the interest rate (i) simultaneously . See below;

The only point of simultaneous equilibrium for the goods market (IS) and the money market (LM) is at
the intersection of these curves, denoted as point E. If the economy is at any other point, market forces
drive adjustments toward this general equilibrium. For instance, if the economy is at point A on the IS
curve but not on the LM curve, the interest rate is above its equilibrium level. People, having more
money than desired, buy bonds, causing bond prices to rise, interest rates to fall, and aggregate output
to rise along the IS curve until reaching equilibrium at point E.

Similarly, if the economy is on the LM curve but off the IS curve at point B, where money demand equals
supply but output exceeds the equilibrium level, unplanned inventory accumulates, prompting firms to
cut production. This reduction in output leads to a fall in money demand, lowering interest rates, and
the economy moves along the LM curve until reaching equilibrium at point E.

The IS-LM model provides insights into how interest rates and aggregate output are determined when
the price level is fixed, allowing policymakers to understand how monetary and fiscal policies can
influence economic activity. Note that this model does not assume full employment at equilibrium and
highlights the potential for policymakers to use monetary and fiscal tools to impact aggregate output
and employment.

i ---------------- Investment----------------Y (-ve)----------------------- IS (Goods Market)

i ---------------- Money Demand---------Y (+ve) ---------------------- LM (Money/Financial Market)

Slope of IS Curve:
The interest elasticity of investment refers to the measure of responsiveness of percentage change in the
planned investment to percentage changes in the interest rate. It tells how responsive the planned
investment is when interest rate changes.
1) If investment is highly sensitive to changes in the interest rate, a small change in interest rates will
lead to a relatively larger change in the planned investment. In this case, the investment will be elastic
and the IS curve will be steep (high interest elasticity of investment). (1<IEI<infinity)
2) Conversely, if investment is little responsive to changes in interest rate, a small change in interest rates
will lead to a relatively lesser change in planned investment. In this case, the investment will be inelastic
and IS curve will be flat (low interest elasticity of investment). (0<IEI<1)
3) If interest elasticity of investment is 0, it means that any change in interest rate is insensitive to bring
about any change in the planned investment.
 The central bank needs to be aware of the interest elasticity of investment (the slope of IS curve)
before using the expansionary fiscal policy to determine whether it would be effective in increasing
the aggregate output (Y) or not.

Several factors influence the interest elasticity of investment, shaping how sensitive investment spending
is to fluctuations in interest rates. Here are some key factors:

1) Cost of Capital: The cost of capital is a crucial factor influencing the interest elasticity of investment. If
the cost of borrowing for businesses is a significant portion of their overall costs, changes in interest
rates will have a more substantial impact on investment decisions.

2) Business Confidence: The confidence of businesses in the economic environment affects their
willingness to invest. In times of high confidence, businesses may be more likely to invest even if interest
rates are relatively high. Conversely, low confidence can make businesses more cautious, and they may
be less responsive to changes in interest rates.

3) Expectations of Future Rates: Businesses consider not only the current interest rate but also
expectations about future interest rates. If businesses anticipate that interest rates will decrease in the
future, they may be more inclined to invest at higher current rates.

4) Availability of Credit: The ease with which businesses can access credit influences the interest
elasticity of investment. If credit is readily available, businesses may be more responsive to changes in
interest rates. Conversely, if credit conditions are tight, the impact of interest rate changes on investment
may be muted.

5) Degree of Irreversibility of Investments: The degree to which investments are reversible or

irreversible affects the interest elasticity. Irreversible investments, such as major infrastructure projects,
are more likely to be influenced by long-term interest rates and may have a lower interest elasticity.
6) Technology and Innovation: The level of technological advancement and innovation in an economy
can influence the interest elasticity of investment. In industries where technology changes rapidly,
businesses may be more responsive to interest rate changes as they assess the cost of upgrading or
adopting new technologies.

7) Government Policies and Incentives: Government policies, such as tax incentives or subsidies for
certain types of investments, can influence the interest elasticity of investment. Favorable government
policies may encourage businesses to invest even when interest rates are relatively high.

8) Global Economic Conditions: Global economic conditions and international interest rates can also
impact the interest elasticity of investment, especially in economies that are highly integrated into the
global market.

9) Time Horizon of Investments: Investments with longer time horizons may be more sensitive to
changes in interest rates. For example, long-term capital projects may be more influenced by long-term
interest rates than short-term fluctuations.

Understanding these factors helps policymakers, economists, and businesses anticipate how changes in
interest rates may affect investment decisions. The interest elasticity of investment is a dynamic concept
influenced by a combination of economic, financial, and behavioral factors.

Slope of LM curve:
The interest elasticity of money demand refers to the measure of responsiveness of percentage change
in the money demand to percentage changes in the interest rate. It tells how responsive the money
demand is when interest rate changes.
1) If money demand is highly sensitive to changes in the interest rate, a small change in interest rates
will lead to a relatively larger change in the money demand. In this case, the Md will be elastic and the IS
curve will be steep (high interest elasticity of money demand). (1<IEMD<infinity)
2) Conversely, if money demand is little responsive to changes in interest rate, a small change in interest
rates will lead to a relatively lesser change in money demand. In this case, the Md will be inelastic and IS
curve will be flat (low interest elasticity of money demand). (0<IEMD<1)
3) If interest elasticity of money demand is 0, the money demand does not changes regardless of
increase or decrease in the interest rate.
Several factors influence this elasticity, shaping how individuals and businesses adjust their demand for
money in response to changes in interest rates. Here are key factors influencing the interest elasticity of
money demand:

1) Opportunity Cost of Holding Money: The interest rate represents the opportunity cost of holding
money rather than interest-bearing assets. A higher interest rate increases the cost of holding money,
making alternative interest-bearing assets more attractive. The opportunity cost influences the interest
elasticity of money demand.

2) Transaction Demand for Money: The primary motive for holding money is often for transactional
purposes, such as making everyday purchases. The interest elasticity of money demand may be lower for
transactional balances, as the need for these balances is relatively stable regardless of changes in
interest rates.

3) Precautionary Demand for Money: Individuals and businesses hold money as a precautionary
measure for unexpected expenses. The interest elasticity may be higher for precautionary balances, as
the decision to hold money for this purpose can be influenced by changes in interest rates.

4) Speculative Demand for Money: Money is sometimes held speculatively as individuals and businesses
anticipate changes in interest rates or asset prices. Speculative motives can contribute to higher interest
elasticity, especially if individuals expect interest rates to change in the future.

5) Income Level: The overall level of income in an economy can influence the interest elasticity of money
demand. In periods of economic growth, individuals and businesses may be more willing to forego
interest earnings and hold more money, leading to lower interest elasticity.
6) Financial Innovations and Technology: Advances in financial technology and innovations, such as
online banking and digital currencies, can influence the interest elasticity of money demand. Changes in
technology may alter how individuals and businesses manage their financial transactions and holdings.

7) Inflation Expectations: Expectations about future inflation can impact the interest elasticity of money
demand. If individuals expect higher inflation, they may be less inclined to hold money, leading to a
more elastic response to changes in interest rates.

8) Central Bank Policy: The monetary policy stance of the central bank, including decisions on interest
rates and money supply management, can influence the interest elasticity of money demand. Central
bank policies can shape expectations and behaviors related to money holding.

9) Global Economic Conditions: International economic conditions and interest rates can also influence
the interest elasticity of money demand, especially in economies with strong global connections.

10) Financial Regulation and Policies: Government regulations and policies, including those related to
banking and financial markets, can influence the interest elasticity of money demand by shaping the
overall financial environment.

Understanding these factors is crucial for policymakers and central banks as they formulate monetary
policies and manage interest rates to achieve their economic objectives. The interest elasticity of money
demand plays a vital role in the overall functioning of the monetary system.

Major Factors that Shifts IS Curve:

1) Changes in Govt Spending:
When the government increases its spending on goods and services, it directly contributes to aggregate
demand. This increase in government spending shifts the IS curve to the right. The rationale is that
higher government spending stimulates economic activity, leading to an increase in output at each level
of the interest rate. This shift is more pronounced in a Keynesian framework where changes in
government spending have a direct impact on aggregate demand.

Intuitively, we can see why an increase in government purchases leads to a rightward shift of the IS curve
by recognizing that an increase in government purchases causes aggregate demand to increase at any
given real interest rate. Since aggregate output equals aggregate demand when the goods market is in
equilibrium, an increase in government purchases that causes aggregate demand to rise also causes
equilibrium output to rise, thereby shifting the IS curve to the right. Conversely, a decrease in
government purchases causes aggregate demand to fall at any given real interest rate and leads to a
leftward shift of the IS curve

2) Changes in Taxes:

An increase in taxes has the opposite effect. Higher taxes reduce disposable income, leading to lower
consumption spending and, consequently, a decrease in aggregate demand. This decrease in aggregate
demand shifts the IS curve to the left. The rationale is that higher taxes reduce overall spending,
dampening economic activity at each level of the interest rate.
 We have the following result: At any given real interest rate, a rise in taxes causes aggregate demand
and hence equilibrium output to fall, thereby shifting the IS curve to the left. Conversely, a cut in tax at
any given real interest rate increases disposable income and causes aggregate demand and
equilibrium output to rise, shifting the IS curve to the right.