Analysis of IS-LM Economic Model - Essay Example

ISLM model: IS-LM model is basic macroeconomic model that describes the relationship between interest rates and real output levels in goods and money markets. In the IS-LM model, the IS curve represents all those combinations of interest rate and real output at which goods market is in equilibrium. Therefore, at every point on IS curve total demand for goods and services in an economy at any particular time is equal to the total supply of output at that time, or in other words to say, total investment is equal to total saving. The LM curve on the other hand, shows all those combinations of interest rates and output levels at which money market is in equilibrium, i.e. money demand equals to money supply. In the IS-LM model, money demand is assumed to be given exogenously at any point of time. It is the Central Bank, which determines money supply in any economy at any given point of time. The intersection of the two curves is known to be as the point of general equilibrium at which both the money market and the goods market are in equilibrium. (Hicks, 1937; Hicks, 1980-81) r LM r* E* IS y y* In the above figure, the positively sloped curve is the LM curve, while the negatively sloped curve is the IS curve. E* is the intersection point of the two curves and represents general equilibrium. r* and y* is the general equilibrium values of r and y at which goods and money markets are simultaneously in equilibrium. This IS-LM model is based on two fundamental assumptions as follows: 1. There exists only one interest rate in the market of loanable funds as well as in the market of money. 2. Price level is fixed. (Mankiw, 2003; Solow,1984) Whether an economic model is reliable in terms of the values of different variables that it predicts and/or whether an economic model is capable enough of capturing what is actually happening in the real world depends on the reasonability of the assumptions it is based on. To examine how well IS-LM model captures what actually happens in the economy, one needs to check whether the two basic assumptions of the IS-LM model are reasonable. The major problem with the IS-LM model is that its two basic assumptions mentioned above have certain limitations and for this reason in spite of being a fundamental macroeconomic model, economists not very frequently use it for estimating the parameters involved in this model as well as the future values of output. (Clarida and Gertler, 1999 First, consider the problem with the assumption of price rigidity. IS-LM model always makes a prediction that equilibrium can be obtained at any level a it considers a passive kind of supply. According to this model, producers produce whatever is demanded by the buyers. In IS-Lm framework, if in an economy demand changes, then the economy will make all the adjustments to that change in demand in terms of changing the level of output rather than in terms of price change. But in reality, the situation is not the same as predicted by the model. In practice, it is the process of price adjustment that is undertaken for responding to a change in demand and settling moving towards anew equilibrium point. But it is the major weakness of the IS-LM model that it just fails to comment on anything regarding price adjustment that actually occurs in any economy. (Young, 1987; Yun, 1996) Coming now to the second assumption of the IS-LM model, it can again be said that it is not a kind of assumption that holds in reality. There is a huge requirement for incorporating real as well as nominal interest rate in this model for making reliable predictions regarding any parameters or variables like real output level. The reason for making a clear distinction between real and nominal interest rate is that investment, in reality, depends on real interest rate, while money demand, in practice, is dependent on nominal interest rate. (Young and Zilberfarb, 2000; Wychak, 2002) The dependence of investment only on real interest rate can be explained by an example. Suppose an individual buys a machine worth $100 and expects to earn $105 from it in the next year. Along with it one further assumption regarding zero inflation rate can be made. In this situation investment on this machine will be worthwhile only if the interest rate is less than 5 percent. But if inflation increases to a level of 10 percent, then the level of output to be produced by that machine will remain the same, but the value of that output would be greater than before. Thus the machine worth $100 will earn $115.05, which is 10 percent more than the earlier earning of $105. In this situation purchasing of the machine will be worthwhile if nominal interest rate is below 15 percent. There will be no change in the investment if real interest rate remains constant. Change in nominal interest rate does not assure the same or real interest rate and therefore cannot be a determinant for investment. (Young and Zilberfarb, 2000; Tobin, 1980; Colander, 2000) On the other hand, demand for money depends on nominal interest rate. The reason is quite simple. While making a decision regarding how much of the asset to be hold in case balances, people only take into account their purchasing power. The nominal interest rate is treated as the cost of holding purchasing power. If inflation rises, nominal interest rate will also rise. Consequently people want to hold lesser amount of purchasing power as it becomes costly. Hence, demand for money will be less. (Klein, 2000) Hence, in real life to get appropriate response of money demand and investment, then investment has to be made a function of real interest rate, while money demand should be made a function of nominal interest rate. Since the principal assumptions of IS-LM model suffers from critical problems, academicians are very much reluctant in using the IS-LM model for any kind of empirical studies as they perceive the notion that IS-LM model is not capable of predicting what is actually happening in the economy. To get rid of the fundamental problems of IS-LM model, new IS-LM model has been developed. Some empirical studies have been conducted to examine the efficiency of this New IS-LM model in explaining actual macroeconomic phenomena. For example Saori Chiba and Kaiwen Leong has made some serious efforts to investigate whether the IS-LM model can truly explain actual economic phenomena. They have checked a number of hypotheses. First, they have conducted an empirical analysis to examine whether there is a negative correlation between net exports and real interest rate. Second, they have tries to find our whether lower level of inflation in able to stabilize real rate of interest at a lower level. Third, they have examined whether a lower level of real interest rate is generated through an increase in real GDP. And finally they have made use of available data to find out the relationship between budget deficit and real interest rate. All the hypotheses have been made on the basis of the policies suggested by new IS-LM models. They have used quarterly data on macroeconomic variables of the U.S. economy. Regarding the first hypothesis, they have come to the conclusion after conducting rigorous empirical analysis that in the new IS-LM model framework, “exports are not consistently significantly predictive of real interest rates and GDP”. As for the second hypothesis, they have not found any evidence that “when inflation is weak, the real interest rate is steady at a lower level. Whether inflation is weak or strong, the real interest rates fluctuate in almost the same way.” As for the third hypothesis, it has also not been found to hold good in reality. As for the fourth hypothesis “the data does not suggest a positively predictive relationship between the government deficit and real interest rates” (Chiba and Leong, 2008). It can therefore, be said that no conclusive answers could be drawn from the empirical study on the effectiveness of the policies suggested by the new IS-LM model. References 1. Chiba, S. and Leong, K. 2008, “Can the IS/LM Model Truly Explain Macroeconomic Phenomena?” Journal of Young Investigators. 2008. Volume 17, Available at http://www.jyi.org/research/re.php?id=1242 [accessed on 25th March, 2009] 2. Clarida, J. G. and Gertler, M. 1999. “The Science of Monetary Policy: A New Keynesian Perspective.” Journal of Economic Literature. 3. Colander, D. 2000. Post Walrasian Macroeconomics and IS/LM Analysis. In Young,Warren and Ben Zion Zilberfarb. IS-LM and Modern Macroeconomics. Boston and London: Kluwer Academic Publishers. 4. Colander, D. and Gamber, E. 2002. Macroeconomics. Upper Saddle River, New Jersey: Prentice Hall. 5. Hicks, J. R. 1937. Mr. Keynes and the Classics - A Suggested Interpretation, Econometrica, v. 5 (April): 147-159. 6. Hicks, John 1980-1981. IS-LM: An Explanation, Journal of Post Keynesian Economics, v. 3: 139-155. 7. Klein, L. 2000. The IS-LM Model: Its Role in Macroeconomics.In Young, Warren and Ben Zion Zilberfarb. IS-LM and Modern Macroeconomics. Boston and London: Kluwer Academic Publishers. 8. Mankiw, G. 2003. Macroeconomics. New York: Worth Publishers. 9. Solow, R. 1984. Mr. Hicks and the Classics. Oxford Economic Papers vol. 36. 10. Taylor, J. and Woodford, M. 1999. Handbook of Macroeconomics. North Holland:Amsterdam. 11. Tobin, J. 1980. Asset Accumulation and Economics Activity. Oxford: Basil Blackwell. 12. Wychak, F. 2002. “IS-LM in the Economics Literature.” Unpublished Middlebury College paper. 2002 13. Young, W. 1987. Interpreting Mr. Keynes: The IS-LM Enigma. Cambridge: Polity Press. 14. Young, W. and Zilberfarb, B.Z. 2000. IS-LM and Modern Macroeconomics. Boston and London: Kluwer Academic Publishers. 15. Yun, T. 1996. Nominal Price Rigidity, Money Supply Endogeneity, and Business Cycles.Journal of Monetary Economics. Read More