KEY POINTS

1. In the short run, we assume prices are sticky at some preset level P. There is thus no inflation, and nominal and real quantities can be considered equivalent. We assume output GDP equals income Y or GDNI and that the trade balance equals the current account (there are no transfers or factor income from abroad).
2. The Keynesian consumption function says that private consumption spending C is an increasing function of household disposable income Y − T.
3. The investment function says that total investment I is a decreasing function of the real or nominal interest rate i.
4. Government spending is assumed to be exogenously given at a level G.
5. The trade balance is assumed to be an increasing function of the real exchange rate EP^*/P, where P^* denotes the foreign price level.
6. The national income identity says that national income or output equals private consumption C, plus investment I, plus government spending G, plus the trade balance TB: Y = C + I + G + TB. The right-hand side of this expression is called demand, and its components depend on income, interest rates, and the real exchange rate. In equilibrium, demand must equal the left-hand side, supply, or total output Y.
7. If the interest rate falls in an open economy, demand is stimulated for two reasons. A lower interest rate directly stimulates investment. A lower interest rate also leads to an exchange rate depreciation, all else equal, which increases the trade balance. This demand must be satisfied for the goods market to remain in equilibrium, so output rises. This is the basis of the IS curve: declines in interest rates must call forth extra output to keep the goods market in equilibrium. Each point on the IS curve represents a combination of output Y and interest rate i at which the goods and FX markets are in equilibrium. Because Y increases as i decreases, the IS curve is downward-sloping.
8. Real money demand arises primarily from transactions requirements. It increases when the volume of transactions (represented by national income Y) increases, and decreases when the opportunity cost of holding money, the nominal interest rate i, increases.
9. The money market equilibrium says that the demand for real money balances L must equal the real money supply: M/P = L(i)Y. This equation is the basis for the LM curve: any increases in output Y must cause the interest rate to rise, all else equal (e.g., holding fixed real money M/P). Each point on the LM curve represents a combination of output Y and interest rate i at which the money market is in equilibrium. Because i increases as Y increases, the LM curve is upward-sloping.
10. The IS-LM diagram combines the IS and LM curves on one figure and shows the unique short-run equilibrium for output Y and the interest rate i that describes simultaneous equilibrium in the goods and money markets. The IS-LM diagram can be coupled with the forex market diagram to summarize conditions in all three markets: goods, money, and forex. This combined IS-LM-FX diagram can then be used to assess the impact of various macroeconomic policies in the short run.
11. Under a floating exchange rate, the interest rate and exchange rate are free to adjust to maintain equilibrium. Thus, government policy is free to move either the IS or LM curves. The effects are as follows:
    • Monetary expansion: LM shifts to the right, output rises, interest rate falls, exchange rate rises/depreciates.
    • Fiscal expansion: IS shifts to the right, output rises, interest rate rises, exchange rate falls/appreciates.
12. Under a fixed exchange rate, the interest rate always equals the foreign interest rate and the exchange rate is pegged. Thus, the government is not free to move the LM curve: monetary policy must be adjusted to ensure that LM is in such a position that these exchange rate and interest rate conditions hold. The impacts are as follows:
    • Monetary expansion: not feasible.
    • Fiscal expansion: IS shifts to the right, LM follows it and also shifts to the right, output rises strongly, interest rate and exchange rate are unchanged.
13. The ability to manipulate the IS and LM curves gives the government the capacity to engage in stabilization policies to offset shocks to the economy and to try to maintain a full-employment level of output. This is easier said than done, however, because it is difficult to diagnose the correct policy response, and policies often take some time to have an impact, so that by the time the policy effects are felt, they may be ineffective or even counterproductive.