ECON5002 · Macroeconomic Theory
The IS-LM Model and Macroeconomic Policy
The IS-LM model welds the goods market and the money market into one diagram in output-interest-rate (Y, i) space: the IS schedule is every pair where the goods market clears (AD = Y, i.e. injections = leakages), the LM schedule is every pair where the money market clears, and their intersection is the one (Y*, i*) where both clear at once. The single most important thing to know in this unit is that ECON5002 is a lecturer's course: Dr Smith teaches a horizontal LM at the policy-set interest rate (interest-setting policy plus endogenous money), not the textbook upward-sloping LM. That one assumption drives the headline result — a fiscal expansion shifts IS along a flat LM, so output rises by the full multiplier with zero crowding-out below full employment, while monetary policy works as a vertical shift of the flat LM. IS-LM is Topic 3, examined only in the closed-book mid-semester test (Topics 1-3), so every diagram must be drawable from memory and the algebra fast.
What this chapter covers
- 011. The IS schedule — pairs (Y, i) where the goods market clears (AD = Y, injections = leakages); downward-sloping because a lower i lifts interest-sensitive spending A(i)
- 022. The LM schedule — pairs (Y, i) where the money market clears; in this course horizontal at the policy-set rate because money is endogenous
- 033. Interest-sensitive autonomous demand A(i) — A = Ā + A(i), the channel through which the interest rate reaches output
- 044. The open-economy multiplier k = 1/(1 − c + ct + m) — the proportional tax ct and import leakage m both shrink it
- 055. Joint goods-money equilibrium (Y*, i*) — monetary policy pins i*, the real sector then delivers Y* where IS crosses the flat LM
- 066. Fiscal vs monetary policy — fiscal shifts IS horizontally (full kΔĀ effect), monetary shifts the flat LM vertically
- 077. Crowding out — Smith's signature result: zero below full employment because credit is supplied at the unchanged policy rate; it appears only past natural output Yn
- 088. Risk-premium and policy shocks — a higher 5-year premium raises the market rate i = iT + ρ even with the cash-rate target fixed, a contractionary vertical shift of the effective LM
Solving IS-LM with interest-setting policy and a fiscal expansion
- +2Multiplier: k = 1/(1 − c + ct + m) = 1/(1 − 0.7 + 0.7×0 + 0.1) = 1/0.4 = 2.5.
- +2Equilibrium output: Y* = k[A − R·i] = 2.5 × [400 − 100(0.04)] = 2.5 × (400 − 4) = 2.5 × 396 = 990.
- +1Fiscal expansion: autonomous demand rises to A = 400 + 20 = 420, with i held at 4%. New output Y = 2.5 × [420 − 100(0.04)] = 2.5 × 416 = 1040.
- +1Change in output: ΔY = 1040 − 990 = 50 = k·ΔG = 2.5 × 20 — the full multiplier passes into Y.
- +1Zero crowding-out: with a horizontal LM the RBA holds i fixed and money is endogenous, so the rate does not rise to choke off private spending; the IS shift translates fully into higher output (below full employment).
Key terms
- IS schedule
- The set of output-interest-rate pairs (Y, i) at which the goods market clears, i.e. planned aggregate demand equals output (AD = Y), equivalently injections equal leakages (I + G + X = S + T + M). Slopes downward because a lower rate raises interest-sensitive spending.
- LM schedule
- The set of (Y, i) pairs at which the money market clears (M/P = Y·L(i)). In this course it is horizontal at the policy-set rate; in the textbook, with a fixed money stock, it slopes upward.
- Horizontal LM (interest-setting policy)
- The defining feature of this unit: the RBA sets the cash rate and the quantity of money is endogenous, adjusting to demand at that rate for any level of output — so the LM is flat and a policy change is a vertical shift, not a movement along an upward slope.
- Interest-sensitive autonomous demand A(i)
- The part of autonomous spending that falls as the interest rate rises, A = Ā + A(i); it is the channel through which the rate set by the LM reaches output through the IS curve.
- Open-economy multiplier
- The factor k = 1/(1 − c + ct + m) by which an autonomous spending change raises equilibrium income; the proportional tax ct and the marginal propensity to import m are leakages that both shrink it.
- Crowding out
- The displacement of private spending by a fiscal expansion. In this course it is zero below full employment because credit is supplied at the unchanged policy rate; it appears only once demand is pushed beyond natural output Yn and the central bank raises the rate to defend its inflation target.
- Movement along IS vs shift of IS
- A change in the interest rate i is a movement along the IS curve (it is the LM that moved); a change in non-interest autonomous spending (G, X, T, confidence) shifts the whole IS curve by ΔY = k·ΔĀ.
- Risk premium shock
- An increase in the yield-curve risk premium ρ raises the market rate borrowers face, i = iT + ρ, even when the cash-rate target iT is unchanged — a contractionary vertical shift of the effective LM that lowers output.
The IS-LM Model and Macroeconomic Policy FAQ
Why is the LM horizontal in ECON5002?
Because this is a lecturer's course built on interest-setting policy and endogenous money. The RBA sets the cash rate and the quantity of money adjusts to whatever is demanded at that rate, so the rate does not have to rise as output grows — the LM is flat at the policy-set rate. Drawing the textbook upward-sloping LM (which assumes a fixed money stock) and concluding that fiscal policy raises the rate is the classic wrong answer here.
Why is there zero crowding-out in this model?
Under endogenous money the pool of loanable funds is not fixed; the banking system supplies the credit demanded at the policy rate. A fiscal expansion shifts IS right along the flat LM, the rate stays put, and private spending is not displaced — so output rises by the full multiplier k·ΔĀ. The important caveat: this holds only below full employment. Past natural output Yn the bank raises the rate to defend its inflation target, and crowding-out reappears.
When is IS-LM examined?
IS-LM is Topic 3, so it is tested in the 30% closed-book mid-semester test (Topics 1-3), which has 15 multiple-choice questions plus a two-part essay marked out of 20. It is not on the final, which covers Topics 4-8. Always confirm dates and weights against your own unit outline.
What is the difference between a movement along IS and a shift of IS?
A change in the interest rate moves you along the IS curve — the rate was changed by the LM. A change in non-interest autonomous spending (government spending, exports, taxes, or a confidence-driven jump in consumption or investment) shifts the whole IS curve by ΔY = k·ΔĀ. Keeping the cause straight is essential to getting the policy story right.
How do I get the multiplier right under exam pressure?
Compute k = 1/(1 − c + ct + m) before anything else, and remember that both the proportional tax (ct) and the import leakage (m) sit in the denominator and shrink it — dropping either inflates your answer. A sign slip in the denominator is the most common arithmetic error on this question.
Is this guide official or affiliated with the University of Sydney?
No. This is an independent AskSia study resource to help students revise. It is not produced, endorsed by, or affiliated with the University of Sydney. Always check Canvas and the official unit outline for current dates, weights and rules.
Exam move
Treat IS-LM as one diagram with one assumption attached, and lead every answer with that assumption. Before you draw anything, state the world: interest-setting policy plus endogenous money gives a horizontal LM, which is the single biggest departure from the textbook and the source of most marks. Then make the cross drawable from memory — labelled axes (Y, i), a downward IS, a flat LM, and the equilibrium (Y*, i*) — and practise the two policy moves until they are automatic: fiscal policy shifts IS horizontally for the full k·ΔĀ effect with the rate unchanged, while monetary policy (or a risk-premium shock) shifts the flat LM vertically. For the numbers, drill the routine of computing k first, then Y, then the money stock, on fresh problems against the clock. Finally, rehearse the discriminators the mid-semester keeps returning to: zero crowding-out holds only below full employment, fiscal policy has no systematic effect on the interest rate, and a risk-premium rise contracts output even with the cash-rate target fixed.
