# Money and Banking

## 6. Policy Models: IS/LM and IS/MP

The IS/LM and IS/MP are macroeconomic models that explain short-run fluctuations in real GDP and the interest rate. These models help explain how recessions occur and they are conducive to exploring monetary policy prescriptions to remedy such short-run problems. The IS curve in each of these models is a graphical relationship explaining how aggregate demand fluctuations impact interest rates and real GDP when the market for goods and services is in equilibrium. The LM and MP curves are both graphical relationships showing how monetary policy and the market for money affects interest rates and real GDP. While each of these representations are equivalent descriptions of the same type of behavior, one model may be more useful than the other, depending on how one wants to think about the conduct of monetary policy.

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## IS CurveThe IS curve is a graphical representation of the relationship between interest rates and demand for all final goods and services. In this Pencast, we discuss how interest rates should affect consumption decisions, investment decisions, and export and import decisions, each of which is a component of aggregate demand. We conclude the Pencast with a graphical illustration that describes this behavior. |

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## LM CurveThe LM curve is a graphical representation of the relationship between interest rates and real GDP when the market for money is in equilibrium. In this Pencast, we suppose real GDP increases and use the model of the market for money to show what should happen to interest rates in equilibrium. We use this result to derive the LM curve. We conclude the Pencast by showing the IS and LM curve together on one graph. The intersection of these curves reveals the level of real GDP and interest rate such that both the market for money and the market for all final goods and services are in equilibrium. |

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## Shifts in the IS CurveWhen something besides the interest rate affects aggregate demand, this causes a shift in the IS curve. We discuss one example: a drop in consumer confidence, which causes a drop in demand for final goods and services, and therefore a leftward shift in the IS curve. We use the IS/LM model to illustrate the short-run effects on the interest rate and real GDP. |

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## Shifts in the LM CurveWhen something besides the interest rate or real GDP affects the equilibrium in the market for money, this causes a shift in the LM curve. The LM curve shifts if there is a change in monetary policy that shifts the supply or money, or if something besides real GDP affects the demand for money. We show how this works by combining the model of the market for money with the LM curve. |

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## Effect from a Currency AppreciationA currency appreciation affects demand for imports and exports, and therefore aggregate demand. We use the IS/LM model to describe the short-run effects of a currency appreciation on real GDP and the interest rate. |

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## Effect from an Increase in Foreign IncomeAn increase in foreign income affects demand for a country's exports, and therefore its aggregate demand. We use the IS/LM model to describe the short-run effects on real GDP and the interest rate. |

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## Great Recession and Monetary PolicyThe recession that the United States experienced from December 2007 through June 2009 is sometimes referred to as the "Great Recession" as it was the most severe economic contraction since the Great Depression. Consumers lost considerable wealth as the value of their assets diminished considerably, which included financial assets such as equities and bonds and physical assets such as homes and other real estate. We use the IS/LM model to illustrate the effect that this had on real GDP and interest rates, then use the model to describe the monetary policy response which was aimed at diminishing the severity of the economic crisis. |