The document provides an overview of the IS-LM framework for macroeconomic analysis. It discusses the relationship between goods markets and money markets, and how equilibrium is reached. It also outlines the derivation of the IS and LM curves and how they are used to show equilibrium between interest rates and income. Fiscal and monetary policies can be used to shift the curves and achieve different macroeconomic outcomes like increasing output. The document contains several chapters that cover these topics at a conceptual level.

1. IS – LM Framework, Fiscal and
Monetary Policy
Macroeconomics II
W. A. Upananda
Former Assistant Professor/Senior
Lecturer

2. Why IS (Goods) and LM (Money)
Equilibrium?
• We need goods and services to satisfy our
endless needs although availability of money is
limited; similarly we need money to purchase
goods and services that we needed.
• Then it is important to understand the behaviour
of markets where these goods and money are
circulating. Demand for goods and supply of
money determine the equilibrium level which in
turn determine the general price level of a
country.

3. Chapter One
IS-LM Framework and General Equilibrium
• Contents: IS-LM Framework
– Money market (LM)
– Commodity Market (IS)
• Learning Objectives
– Describe money market and commodity market
– Derivation of IS and LM curve

4. IS-LM Framework
• IS-LM framework attempts to describe
equilibrium between goods market and
money market.
• Goods market is defined as equality between
savings and investments. Saving is function of
Income while investment is inverse function
of rate of interest. When product market is in
equilibrium I = S.

5. Money Market : LM
• Market equilibrium attained when demand of
money (L) equated the supply of Money (M) or
L=M.
• Money is used for transactions, precautions, and
speculations. Demand for money is divided into
L1 which covers transaction demand and
precautionary demand while L2 stands for
speculative demand. Speculative demand for
money is inverse functions of Interest rate.
In equilibrium L=M which meet the equilibrium of
goods market where I = S.

6. Overview of IS-LM Framework
Asset Market Goods Market
Money Supply Output or goods supply
Income
Demand for Money Aggregate Demand
Fiscal Policy Autonomous
spending

7. Commodity Market Equilibrium
Derivation of IS Curve
Savings Savings I = S
Income Investment
Interest IS curve
Interest
Income Investment

8. Motives of Keeping Money
Retrieved from: http://bilbo.economicoutlook.net/blog/?p=25090
• Transactions motive – people need money to engage
in daily transactions. Thus the demand for liquidity will
be some proportion of total national income.
• Precautionary motive – at times major events occur
that need to be resolved through transactions – for
example, maintaining a cash balance to pay for engine
repairs on a car.
• Speculative motive – People used money in times of
uncertainty over movements in interest rates. They
have a choice between holding money which earns no
interest return or purchasing an interest-bearing asset,
which has less liquidity. .

9. Financial Wealth of Individuals and of
an economy
• Nominal financial wealth (W)/price level (P) =
Real financial wealth = W/P;
• Demand for real balance (L) and demand for
bond (V) equate the financial wealth of a an
individual. Similarly, the financial wealth of an
economy can be written as
• W/P = M/P (demand for money) + P
• Money supply has to derive with respect to
the demand for money.

10. Fundamentals of deriving LM curve
• Demand for money is created only by
transaction demand and speculative demand.
• Speculative demand is inversely related to rate
of interest.
• National income is determine with respect to
the transaction demand for money.
• Transaction demand and speculative demand
react in opposite direction.

11. Money Market Equilibrium:
Derivation of LM Curve
Transaction
Demand
ransaction
Demand
Income Speculative
demand for Money
Interest (i) LM
curve
interest
Income
Speculative
demand for Money

12. Chapter Two
Goods and Money Market Equilibrium
IS Curve
Interest
LM Curve
Equilibrium
Income (Yo)

13. IS-LM Framework in Detail
Retrieved from:http://bilbo.economicoutlook.net/blog/?p=25090
By changing interest rate income level could also be changed

14. Monetary Policy
• Monetary policies deals with real quantity of
money which influence level of income and
interest rate.
• Central Bank of Sri Lanka manipulate the quantity
of money by relative supply of money and bonds.
When CBSL buys bonds prices will be high and
the yield will be lower making interest rate fall.
Then public will not hold bonds then the
circulation of money increases.

15. Autonomous
Expenditure/Consumption
Extracted from Investopedia
• An autonomous expenditure describes the components of an
economy's aggregate expenditure that are not impacted by that
same economy's real level of income.
• The classical economic theory states that any rise in autonomous
expenditures will create at least an equivalent rise in aggregate
output, such as GDP, if not a greater increase.
• Autonomous consumption is defined as the expenditures that
consumers must make even when they have no disposable income
to be purchased, regardless of how much money is coming in.

16. Manipulation of Quantity of Money to
Increase output
Interest LM1 LM2
IS
Output

17. Liquidity Trap
situation where monetary policy become ineffective
• When public is prepared to hold all money
supplied at certain interest rate LM curve
become horizontal which make monetary
policy ineffective. When LM curve become
vertical interest rate has no effect and
demand for money is depends on level of
output.

18. Fiscal Policy
• Fiscal policy deals with government spending.
• When monetary policy is ineffective government
spending may increase output
LM
Interest rate
Multiplier
Yo Y1
Output

19. Crowding out Effect
Situation where government spending has no effect on output
• This is the case when government spending
has no effect on output. LM curve remain
vertical and demand for money remained the
same.
• Reason for this situation may be that effect of
government spending may offset by the
reduced investment spending.

20. Chapter Three
Money and Its Functions
• Contents: Nature, and functions of money,
supply of money in Sri Lanka.
• Definition: money is medium of exchange.
• Functions: Medium of exchange, standard of
value, store of value, standard for differed
payment (money to be paid in future),
dynamic force of economy.

21. Factors affecting Money Supply
• Three factors may influence Money supply:
– Outstanding net domestic credit extended to
government and private sector
– Net foreign asset held by com. banks: Foreign
currency in hand; balance due from abroad,
export bills, and overdraft from aboard.
– Difference between non-monetary assets and
liabilities.

22. Sri Lankan Experience in Money Supply
• 1. 1950- 1960: Fair degree of price stabiity;
1961-1969 is characterized by monetary
restrictions.
• 2. 1970- 1977: emergence of inflationary
pressure and low capital accumulation. Overall
Financial reforms with liberalized economy.

23. Chapter Four
Intermediary Role of Bank
• Contents: Banking history; financial
intermediary; Banking system in Sri Lanka
• Definition of Bank: A bank or banker is a person or
institution carrying on the business of receiving money and
collecting draft for customers subject to obligation of
honoring cheques drawn upon them form time to time by
customers.
• Functions of a bank: Safeguard and transfer funds; lend
facilities; guarantee credit worthiness; exchange money.

24. Financial Intermediary model
Financial
Claims
Financial
intermediation
Maturity transaction
Aggregation
Risk transformation
Financial
Claims
Borrowers
Savings

25. Banking System in Sri Lanka
• Commercial banking: Bank of Kandy in 1828 and Bank of Ceylon in 1841. in
1961,People’s Bank established after replacing cooperative federal bank.
Later in the 19th century, branches of foreign banks established to serve
plantation sector and its exports. Reorganized bank of Ceylon under
ordinance No. 39 of 1939. Commercial Bank of Ceylon Ltd.. In 1907 and
Hatton National Bank in 1970 were established as private commercial
banks.
• With trade liberalization in 1977, de-regulation, imposed inviting more
competition. Total number of commercial bank increased from 12 to 23.
• By 2017 Sri Lankan banking sector is comprised of
– Licensed Commercial Banks
– Registered Finance Companies
– Licensed Specialized Banks

26. Asset Distribution in Sri Lankan Banking
Sector

27. Chapter Five
Money Creation
• Money creation: Total cash deposits are not
utilized and remaining cash could be advanced
to other customers which becomes an asset
for the bank. Reserve ratio is determine the
percentage that could be advanced.
• Deposit coefficient: 1/ r; where r is the
Reserve ratio.

28. Chapter Six
Money and Prices: Theory and Practice
• Contents: Relationship between money and
prices; quantity of Money (M); Velocity of
Circulation (V), Price level (P); Output (Q);
Keynesian and monetarist views; and
limitation of monetary theory.
• Objectives: How money and price related;
effect of money supply on price level;
Understand Keynesian and monetarist
theories; Limitations of Monetary theories.

29. Money and prices
• Money is the assets which could purchase goods and
services while price determines what to produce and
how much to produce through the demand created by
money supply and its value.
• Theory which explains relationship between money
and prices: Equation of exchange:
• Where M is money supply; V as velocity of income; P
as price level and Q final output of the economy.
• M1 = Currency held outside banks; demand deposits;
other checkable deposits.
PQMY 

30. Income Velocity
• Income velocity is defined as the number of time average
rupee is spent on goods and services. For example, M1 in
1995 in Sri Lanka was Rs. 75 billion and the GNP (Q) in the
same was Rs. 659 billion. Then the income velocity is
659/75= 8.78. Then we can write,
• V=GNP/M; V = PQ (output or GNP at current price);
• MV = PQ (Fisher equation) ; According to this equation Q
could be remained constant even M is increased. Because P
(price level) may increased (inflation) to compensate the
increased quantity of money.

31. Keynesian Monetary Theory
• Keynes added third motive, speculative motive,
for holding money to existing motives:
transaction motive and precautionary motive.
• Speculative motive arise as a result of uncertainty
of interest rate fluctuation: either to hold or to
invest on non-monetary assets. Here, interest
rate is the cost of holding money.
• Keynes stated that’ increased in money supply
may have little or no effect on the price level if
the spending generated by interest rate decrease.

32. Keynes Monetary theory: an
explanation on effect on price
Price may
increase
Business
investment and
private
consumption
Decrease in
Interest rate
Increase in
speculative
demand
Increase in
Money supply

33. Chapter Seven
Fiscal Policy
• Contents
– Goals of macroeconomics
– Full employment, Price stability, and economic growth
– Taxation and spending
• Objectives
– How fiscal policy is used to achive macroeconomic
goals
– How government spending and tax policy help
establish stability
– Fiscal policy of Sri Lanka

34. Goals of Macroeconomics
• Three main objectives
– Full employment; Price stability, and economic
growth
– Full employment (Full employment of Land,
labour, capital, and entrepreneurship
– Price stability ; absence or mitigation of inflation
or deflation
– Economic growth: sustained increase in overall
productive capacity

35. Aggregate Demand and Supply
Price
Level
Real GDP
AS
Curve
Price Level
Real GDP

36. Equilibrium
Aggregate
Supply
Price Level
Aggregate
Demand
Real GDP

37. Fiscal Policy
• Fiscal policy deals with Taxation, Government
expenditure, borrowing and management of public
debt.
• Tax cuts : When tax cuts imposed disposable income
increases and increases consumption spending which
stimulate aggregate demand for goods and services.
• Government spending: Government spending will
added to NI with multiplier effect which depends on
MPC . Consumption multiplier : K = 1/1-MPC
• If Rs. 1000 million spent it will add K times of
government spending.

38. Fiscal Policy
• Learning Objectives:
• How fiscal policy achieve macroeconomic goals.
• How tax policy and government spending help stabilize the
economy
• How fiscal policy affect economic objectives of government
• Brief history of fiscal policy of Sri Lanka
• Goals of Macroeconomics: Specifically three to five objectives
are there: 1, full employment (land, labor, capital,
entrepreneurship). 2. Price stability 3. Economic growth 4.
equilibrium in balance of payment 5. Fair distribution of
income or minimize inequality in wealth distribution

39. Achieving Macroeconomic Goals
Price stability
Price level Aggregate
Demand
Aggregate supply
AD 2
AD1
Q1 Q2
Real GDP

40. Fiscal Policy in Sri Lanka
Retrieved from https://www.cbsl.gov.lk/en/economic-and-statistical-charts
• Regimes of fiscal policy could be divided into four eras:
• 1950- 1960: State’s role in economic activities were limited and
confined to welfare while private sector played dominant role.
• 1960-1977: Inward looking economic policy and state involvement
in infrastructure development activities. Economic growth rate was
negative in some years
• 1978-1994: By end 1993, 42 state enterprises had been privatized.
Further, most of the state-owned plantations were handed over to
22 companies for management.
• 1995-2004:In 2001 to 2004, Sri Lanka faced bankruptcy with debt
reaching more than 100% of GDP.

41. Fiscal policy: 2005- 2017:
• Govt. debt declined to 82.9% of GDP in 2009.
Sri Lanka’s economy grew at an average 5.8
percent during the period of 2010-2017
(World Bank in Sri Lanka).

42. End
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