David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

20.3 The IS-LM model in action
Fiscal policy: shifting the IS schedule
Figure 20.4 shows the effect of a fiscal expansion that shifts the IS schedule from IS0 to IS 1• If unchanged
monetary policy is shown by LM0, equilibrium moves from E to E1• Fiscal expansion leads to higher income
but also higher interest rates. Higher output tends to increase the quantity of money demanded. Only
higher interest rates prevent this from happening.
Fiscal contraction has the opposite effect. The IS schedule shifts to the left and output falls, tending to
reduce money demand. Only lower interest rates restore money demand to the unchanged level of money
supply, preserving money market equilibrium. In Figure 20.4, this is a move from E1 to E when the IS
schedule shifts down from IS 1 to IS0.
LM
Ill
!
2
- Ill
Cl)
..
! G
c
r* -----------------
-----------------
IS
The goods market is in equilibrium at
all points on the IS schedule. The money
market is in equilibrium at all points on
the LM schedule. Hence only at point E
are both markets in equilibrium.
Figure 20.3
Equilibrium in the goods and money markets
A fiscal expansion shifts the IS schedule
from IS0 to IS1 but leaves the LM schedule
unaltered at LM0. Equilibrium moves from
E to E1• Output rises only from Y0 to Y1
because the output expansion induces
a rise in interest rates from r0 to r1 that
dampens the rise in aggregate demand.
By accompanying the fiscal expansion
with a monetary expansion from LM0 to
LM1, policy could make output rise to Y2•
Fiscal expansion makes output rise more
if monetary policy is loosened to keep
interest rates unaltered.
Figure 20.4
Fiscal expansion shifts the IS schedule
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