Having being developed by John Hicks and reviewed by Alvin Hansen, the IS-LM model has practical applications in different economic situations. The IS-LM model is a macroeconomic model of graphically representing the link between interest rates and asset markets. The intersecting curves in the model are “investment-saving” and “liquidity preference-money supply”. At the point of intersection, equilibrium is achieved at which point the interest and asset markets are at a balance. Despite this clarity, the model presents two possible interpretations. It can be used to explain the changes in national income when price level is fixed short run or point out the reason for a shift in the aggregate demand curve. Consequently, the model is an ideal tool for analyzing the different economic shifts and also suggesting possible levels of applying requisite policies to stabilize the economy (Romer, 37). It is not surprising, therefore, that the model is still an important framework for analysis of macro economics today.
The bank of Canada has the responsibility of setting the primary interest rate in the country that is then used by banks to extend money to the public. In cases where the bank anticipates a probable increase in the level of inflation, it may take measures to deal with the situation. Quite often, such decisions are informed by the IS-LM model through changes in either the money supply or the interest rate. In case the bank decides to decrease the money supply it can achieve this outcome by increasing the base rate thus slowing down the rate of economic growth. The logic behind this increase in interest rate is that banks will also increase their lending interest rates thus making the cost of money to go high. It is no doubt that smaller money supplies have the effect of raising the market interest rates as demand for money exceeds the supply from the bank of Canada.
A decision by the bank of Canada to reduce the money supply has the direct effect of increasing the interest rates. However, that is not the sole effect and the decision has multiple effects on the economy at large. Initially, the decrease in money supply will definitely result in an increase in the costs of borrowing from higher interest rates on loans and credit cards (Allsopp & David, p. 5). Following this increase in cost, people are more discouraged from borrowing and saving as they use their personal savings for expenditures they would have financed through borrowing. In addition, people that have active loans face the most difficult times as their disposable income is reduced from increased interest payments. It is also common for people to reduce and minimize their areas of consumption in response to higher interest rates. Still, the scenario can also affect people’s ability and willingness to spend and save money. Higher interest rates normally result in an increased desire to save rather than to spend as people scramble for the high interest returns on savings.
There is also a high chance that decisions by the Bank of Canada have an impact on the real estate field and particularly the interest payments on mortgage. An increase in interest rates will also affect the interest payments on mortgages as real estate firms struggle to offset the high cost of borrowing. Increases in mortgage interest payments have the potential significantly affecting consumer spending by limiting their disposable income. For instance, a simple increase of 0.6% in interest rate can lead to a huge increase on the amount payable as interest on mortgages. Ultimately, increases in interest rates have the impact of reducing personal discretionary income among the citizens. The impacts of these shifts in the IS and LM curves are cross sectional affecting both firms and individuals (Romer, p. 41). Consequently, the economy faces the likelihood of a growth decline as the country witnesses reduced investment and consumption.
Potential impacts of increased interest rates are on the value of the currency owing to fluctuations at the global stage. High interest rates can result in hot money flows thus translating into more savings in Canadian banks from investors. Indeed, higher interest rates among Canadian banks attract investors from across the world to save within these banks as opposed to those in other countries. In the end, the local currency stands to increase in value thus resulting in expensive costs of exporting goods outside the country. Conversely, the cost of importation is lower thus attracting more imports than exports. The overall effect is that the aggregate demand in the economy is reduced (Allsopp & David, p. 8). Still, the government could be affected through its interest repayment on debts. An increase in the interest rate could result in significantly higher repayments for the government. In case the situation is not normalized in time, the government could revert to higher taxations to cover for the impeding deficits.
Despite the necessity of having higher interest rates in normalizing a country’s economy, it could be detrimental for the country in the long run. Indeed, lowered money supply by the bank of Canada could result in reduced confidence among the citizens and investors thus affecting the economy negatively. It is true that high interest rates have a combined effect on both business and consumer confidence. Ideally, higher rates discourage investments as firms and individuals find it too risky to make purchases and investments (Allsopp & David, p. 15). The reduced confidence levels among business and individuals then translates into reduced aggregate demand. Also, reduced aggregate demand has the potential of lowering the economic growth of a country up to levels of recession. It could also lead to high unemployment levels as companies downsize their operations citing hard economic environments. That notwithstanding, the decision could lead to improvements in the current account as imports reduce and improvements are made on exports competitiveness.
Undoubtedly, the IS-LM curve is a key element of any macroeconomic analysis. It provides important insights and has applications in numerous situations including the central bank. A decision by the Bank of Canada to lower the money supply directly affects the interest rates by increasing the cost of borrowing. Ideally, higher interest rates result in reduced confidence among businesses and individuals and could result in slow economic growth from such factors as unemployment and lower production. Further, it is expected that higher rates increase the cost of government interest payment as well as mortgage payments. Although the local currency benefits in the short term, there is an overall reduction in investment and spending due to hard economic times. Ultimately the interactions between the high interest rates and the economy are based on the increased cost of borrowing that reduces the people’s level of disposable income.
Allsopp, Christopher, and David Vines. “The assessment: macroeconomic policy.” Oxford Review of Economic Policy 16.4 (2000): 1-32.
Romer, David. Keynesian macroeconomics without the LM curve. No. w7461. National bureau of economic research, 2000.
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