Adjustable IS–LM Model & Stock-Price Response
IS–LM Diagram
Stock Price Response
Interpretation
In this model, output springs from the familiar identity Y = C + I(r) + G, where investment bends to the pull of interest rates and government spending shifts demand in the old, time-tested way. When fiscal hands grow generous, the IS curve marches rightward, pushing both income and rates upward until the economy settles again with the LM curve’s quiet insistence that real money balances must satisfy M / P = L(Y, r). Higher rates, of course, tighten the cost of borrowing and the discounting of future streams, even as stronger output stirs the hopes of rising earnings.
On the monetary side, a larger stock of real balances nudges LM to the right. This easing lowers rates even as it expands activity, a tilt both markets and old-fashioned theorists know well. The outcome is a gentler interest burden and a livelier pace of spending—a combination that often speaks more sweetly to investors than fiscal thrusts, which push up rates even as they lift demand.
Stock prices in this framework follow the simple expression S ≈ S₀ · exp(Ξ±Y − Ξ²r). The first term captures how rising output breathes life into prospective profits; the second records how interest rates, stern and unyielding, press valuations down through discounting. It is a delicate tension. Yet history has long taught that when money is loosened—when LM shifts right—equities often feel the softer breeze: higher output, lower rates, and a valuation climate that invites optimism. Fiscal expansion, by contrast, brings growth but also higher rates, muting its lift on asset prices. Thus the model offers a quiet, steady reminder of the trade-offs at the heart of macro policy, and how they echo through the world of financial engineering.
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