IS an LM derivation

Consumption demand is function of disposable income. Disposable income is level of income minus
taxes (Yd = Y – T) where Yd stands for disposable income and T for taxes. However, in a two-sector
model where we do not incorporate taxation by the government, Yd = Y.
Investment depends on rate of interest. With a given level of income, a higher rate of interest reduces
investment demand and a lower rate of interest leads to more investment, that is, investment is negatively
related to rate of interest. Thus,

I = I – di

Therefore, we have the following equation for aggregate demand (AD) or output

1/1-b is the income multiplier and b is marginal propensity to consume. Given the value of autonomous
expenditure, we can obtain value of Y at different rates of interest to draw an IS curve. It is worth noting
that the value of autonomous (A) determines the intercept of the IS curve, d in the term di in equation (3)
shows the sensitivity of investment to the changes in rate of interest and determines the slope of IS curve.
Since fall in interest rate increases investment spending, it will raise aggregate demand and thus the
equilibrium level of income. Besides, the slope of the IS curve depends on the size of income multiplier.
Problem 1:
The following equations describe an economy:
C = 10 + 0.5 Y (Consumption function)

I = 190-20i (Investment function)

Derive the equations for IS curve and represent it graphically.

IS Curve: Three-Sector Model with Taxation and Transfer Payments:

C = a + bYD …(1)
Now, disposable income YD is obtained from deducting tax and adding transfer payments by the
government. Thus
YD = Y – T + R
where T is tax revenue and R is the transfer payments by the government. Whereas a tax reduces
disposable income, transfer payment raises it.

Further, whereas transfer payments are assumed as lump sum amount, tax can be lump sum tax or levied
as proportion of income. If we assume proportionate income tax, then,

T = tY

where t is the proportion of income which is taken away by way of tax. …(2)
Let us derive IS equation incorporating proportionate income tax and lump sum transfer payments.

where 1/1-b(1-t) is the value of multiplier in case of proportionate income tax. Equation (4) represents IS
curve in case of proportionate income tax.

It may be noted in the context of IS equations (3) and (4) that a change in autonomous spending (A) as a
result of any of its components will cause a shift in IS curve.

Problem 2:
The following equations describe an economy:
Derivation of LM Curve: Algebraic Analysis:
Having derived algebraically equation for IS curve we now turn to the derivation of equation for LM
curve. It will be recalled that LM curve is a curve that shows combinations of interest rates and levels of
income at which money market is in equilibrium, that is, at which demand for money equals supply of
money.

We explain the derivation of LM curve in two steps. First, we show how money demand depends on
interest rate and level of income. It is worth noting that in their demand for money people care more
about the purchasing power of money, that is, people’s demand is for real money balances rather than
nominal money balances. Real money balances are given by M/P where M stands for nominal money
demand and p for price level.

The demand for real money balances depends on the level of real income and interest rate. Thus M d =
L(Y, i). Demand for real money balances increases with the rise in level of income and decreases with
rise in rate of interest. Let us assume that money demand function is linear. Then
L(Y, i) = kY – hi k, h > 0 …(5)

Parameter k represents how much demand for real money balances increases when level of income rises.
Parameter h represents Low much demand for real money balances decreases when rate of interest rises.
The equilibrium in the money market is established where demand for real money balances equals supply
of real money balances and is given by

M/P = kY – hi …(6)

Money supply (M) is set by the central bank of a country and we assume it to remain constant for a
period. Besides, we assume the price level (P) to remain constant.

Solving the equation (6) for interest rate we have

i = 1/h (kY – M/P) …(7)

The above equation (7) describes the equation for LM curve. To be precise it gives us the equilibrium
interest rate for any given value of level of income (Y) and real money balances. In drawing LM curve,
real money balances are assumed to be constant.
Thus LM curve describes money market equilibrium for different values of income and rate of interest,
given a fixed value of real money balances (M/P). Thus, given the real money balances (M/P), we can
obtain a rate of interest for different values of income.

Let us state some conclusions about LM curve as given by equation (7). First, since in equation (7) for
LM curve, the coefficient (k) of income (Y) is positive, LM curve will slope upward. That is, higher
income requires higher interest rate for money market to be in equilibrium, given the supply of real
money balances.

Second, since the coefficient of real money balances is negative, the expansion in real money balances
will cause a shift in the LM curve to the right, and decrease in the real money balances will shift LM
curve to the left.

From the coefficient of income k/h, we can know whether LM curve is steep or flat. If demand for money
is not much sensitive to level of income, then k will be small. Therefore, in case of small k (i.e. low
sensitivity of interest with respect to changes in income), small change in interest rate is required to offset
a small increase in money demand caused by a given increase in income.

Problem 3:
Given the following data about the monetary sector of the economy:
Md = 0.4 Y – 80i
Ms = 1200 crores.

where Md is demand for money, Y is level of income, Ms is rate of interest and M is the supply of money
1. Derive the equation for LM function
2. Give the economic interpretation of the LM curve. Draw LM curve from the above data
Solution:
For money market to be in equilibrium:
Md = M s
0.4 Y – 80 i = 1200

80 i = 0.4 Y – 1200

i = (0.4Y/80) – (1200/80)

i = (1/200) Y – 15 ….. (i)

Alternatively, LM equation or function can also be stated as:

LM curve means what would be rate of interest when money market is in equilibrium, given the level of
income. Thus, if level of national income is Rs. 4000 crores, then using LM equation (i) we have

i = (1/200) x (4000 – 15)

= 20 – 15 = 5%

Thus, at income of Rs. 4000 crores, rate of interest will be 5 per cent when money market is in
equilibrium.

Now, if level of income is Rs. 4400 crores, equilibrium rate of interest will be

i = (1/200) Y – 15

= (1/200) x (4400 – 15)

= 22 – 15 = 7%

With two combinations of interest rate and income level when money market is in equilibrium we can
draw LM curve as shown in 20.19.

With two combinations of interest rate and income level when money market is in equilibrium we can
draw LM curve as shown in 20.19.
Problem 4:
The following data is given for the monetary sector of the economy:
Transaction demand for money, Mt = 0.5Y. Speculative demand for money, Msp = 105 – 1500 i
Money supply Ms = 150
Derive LM equation from the above data

Solution:
Total demand function for money can be obtained by adding up the transactions demand for money (M)
and speculative demand for money (Msp). Thus
Md = Mt + Msp
Md = 0.5 Y + 105 – 1500i
In money market equilibrium
Problem 6:
Consider the following economy: