CHAPTER

11
IS-LM Framework
Aggregate Demand I:
Building the IS-LM Model

© 2016 Worth Publishers, all rights reserved

 IN THIS MODULE, YOU WILL LEARN:

The IS curve and its relation to:

the Keynesian cross (Equilibrium)
The LM curve and its relation to:
the theory of liquidity preference
How the IS-LM model determines income and the interest rate
simultaneously in the short run when P is fixed

2
Context
 Module 4, introduced the model of aggregate demand and aggregate supply.
 Short run:
 prices fixed
 output determined by aggregate demand
 Goods Market Equilibrium: (Saving = Investment) (Agg. Demand = Agg. Supply)
 Module 5, Introduced the models of Demand and supply of Money. (Money Market) (Dm= Sm)
 Keynes’ theory suggests that Dm and SM determine the rate of interest.
 Without knowing the level of income we cannot know the transaction demand for money as well as
the speculative demand for money.
 Obviously, as income changes, liquidity preference schedule changes—leading to a change in the
interest rate.
 Therefore, one cannot, determine the rate of interest until the level of income is known and the level
of income cannot be determined until the rate of interest is known.
 Hence indeterminacy.
 J.R Hicks developed the IS-LM model in 1937 by determining simultaneously the rate of interest and
the level of income. Extended mathematically by Hansen. This called Hicks and Hansen Model
 The main reason is that it provides a simple and appropriate framework for analysing the effects of
monetary and fiscal policy changes on the demand for output and interest rates.
The Goods Market and the IS Curve: Derivation
 IS curve represents the goods market.
 It shows combinations of interest rates and levels of output (Income) such that planned
(desired) spending (expenditure) equals income. Y = C+I.
 IS Curve is a graphical representation of all combinations of Interest rate (r) and Income
(Y) that result in goods market equilibrium
 The IS schedule means I= S, shows the equilibrium path of the product market at different
rate of Interest.
 To develop this relationship, we start with a basic model called the Keynesian cross.
 This model is the simplest interpretation of Keynes’s theory of how national income is
determined and is a building block for the more complex and realistic IS–LM model.
Elements of Keynesian Model
A simple closed-economy model in which income is determined by expenditure (AD).
Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & planned expenditure = unplanned inventory investment
Extension by Hicks and Hansen
I= Investment. where it is function of Autonomous investment and rate of Interest I= I̅ - cr, c >
0
S= Savings
L= Liquidity Demand
M= Money Supply
Equilibrium condition in Goods market
Actual expenditure (AS) = Planned expenditure (AD)

Y = PE
This investment is no longer fully exogenous but is also determined by the rate of interest
(which is a policy variable).
Contd….
 The Keynesian cross (Equilibrium)is useful because it shows how the spending plans of
households, firms, and the government determine the economy’s income.
 To add this relationship between the interest rate and investment to our model, we write the
level of planned investment as I = I(r).
 The investment function is expressed as: I = I̅ - cr, c > 0, where r is the rate of interest and
measures the interest response of investment, c measuring the responsiveness of investment
spending to the interest rate.
 Thus IS curve can be derived by assessing the relationship between the interest rate and the
level of income.
 Fig. 11.7 (a) shows a typical investment (demand) schedule.
 It shows the planned level of investment (spending) at each rate of interest.
 Since higher rates of interest reduce the profitability of additions to the capital stock, they
imply lower planned rates of investment spending. (Changes in autonomous investment shift
the investment schedule).

6
Contd…
Explanation
 To determine how income changes when the interest rate changes, we can combine the
investment function with the Keynesian-cross diagram.
 Because investment is inversely related to the interest rate, an increase in the interest rate
from r1 to r2 reduces the quantity of investment from I(r1) to I(r2).
 The reduction in planned investment, in turn, shifts the planned-expenditure function
downward, as in panel (b) of Figure 11-7.
 The shift in the planned-expenditure function causes the level of income to fall from Y1 to
Y2. Hence, an increase in the interest rate lowers income.
 The IS curve, shown in panel (c) of Figure 11-7, summarizes this relationship between the
interest rate and the level of income.
 In essence, the IS curve combines the interaction between r and I expressed by the investment
function and the interaction between I and Y demonstrated by the Keynesian cross.
 Each point on the IS curve represents equilibrium in the goods market, and the curve
illustrates how the equilibrium level of income depends on the interest rate.
 Because an increase in the interest rate causes planned investment to fall, which in turn
causes equilibrium income to fall, the IS curve slopes downward
Four Quadrant
The LM curve and its Derivation
❑ Having developed the theory of liquidity preference (Theory of Interest)as an explanation
for how the interest rate is determined, we can now use the theory to derive the LM curve.
❑ We begin by considering the following question:
❑ How does a change in the economy’s level of income Y affect the market for real money
balances?
❑ The answer is that the level of income affects the demand for money. When income is
high, expenditure is high, so people engage in more transactions that require the use of
money.
❑ Thus, greater income implies greater money demand. We can express these ideas by
writing the money demand function as

(M P)
d
= L (r ,Y )
The LM curve is a graph of all combinations of r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
M P = L (r ,Y )
Derivation of LM Curve
 Using the theory of liquidity preference, we can figure out what happens to the equilibrium
interest rate when the level of income changes and can derive LM curve.
 The LM curve is a graph of all combinations of r and Y that equate the supply and demand
for real money balances.
 Consider what happens when income increases from Y1 to Y2 in Figure 11-11.
 As panel (a) illustrates, this increase in income shifts the money demand curve to the right.
With the supply of real money balances unchanged, the interest rate must rise from r1 to r2
to equilibrate the money market.
 Therefore, according to the theory of liquidity preference, higher income leads to a higher
interest rate.
 The LM curve shown in panel (b) of Figure 11-11 summarizes this relationship between the
level of income and the interest rate.
 Each point on the LM curve represents equilibrium in the money market, and the curve
illustrates how the equilibrium interest rate depends on the level of income.
 The higher the level of income, the higher the demand for real money balances, and the
higher the equilibrium interest rate. For this reason, the LM curve slopes upward
Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r2
L ( r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P
Deriving the LM Curve Panel (a) shows the market for real money balances: an increase in income
from Y1 to Y2 raises the demand for money and thus raises the interest rate from r1 to r2.
• Panel (b) shows the LM curve summarizing this relationship between the interest rate and income:
the higher the level of income, the higher the interest rate.
Four Quadrant Approach
Why the LM curve is upward sloping
 An increase in income raises money demand.
 Since the supply of real balances is fixed, there is now excess demand in the money
market at the initial interest rate.
 The interest rate must rise to restore equilibrium in the money market.
 Shift In LM curve (Given level of Income)
 Change in Demand for money
 Change in supply o Money
How ΔM shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L ( r , Y1 )

M2 M1 M/P Y1 Y
P P
A Reduction in the Money Supply Shifts the LM Curve Upward Panel (a) shows that for
any given level of income Y– , a reduction in the money supply raises the interest rate
that equilibrates the money market. Therefore, the LM curve in panel (b) shifts upward.
Explanation
➢ Suppose that the reserve bank decreases the money supply from M1 to M2, which causes
the supply of real money balances to fall from M1/P to M2/P.
➢ Figure 11-12 shows what happens.
➢ Holding constant the amount of income and thus the demand curve for real money
balances, we see that a reduction in the supply of real money balances raises the interest
rate that equilibrates the money market.
➢ Hence, a decrease in the money supply shifts the LM curve upward.
➢ In summary, the LM curve shows the combinations of the interest rate and the level of
income that are consistent with equilibrium in the market for real money balances.
➢ The LM curve is drawn for a given supply of real money balances.
➢ Decreases in the supply of real money balances shift the LM curve upward.
➢ Increases in the supply of real money balances shift the LM curve downward
NOW YOU TRY
Shifting the LM curve
 Suppose a wave of credit card fraud causes consumers to use cash more frequently in
transactions.
 Use the liquidity preference model to show how these events shift the LM curve.

17
ANSWERS
Shifting the LM curve

(a) The market for

(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2
L ( r , Y1 )
r1 r1
L (r , Y1 )

M1 M/P Y1 Y
P
18
Things to Note for money market
 If Income Increase, Demand for money will increase and Interest rate will increase
in money market
 If Demand for money is greater than Supply for money Interest rate will increase
in money market
 If supply of money of money is greater than demand for money, Interest rate will
decrease in money market
 At a given level of income, if demand for money increase then interest rate will
increase in money market
EQUILIBRIUM IN THE TWO MARKETS: THE GOODS MARKET AND
MONEY MARKET
 The IS Curve: An Algebraic Explanation Aggregate Demand–Aggregate Supply Approach.
 We know that goods market is in equilibrium when
 Aggregate demand (PE) = Total Value of Output (Actual Expenditure)
 I.E Y = C+I
 But, C = C+bY and Investment function is I= I – Cr
 Therefore, 𝑌 = 𝐶 + 𝑏𝑌 + 𝐼ഥ - cr
 Hence 𝑌 − 𝑏𝑌 = 𝐶 + 𝐼ഥ - cr
 Or Y (1-b) = 𝐶 + 𝐼ഥ - cr
𝟏
 𝒀= (𝑪 + 𝑰ഥ - cr)
𝟏−𝒃
Numerical Problem:
 Suppose the consumption and investment functions for two sector economy are as
follows: C =100 + 0.75 Y; I = 250 - 5r
 Find the equation of the IS curve.
 Solution: Y=C+I
 Y= 100+0.75Y+250-5r
 Y-0.75Y = 350 -5r
 0.25Y = 350-5r
 Y= 350-5R/0.25
 Y= 1400-20r
The LM Curve: An Algebraic Explanation
 The money market is in Equilibrium when
 Demand for money =supply for money
 Or md= ms
 Md = mt +msp
 However for the sake of convenience, we assume that the speculative demand for
money is a linear function. Hence, we have 𝑚𝑠𝑝 = 𝑚𝑠𝑝 − 𝑓(𝑟)
 Therefore, demand for money is md= kY + 𝑚𝑠𝑝 − 𝑓(𝑟)
 Thus the money market equilibrium condition can be written as
 𝑚𝑠 = 𝑘𝑌 + 𝑚𝑠𝑝 − 𝑓(𝑟)
1
 Y = (𝑚𝑠 − 𝑚𝑠𝑝 + 𝑓(𝑟)
𝑘
Numerical Problem 2
 Suppose that the supply of money is Rs. 400. The transactions and speculative demand for
money functions are as follows: mt = 0.25Y ; msp = 100 - 4r
 Find the equation of the LM curve.
 Solution:
 We know equilibrium in money market is where md=ms
 Where md = mt +ms
 Md = 0.25Y+100-4r
 At equilibrium
 0.25Y +100-4r = 400
 0.25Y= 300+4r
 Y = 300+4r/0.25
 Y = 1200+6r
Simultaneous Equilibrium in two markets
 A simultaneous equilibrium in both the goods and money markets can be determined by
solving the equations for the IS and LM curves .
 We now have all the pieces of the IS–LM model. The two equations of this model are
𝟏
 𝒀= (𝑪 + 𝑰ഥ - cr)
𝟏−𝒃
1
 Y = (𝑚𝑠 − 𝑚𝑠𝑝 + 𝑓(𝑟)
𝑘
 Given these exogenous variables, the IS curve provides the combinations of r and Y that
satisfy the equation representing the goods market, and the LM curve provides the
combinations of r and Y that satisfy the equation representing the money market.
 The equilibrium of the economy is the point at which the IS curve and the LM curve
cross.
 This point gives the interest rate r and the level of income Y that satisfy conditions for
equilibrium in both the goods market and the money market.
 In other words, at this intersection, actual expenditure equals planned expenditure, and
the demand for real money balances equals the supply.
Equilibrium In The Two Markets: The Goods Market And Money Market In Two Sector
Model

Equilibrium in the IS–LM r

Model LM
The intersection of the IS and
LM curves represents
simultaneous equilibrium in
the market for goods and
services and in the market for IS
real money balances for given Y
values of consumption, Equilibrium Equilibrium
investment, the money supply, interest level of
rate income
and the price level.
➢ In the given figure
All points to the right of IS,
Y> C+I (Excess supply for Goods), so income level should fall to
maintain equilibrium

All points to the left of IS,

Y< C+I (Excess Demand For Goods), , so the income level should
rise to maintain equilibrium

All points to the right of LM,

DD for money> Supply of money,
rate of interest should rise to maintain the equilibrium.

All points to the left of LM, DD for money < Supply of money, rate
of interest should fall to maintain equilibrium
Disequilibrium to Equilibrium : The process of Adjustment

 At any point other than E* there will exist disequilibrium.

Space Goods Market Adjustment Money Market Adjustment in
in Goods Money market
Market
Space 1 S > I, Y > C+I Income will Md < Ms
Interest rate will
fall
Fall
Space 2 S > I, Y >C+I Income will Md > Ms
fall Interest rate will
Raise

Space 3 S<I, Y< C+I Income will Md > Ms Interest rate will
Raise Raise
Space 4 S<I, Y< C+I Income will Md < Ms Interest rate will
Raise Fall
Numerical Problem 3
 Suppose the consumption and investment functions are as follows:
 C = 100 + 0.75Y
 I = 250 - 5r
 Also assume that the supply of money is Rs. 280. The demand for money function is as follows:
md = 0.25Y - 2r
 Find the equation for Is Curve
 Find Equation for LM Curve
 Simultaneous equilibrium for the IS and LM Curves
 Solution :
 From previous numerical problem 1 we have
 Y= 1400-20r (IS Curve )
 LM Equation is md = 0.25Y-2r
 Ms= 280
 Thus equilibrium = 0.25Y - 2r = 280
 0.25Y= 280+2r
 Y= 280+2r/0.25
 Y= 1120+8r
Contd….
 Therefore, simultaneous Equilibrium for IS and LM in two sector model is where
 IS= LM
 1400-20r=1120+8r
 28r= 280
 R= 10%
 Y= 1400-20*10
 Y= 1200
 Simultaneous equilibrium for the IS curve and LM curves exists when Y = 1200 and r
=10%.
Three Sector Model
 Derivation of IS Curve
 As already observed, there are two approaches to determine the equilibrium level of income. In a three sector economy,
they can be expressed as
 (1) Aggregate Demand–Aggregate Supply Approach
 Aggregate demand (PE)= Total value of output (or income)(AE)
 or Y = C+I+G
 𝑌 = 𝐶 + 𝑏𝑌 + 𝐼ഥ - cr+ G
 𝑌 = 𝐶 + 𝑏(𝑌 − 𝑇) + 𝐼ഥ - cr+ G
 Hence 𝑌 = 𝑐 + 𝑏𝑌 − 𝑏𝑇 + 𝐼ഥ - cr +G
 Or Y-bY = (𝑪 − 𝒃𝑻 + 𝑰ഥ - cr + G)
𝟏
 𝒀 = 𝟏−𝒃 (𝑪 − 𝒃𝑻 + 𝑰ഥ - cr + G) ( When Tax is lump sum)
 Note: ▲Y/▲G = 1/1-b (Fiscal policy multiplier with change in Govt . Exp)
𝟏
 𝒀 = 𝟏−𝒃 (𝟏−𝒕) (𝑪 − 𝒃𝑻 + 𝑰ഥ - cr + G) ( When Tax is function of Income)
 Note: ▲Y/▲T = 1/1-b (1-t) (Fiscal policy multiplier with change in tax rates)
 (2) Injections equal Leakages Approach I+G=S+T
𝟏
 𝒀 = 𝟏−𝒃 (𝑪 − 𝒃𝑻 + 𝑰ഥ - cr + G) ( When Tax is lump sum)
𝟏
 𝒀 = 𝟏−𝒃 (𝟏−𝒕) (𝑪 − 𝒃𝑻 + 𝑰ഥ - cr + G) ( When Tax is function of Income)
Derivation of LM Curve in three sector model
 The money–market equilibrium in three sector model is similar to that of a two sector
economy.
 Demand for money =supply for money
 Or md= ms
 Md = mt +msp
 However for the sake of convenience, we assume that the speculative demand for money is a
linear function. Hence, we have 𝑚𝑠𝑝 = 𝑚𝑠𝑝 − 𝑓(𝑟)
 Therefore, demand for money is md= kY + 𝑚𝑠𝑝 − 𝑓(𝑟)
 Thus the money market equilibrium condition can be written as
 𝑚𝑠 = 𝑘𝑌 + 𝑚𝑠𝑝 − 𝑓(𝑟)
1
 Y = (𝑚𝑠 − 𝑚𝑠𝑝 + 𝑓(𝑟)
𝑘
 Note: ▲Y/▲ms = 1/k ( Monetary policy multiplier)
Points to note For LM curve:

 All points to the right or below the LM curve – DD for money >
Supply of Money.
 So the rate of interest will rise to maintain the equilibrium
 All points to the left or above the LM curve – DD for money < Supply
of Money.
 So the rate of interest will fall to maintain the equilibrium
Equilibrium in Three Sector Model
➢ We have already discussed that there is only one
combination of income and the rate of interest at
which both the goods and the money market are in
equilibrium.
➢ This has been depicted in Figure 17.2.
➢ This combination exists at point E at which the IS
and LM curves intersect to determine the
equilibrium rate of interest at r * and the
equilibrium level of income at Y * .
➢ It is important to note that at all other points, there
exists disequilibrium in either the goods market or
the money market.
➢ All combinations of income and interest that lie
above and towards the right of the IS curve, like
point R, indicate a situation where Y> C+I+G (AD
<AS) or saving plus taxes is greater than planned
investment plus government expenditures.
➢ There exists an excess supply of goods.
➢ Hence, the level of income will fall.
Contd….
 All combinations of income and interest that lie below and towards the left of the IS curve,
like point P, indicate a situation where Y < C +I+G ( AD>AS) or saving plus taxes is less
than planned investment plus government expenditures.
 There exists an excess demand for goods.
 Thus, there will be an increase in the income level.
 Similarly as far as the LM curve is concerned, at all combinations of income and interest
that lie below and towards the right of the LM curve, like point R, the demand for money
is greater than the supply of money or there is an excess demand for money.
 Hence, the rate of interest will rise.
 At all combinations of income and interest that lie above and towards the left of the LM
curve, the demand for money is less than the supply of money or there is an excess supply
of money.
 Hence, the rate of interest will fall.
 It is only at point E that there is equilibrium in both the goods and money markets which
will remain unchanged until a shift in the IS or LM curve disturbs the equilibrium.
Numerical Problem 4
 Supose an economy has is right now functioning as follows:
C= 60+0.60Yd
I-150-8r
G=Rs 50 Cr
T= Rs 50 cr
In money market, Money supply is Rs 120 cr and Demand for money is md= 0.25Y-5r.
Find:
1. The equation of the IS and LM Curves
2. Calculate the equilibrium level of Income and rate of Interest
Numerical Problem 5
 Suppose the consumption and investment functions are as follows:
 C= 60+0.60Y
 I= 150-8r
 G= 50
 T=30
 Money supply (Ms)= 150
 Demand for money = md = 0.25Y-5r
 A. Given price level is 3, find Level of Income and interest rate at which both good and money
market will be in equilibrium simultaneously
 B. Suppose govt expenditure increase by 100 and at the same time nominal money supply
increase by 150, find new equilibrium level of income and interest rate.
 C. Find the extent of shift in IS and LM Curve
Shift in IS and LM and adjustment in Equilibrium
➢ Shift in the IS curve due to changes in Fiscal Policy
➢ A change in Government Expenditure
➢ The initial equilibrium is at point E1 determined by the
intersection of the IS1 and LM curves with the equilibrium
income and the rate of interest at Y1 and r1 respectively.
➢ An increase in government expenditure by ▲G shift s the IS
curve to the right by an amount equal to the government
expenditure multiplier times the change in government
expenditure, 1/1- b x ▲G.
➢ An increase in income from Y1 to Y2 and an increase in the
rate of interest from r1 to r2 .
➢ One would expect that the increase in the government
expenditure would result in an increase in the income level by
an amount equal to the multiplier times the increase in the
government expenditure or, in other words, by an amount
equal to 1/1 - b x ▲G.
➢ In that case, equilibrium would be at point E′ on the IS 2 curve
and the increase in income would be from Y1 to Y′. Instead,
the equilibrium is at E 2 while the increase in income is from
Y1 to Y2 only. This is due to the crowding out effect.
  Crowding out is a situation which arises when an expansionary fiscal policy–for example, an increase in
government expenditure–leads to an increase in the rate of interest, thus leading to a decrease in private
investment.
 Hence, the adjustments which occur in the rate of interest have a dampening effect on the increase in the
output.
 Change in Taxes
➢ The impact of taxes is felt through a change in the
consumption level.
➢ The economy’s initial equilibrium is at point E 1 determined
by the intersection of the IS1 and LM curves with the
equilibrium income and the rate of interest at Y1 and r1 ,
respectively.
➢ Suppose the government increases the tax by ▲T, this will
shift the IS curve to the left by an amount equal to the tax
multiplier times the change in the tax, -b/1- b x ▲T.
➢ Thus, an increase in tax brings about a decrease in income
from Y1 to Y2 and a decrease in the rate of interest from r1
to r2 .
➢ One would expect that an increase in tax would result
decrease in income by the amount equal to tax multiplier.
➢ Thus equilibrium would be E’ with Y’ level of income.
Contd……
 The reason for this is that an increase in the tax results in a decrease in the consumption level
which leads to a decrease in the production of the goods and services causing a decrease in the
income levels.
 Hence, individuals demand less money leading to decrease in the interest rates. The decrease in
the interest rates is responsible for an increase in investment, thus, off setting the decrease in the
consumption levels to some extent.
Shift in LM Curve due to monetary policy
 The monetary policy operates through the changes in the supply of money.
 A change in the money supply disturbs the money–market equilibrium causing a shift in the LM
curve.
 The shift in the LM curve influences the income level and the rate of interest.
➢ The initial equilibrium is at point E 1 determined by the
intersection of the curves IS and LM 1 . The equilibrium
income is Y1 while the equilibrium rate of interest is r1.
➢ Suppose there is an increase in the money supply. Thus at
the prevailing rate of interest r1 , individuals are now
holding excess money in their portfolio which they will try
to deposit in the banks, buy bonds, etc.
➢ Hence, there will be a decrease in the interest rates.
➢ The equilibrium moves to point E′ at which there is
equilibrium in the money market and the individuals are
willing to hold a larger quantity of money due to a decrease
in the interest rate.
➢ However, at point E′ there is disequilibrium in the goods
market.
Contd….
➢ The decrease in the interest rate will encourage investment leading to an increase
in the income level.
➢ As a result, there occurs a movement up the LM2 until a new equilibrium is
established at point E2 , determined by the intersection of the curves IS and LM2.
➢ The equilibrium income increases to Y2 while the equilibrium rate of interest falls
to r2 .
➢ The mechanism by which the changes in the monetary policy affect the aggregate
demand and, thus, the income level is called the monetary transmission process.
Numerical Problem 6
 Suppose an economy has following features:
 C= 100 +0.8Yd
 I= 120-5r
 G= 50
 T=50
 md = 0.2Y-25r
 Ms = 240
 Given the price level 2, calculate the following:
 A. IS and LM Curve
 B. Level of Income and interest rate at which goods and money market will be in equilibrium
 C. Suppose change its fiscal policy and increased expenditure by 50. What will be new
equilibrium level of income and interest rate.
 D. Find the Extent of Crowding out?
 Effectiveness of Fiscal and Monetary policy
The effectiveness of a policy in achieving the economic objectives depends on the elasticity of the IS and LM
curves.
It is important to note that an expansionary fiscal policy, as it shift s the IS curve to the right, leads to an increase in
both the income level and the interest rate.
On the other hand, an expansionary monetary policy, as it shift s the LM curve to the right, leads to an increase the
income level but a decrease in the interest rate.
1. The Elasticity of LM Curve:
➢ Given the supply of money in an economy, the LM curve has a positive slope as in Figure 17.8.
➢ For most analytical purposes, it can be divided into three ranges:
1. Keynesian range: At some very low rate of interest, say r1 speculative
demand for money becomes perfectly elastic or infinity. At this rate of
interest, all expect the interest rate to increase in the future and, thus,
become bears.
➢ Hence, all individuals prefer to hold only cash and no one prefers to hold
bonds. In this range, no amount of monetary expansion can lower the
interest rate. The extra liquidity, which has been created by the monetary
authorities, is trapped in the asset portfolio of the public.
➢ This range is also called the liquidity trap. The rate of interest serves as
the minimum and cannot fall any further. In this range, the LM curve is 43
horizontal and the interest elasticity is infinity.
Contd….
2. Classical range: At some very high rate of interest, the speculative demand for money becomes
perfectly inelastic.
 All expect the interest rate to fall in the future and become bulls.
 Thus, everyone prefers to hold only bonds and no one likes to hold cash.
 The speculative demand for money becomes zero.
 In this range, the LM curve is vertical. This is called the classical range as it is in accordance with
the classical theory of money where money is demanded for conducting transactions.
 In this range, the LM curve is vertical and the interest elasticity is zero.
3. Intermediate range: This is the range in between the Keynesian range and the classical range. Here,
both the transactions and speculative demand for money exist. The interest elasticity in this range is
greater than zero.
The Elasticity of IS Curve: The IS curve has a positive slope. As far as the elasticity of the IS curve is
concerned, it depends on the responsiveness of investment to changes in the interest rate and on the
magnitude of the multiplier.
(1) If investment is insensitive (or independent) to the rate of interest, then the investment curve will
be perfectly inelastic. The IS curve will be vertical or perfectly inelastic.
(2) If investment is sensitive to the interest rate, or in other words it is interest elastic, then the
investment curve will be elastic. In that case the IS curve will be elastic; the elasticity being
higher, the lower is the marginal propensity to save. (A lower marginal propensity to save implies
a higher multiplier.)
Effectiveness of monetary and fiscal policy
 Effectiveness of Fiscal Policy: Fiscal Policy relates to the utilization of government expenditure
and taxation to achieve some well-defined objectives relating to growth, employment and many
others. The fiscal policy has an immediate impact on the goods market and, thus, leads to shift in the
IS curve
➢ Keynesian range or the liquidity trap: Here, fiscal policy is
very effective. Initially, the equilibrium exists at the
intersection of the IS1 and LM curves to determine the
equilibrium income at Y1 and the rate of interest at r1.
➢ A fiscal expansion, say an increase in the government
expenditure, leads to a shift of the IS1 curve to IS 1 ′.
➢ It is important to note that in the range of the liquidity trap,
an increase in the government expenditure does not affect
the rate of interest and, thus, the level of investment.
➢ Hence, there is a full multiplier effect of the increase in the
government spending and no dampening effects occur
(Crowding out is zero).
➢ The income level increases from Y1 to Y1 ′ while the rate
of interest remains unchanged at r1 . Hence, fiscal policy is
completely effective in the Keynesian range.
Contd…
 Classical range: Here, fiscal policy is not effective.
 Initially, the equilibrium exists at the intersection of the IS3 and LM curves to determine the equilibrium
income at Y3 and the rate of interest at r3 .
 A fiscal expansion, say an increase in the government expenditure, leads to a shift of the IS3 curve to IS3 ′ .
 The income level remains unchanged at Y3 while the rate of interest increases from r3 to r3 ′.
 An increase in government expenditure and the interest rate and an unchanged income level imply that there
occurs an off setting decrease or crowding out of private investment which equals the increase in the
government expenditure.
 Hence, there is full crowding out. Hence, fiscal policy is completely ineffective in the classical range.
 Intermediate range : Here, fiscal policy is effective but it is not as effective as in the Keynesian range.
 Initially, equilibrium exists at the intersection of the IS2 and LM curves to determine the equilibrium
income at Y2 and the rate of interest at r2
 A fiscal expansion, say an increase in the government expenditure, leads to a shift of the IS2 curve to IS2 ′ .
 Thus, the income level increases from Y2 to Y2 ′ while the rate of interest increases from r2 to r2 ′.
 In this range, the expansionary effect of the fiscal policy does succeed in raising the income level.
 Thus, fiscal policy is less effective in the intermediate range as compared to the Keynesian range.
Effectiveness of Monetary policy
 Monetary policy relates to changes in the supply of money by the central bank to achieve the
objectives relating to growth, employment and others. Monetary policy has an immediate impact on
the money market and leads to a shift in the LM curve
➢ we examine the effectiveness of the monetary policy in the
three different ranges of the LM curve with the help of two
types of IS curves, one elastic and the other inelastic.
➢ Keynesian range: Here, monetary policy is completely
ineffective.
➢ (a) Elastic IS curve, IS1 : Initial equilibrium exists at the
intersection of the IS1 and LM1 curves to determine the
equilibrium income at Y1 and the rate of interest at r1 .
➢ In this range a monetary expansion, a shift in the LM curve
from LM 1 to LM 2 , does not lead to an increase in the
income.
➢ Relatively inelastic IS curve, IS: However as with IS1 , IS1′
yields the same equilibrium income at Y1 and the rate of
interest at r1 .
➢ Monetary policy is ineffective in the liquidity trap whatever
the elasticity of the IS curve.
Contd….
 Classical range: Here, monetary policy is completely effective .
 (a) Elastic IS curve, IS3 : Initially, equilibrium exists at the intersection of the IS3 and LM1 curves
to determine the equilibrium income at Y3 and the rate of interest at r3 .
 A monetary expansion leads to a shift of the LM1 curve to LM2 .
 The income level increases from Y3 to Y3′ while the rate of interest decreases from r3 to r3 ′.
 In the classical range, the speculative demand for money is zero due to the high interest rates.
 Money is demanded only for transaction purposes. In such a situation, a monetary expansion will
push down the rate of interest and, thus, encourage investment leading to an increase in the income
level.
 Monetary policy is totally effective in the classical range in bringing about an increase in the income
level.
 (b) Relatively inelastic IS curve, IS 3 ′: As compared to IS3 , the curve IS 3 ′ is relatively less elastic.
Similar to IS 3 , IS3 ′ also yields the same equilibrium income at Y3 and the rate of interest at r3 .
 But as far as the effects of a monetary expansion are concerned, the increase in the income will be
lower while the decrease in the interest rate will be much larger than for the elastic IS curve.
Monetary policy is completely effective in the classical range whatever the elasticity of the IS curve.
Numerical Problem 7
 Suppose the consumption, investment, demand for money and supply of money functions are as
follows:

 C = 0.75 Y

 I = 107.5 crore - 0.25r

 G=100

 T=50

 md = 0.25Y - 2.5r

 ms = 80 crore , Find:

 (1) The equilibrium income and the rate of interest.

 (2) The equilibrium income and the rate of interest when autonomous investment increases to Rs.
135 cr.
Numerical Problem 8
 Suppose autonomous consumption is Rs. 60 crore, investment is Rs. 120
crore, marginal propensity to consume is 0.75 and the value of c, the
behavioural coefficient which measures the sensitivity of investment to
the rate of interest, is 4.
 Further, Suppose that the supply of money is Rs. 400. Th e transactions
and speculative demand for money functions are as follows:
 mt = 0.25Y
 msp = 100 - 4r
 Find the equation of the IS & LM curve?
 Equilibrium level of Y & r
 The equation of the IS curve when c increases to 8.