Block 5

UNIT 12 EQUILIBRIUM IN THE REAL
SECTOR*
Structure
12.0 Objectives
12.1 Introduction
12.2 Goods Markets
12.2.1 Interest Rate and Investment
12.2.2 Aggregate Demand and the Interest Rate
12.3 Derivation of the IS Curve
12.3.1 Slope of the IS Curve
12.3.2 Position of the IS Curve
12.4 Let Us Sum Up
12.5 Answers/ Hints to Check Your Progress Exercises
12.0 OBJECTIVES
After going through this Unit, you should be in a position to

 explain how equilibrium in the goods market is achieved;
 explain the relationship between interest rate and investment;
 discuss the aggregate demand in relation to the interest rate;
 derive the IS curve with the help of aggregate demand and interest rate;
 interpret the slope of the IS curve; and
 explain the position of the IS curve and the factors affecting its position.
12.1 INTRODUCTION
In Unit 6 we learnt that equilibrium rate of interest is determined by the demand

for and supply of money in the economy. In Unit 10 we learnt that equilibrium
output is realized at the level where aggregate demand equals aggregate supply
(of goods and services). The classical economists believed in duality of the real
and monetary sectors of the economy and an increase in money supply results in
proportionate increase in prices, as output cannot be increased (see Unit 9).
According to Keynes, however, there is underemployment of resources in an
economy and an increase in money supply results in a decline in interest.
A decrease in interest rate results in an increase in investment, which in turn
results in an increase in output through investment multiplier. Thus monetary
variables have an impact on real economic variables.
*
Dr. Nidhi Tewathia, Assistant Professor, Gargi College, University of Delhi
IS-LM Analysis The goods and money markets are interrelated – interest rate influences
investment which influences output. Similarly, growth in output influences
demand for investment which in turn affects interest rate. Thus studying goods
market and money market separately does not give us a correct picture of the
economy. For economic stability in the economy, there should be equilibrium in
both goods market (equilibrium output) and in money market (equilibrium
interest rate). In view of this economists such as J R Hicks (1904-1989) and
Alvin Hansen (1887 – 1975) tried to combine the equilibrium in both goods and
money markets.
12.2 GOODS MARKETS
Goods market is the one where aggregate demand and aggregate supply interact
with each other and equilibrium level of income and output are determined. In
the Keynesian model we saw that equilibrium output is realized when saving and
investment are equal. A limitation of that model, however, was that the effect of
interest rate on saving and investment was ignored.
Goods market equilibrium can be described through the IS curve (IS stands for
Investment - Saving) which shows all the positions where investment and saving
in the economy are equal. In Unit 11, we considered investment to be
autonomous or fixed for simplicity. In reality however investment is not fully
exogenous.
As you saw in Unit 11, equilibrium level of output is given by
A
Y0 
1  c  ct
where two determinants of equilibrium income are A and marginal propensity to

consume (c). Higher mpc means higher output level and vice-versa.
12.2.1 Interest Rate and Investment

To have a complete picture, we introduce interest rate as a determinant of
investment. Thus investment is not exogenously given; it is endogenously
determined. We note that investment is lower when the rate of interest is high and
vice versa. Generally, the firms borrow to invest. When interest rate is high,
borrowing cost will increase, which will lower profits of the firms. On the other
hand, if rate of interest is low, borrowing cost will be relatively lower and firms
will borrow more. Thus, if the rate of interest is high, firms borrow less, which
results in lower investment. On a similar logic, if the rate of interest is low, firms
will borrow more, which would result in higher investment. Thus we assume that
rate of interest and investments are inversely related. The investment spending
function can be written as
I= I –bi where b > 0 …(12.1)
i = rate of interest
b = responsiveness of investment to interest rate

152
I = autonomous investment spending Equilibrium In
the Real Sector
In equation (12.1) we assume that investment consists of two components: (i) an
autonomous component which does not depend upon the rate of interest; and (ii)
an endogenous component which is influenced by the rate of interest. There are
certain types of investments which are mandatory (such as repairs, maintenance,
etc.). In Units 10 and 11 we assumed that investment is fixed, or autonomous, or
exogenously given. In this Unit we relax this assumption and assume that certain
types of investment are carried out for expansion of production capacity, and
with a profit motive. The investment function given at equation (12.1) states that
lower interest rate means higher investment. The investment function is shown in
Fig. 12.1.
i
Interest
Rate
I
Investment
O
Fig. 12.1: Investment Function
The position of the investment curve is dependent on the slope of the investment
function, i.e., b and the level of autonomous investment, I . The intercept of the
investment curve will depend on I , while its slope will depend on b. If
investment is highly responsive (value of ‘b’ is larger), the investment curve will
be flatter (see Fig. 12.2). In this case, a small decrease in the rate of interest will
result in a large increase in investment (see Fig. 12.3). On the other hand, if the
responsiveness of investment to a change in the rate of interest is low (value of
‘b’ is relatively small), the investment curve will be steeper.
i i
Rate of Rate of
Interest Interest
I I
I I
O O Investment
Investment
Fig. 12.2: Higher Responsive Investment Fig. 12.3: Lower Responsive Investment
A change in the level of autonomous investment ( I ) will result in a parallel shift

in the investment curve (see Fig. 12.4). If I is higher, the investment curve will
153
IS-LM Analysis shift rightwards (from I to I′). It means that for each rate of interest, more is
invested. Similarly, a lower level of I would indicate a leftward shift in the
investment curve (from I to I").
Interest
rate
Iʹ
I
Iʹʹ
I
O Investment
Fig. 12.4: Shift in Investment Curve
12.2.2 Aggregate Demand and the Interest rate

We have seen that investment is influenced by the rate of interest. Since
investment has changed its form (it is not considered to be fixed anymore), it will
have an impact on the aggregate demand (AD) curve.
AD = C + I + 𝐺̅
AD = C + c TR + c(1 – t)Y + I – bi + 𝐺̅
AD =𝐴̅ + 𝑐̅ Y – bi …(12.2)
where 𝑐̅ = c(1 – t) (see Unit 11 for derivation of this)
and A = c TR + I + 𝐺̅
An increase in the rate of interest rate results in a decrease in AD, while level of
income is considered to be given. As pointed out earlier, A is not affected by the
increase in the rate of interest. In Fig. 12.5 we describe the effect of change in
interest rate on AD curve. At a given rate of interest i, the term ‘bi’ becomes a
constant and hence the vertical intercept of AD curve is ( A – bi).
In Fig. 12.5, we measure AD on the y-axis and output on the x-axis. In the
diagram, we depict the impact of a shift in the AD curve on equilibrium output.
Initially let the aggregate demand curve be AD 1  A  cY  gi 1 when the rate of
interest is 𝑖 . Here the intercept of the AD curve is 𝐴̅ − 𝑏𝑖 . The equilibrium is at
point 𝐸 and equilibrium output is 𝑌 .
Suppose there is a decrease in the rate of interest from 𝑖 to 𝑖 . The intercept of

the AD curve will be 𝐴̅ − 𝑏𝑖 . Notice that 𝐴̅ − 𝑏𝑖 will be larger than 𝐴̅ − 𝑏𝑖 ,
154
because we are subtracting a smaller quantity from 𝐴̅ . Thus there will be an Equilibrium In
upward shift in the AD curve from 𝐴𝐷 to 𝐴𝐷 (see Fig. 12.5). the Real Sector
AD AD= Y
E2 AD 2  A  cY  gi 2
A  gi 2 AD 1  A  cY  gi 1
E1
A  gi1
Y
Y1 Y2
Income and Output

Fig. 12.5: Interest Rate and AD
If you see logically, a decrease in interest rate will lead to an increase in

investment. An increase in investment will lead to an increase in aggregate
demand. Thus the upward shift in the AD curve due to decrease in interest rate is
valid. As per Fig. 12.5, initial equilibrium was at 𝐸 and equilibrium output level
was Y1. Because of the shift in the aggregate demand curve, the new equilibrium
occurs at 𝐸 and the equilibrium level of output is 𝑌 .
Check Your Progress 1

1) Draw an investment curve when the investment is not autonomous and
justify its shape.
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2) In what way the investment curve is affected when the sensitivity of

investment to the interest rate increases?
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3) Explain the impact of a change in the interest rate on the AD curve and
the resulting equilibrium.
155
IS-LM Analysis
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12.3 DERIVATION OF THE IS CURVE
We continue with Fig. 12.5 for derivation of the IS curve. The ground work is
already done in the previous section where we learnt that the AD curve shifts due
to change in the interest rate. Further, there is a change in equilibrium output in
response to change in the AD curve. Thus, in Fig. 12.5, we have various
combinations of interest rate and equilibrium output levels. If we plot such
combinations in a diagram, we get the IS curve. As we observed in Fig. 12.5,
when the rate of interest decreased from i1 to i2, the equilibrium level of output
increased from Y1 to Y2. Thus we find that interest rate and equilibrium output
are negatively related. The IS curve is shown in Fig. 12.6. You should note that
on each and every point of the IS curve the real sector of the economy is in
equilibrium.
i1 E1
Rate of
interest i E2
2
IS curve
O Y
Y1 Y2
Income and Output
Fig 12.6: IS Curve
All the points on the IS curve represent the goods market equilibrium because
this curve is made up of those combinations of rate of interest and output where
savings is equal to investment (or, its equivalent, aggregate demand is equal to
aggregate supply). Fig. 12.6 shows that the IS curve is downward sloping.
Another issue to discuss is the points which are not on the IS curve. Any such
point indicates that there is disequilibrium in the goods market. Point ‘c’ and ‘d’
in Fig. 12.7, for example, show disequilibrium in the real sector , while points ‘a’
and ‘b’ show equilibrium in the goods market.
i
156
i1 a c
Rate of
Equilibrium In
the Real Sector
Fig 12.7: Points off the IS Curve
At point ‘d’ in Fig. 12.7, income is at Y1 but the rate of interest is at i2. At lower
rate of interest, demand for investment will increase. Such increase in demand for
investment will push the rate of interest upward. So, at point ‘d’ there is excess
demand for goods. We can generalize that at any point below and to the left of
the IS curve, there is excess demand for goods.
At point ‘c’ in Fig. 12.7, interest rate is 𝑖 while output is 𝑌 . You should observe
that the equilibrium rate of interest corresponding to 𝑌 level of output is 𝑖
(equilibrium point on the IS curve is ‘b’) which is lower than 𝑖 . Thus there is a
tendency for interest rate to decline. An implication of the above is that there is
excess supply in the market. We can generalize that any point which is above and
to the right of the IS curve, indicates excess supply of goods.
12.3.1 Slope of the IS Curve
Let us derive the equation for the IS curve by using the goods market equilibrium
condition. We know that equilibrium is achieved when Y = AD. Substituting the
value of AD from equation (12.2), we obtain
Y = A + 𝑐̅ Y –bi
Or, Y – c Y = A – bi
Or, (1 − 𝑐̅)𝑌 = 𝐴̅ − 𝑏𝑖
Or, 𝑌 = ( )̅
(𝐴̅ − 𝑏𝑖)
Or, 𝑌 = 𝛼 (𝐴̅ − 𝑏𝑖) …(12.3)
where α G  ̅
= is the multiplier in the presence of the government
sector and 𝑐̅ = c(1 – t).
Equation (12.3) above is the IS equation. The slope of the IS curve is defined as
the rate of change in income due to change in interest rate. The slope of the IS
157
IS-LM Analysis ∆
curve is given by , where ∆ represents a small change in a variable. The slope
∆
of the IS curve is (–)b. αG .
Those of you who are familiar with differential calculus, can see that we take
derivative of (12.3) to find the slope of the IS curve. Thus, = − b. αG . The
slope being negative reinforces the fact that Y and i are negatively related. The
steepness of the curve depends on the two factors, viz., b and αG . Recall that b
represents the sensitivity of investment to changes in the interest rate, and αG
represents the value of the multiplier.
AD AD = Y
'
A  gi 2  c y
Aggregate A  gi 2  c y
Demand
A  gi 1  c' y
A  gi 1  c y
-b Δi E1
Y
Y1 Y1’ Y2 Y2’
Income and Output
Rate of
i1
Interest
i2
IS1 IS2
O Y
Y1 Y1’ Y2 Y2’
Fig 12.8: Multiplier and IS Curve

Suppose there is certain decrease in interest rate and b is relatively large
(responsiveness of investment to interest rate is high). It implies that the
equilibrium income will change by a large amount through a large upward shift
in the AD curve. This will produce a flatter IS curve. On the other hand, when b
is relatively small, responsiveness of investment to interest rate is low. This leads
to a steeper IS curve.
158
Looking at the role of αG in the steepness of the IS curve, let us consider two Equilibrium In
different values of the multiplier, one larger than the other. Larger multiplier will the Real Sector
produce a steeper AD curve. In our analysis, we will consider a change in the
interest rate and then we will consider the change in equilibrium income in both
the cases, i.e., flatter AD curve ( αG is higher) and comparatively steeper AD
curve ( αG is lower). We utilise Fig. 12.8 for this analysis. We will see the impact
of lower interest rate on the AD curve and finally on the IS curve.
AD AD= Y
AD1
AD2
AD2
A2
AD1
E1
A1
Y
Y1 Y2
Income and Output
Fig. 12.8: Impact of Interest Rate on Aggregate Demand
We find that 𝛼 is affected positively by 𝑐̅ because 𝛼 = ̅

. So, AD1 is
represented by the equation carrying 𝑐̅ and AD2 is represented by the equation 𝑐′
where 𝑐′ > 𝑐̅ . When interest rate decreases from 𝑖 to 𝑖 (such that 𝑖 < 𝑖 ), we
observe a parallel shift in both the AD curves (both here means steeper and flatter
AD curves represented by 𝑐′ and 𝑐̅ respectively. The equilibrium shifts from Y1 to
Y2 in case of the flatter AD and from Y1’ to Y2’ in case of the steeper AD. We
observe that the horizontal distance between and Y2’ and Y1’ is more as compared
to the distance between Y2 and Y1. We see in the lower panel of Fig. 12.8 that the
𝐼𝑆 curve turns out to be flatter which is corresponding to the higher 𝑐̅ or c ' . We
can say that higher 𝑐̅ leads to higher αG , and therefore a larger increase in the
equilibrium level of income and output. Slope of the IS curve is dependent on the
multiplier, which means fiscal policy can affect the slope of the IS. For example,
an increase in the tax rate reduces the multiplier. This will lead to a steeper IS
curve and vice-versa
12.3.2 Position of the IS Curve
Once we are done with understanding of the slope of IS, the next thing to learn is
the position of the IS curve. We should be in a position to explain the shifts in the
IS curve. In other words, we should be in a position to identify the factors that
determine the position of the IS curve. Let us once again look at the IS equation.
159
IS-LM Analysis 𝑌 = 𝛼 (𝐴̅ − 𝑔𝑖)
We already know that α G and b are responsible for the slope of the IS curve.
This leaves us with A which shall play a significant role in the IS curve
formation. This role is nothing but the determination of the position of the IS
curve. In case A shifts, it leads to a shift in AD curve and hence shows an impact
on the position of the IS curve. Fig. 12.9 shows how this process takes place. The
upper panel of Fig. 12.9 shows the impact of change in autonomous spending
 
A on the AD curve. For a given rate of interest 𝑖 , equilibrium level of income
and output shifts from Y1 to Y2 due to  A .
AD AD= Y
Aggregate AD2(i1)
Demand E2
AD1(i1)
A2
E1
A1
Y
Y1 Y2
i
Interest rate
i1 E1 E2
IS2
IS1
O Y
Y1 Y2
Income and Output
Fig 12.9: Shift in IS Curve
Now, in the lower panel of Fig. 12.9, at the same interest rate (i1), we have a
higher level of equilibrium income and output (Y2). This shows that the shift in
IS1 to IS2 is as a result of  A . We have a new goods market equilibrium, i.e.,
(𝑖 ,Y2) instead of the old one (𝑖 ,Y1). The next question is, what is the magnitude
of the shift in the IS curve? The shift in the equilibrium level of income and
output can be easily calculated with the help of the multiplier.
Y = αG .  A
160
That is, change in income is equal to the multiplier times the change in A . The Equilibrium In
the Real Sector
components of A are equally responsible for the shifts in the IS curve. Let us
look at these components,
A  c TR  T  G  C
In case the government spending decreases, the AD curve will experience a

parallel shift downwards and this will decrease the level of income. It leads to a
leftward shift in the IS curve. Similarly, if I , TR and C decrease, the IS curve
will shift leftwards.

1) Derive the IS Curve with the help of the Keynesian Cross.
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2) Which are the factors that determine the slope of the IS Curve?
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3) What affects the position of an IS Curve?

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12.4 LET US SUM UP
In this unit, we understood the role of interest rate in determining the investment
level. We dropped the assumption that the investment is autonomous or
exogenous. As the investment gets affected due to interest rate, the aggregate
demand and the equilibrium also experience a change. This process of change in
interest rate and its impact on equilibrium level of income and output helps us to
161
IS-LM Analysis derive the IS curve. All the points on the IS curve show the goods market
equilibrium and all the points off the IS curve show disequilibrium. The slope of
the IS curve is dependent upon the sensitivity of the investment to the interest
rate (b) and the multiplier ( α G ). The position of the IS curve is determined by the
autonomous spending, A .
12.5 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
1) Refer to Sub-Section 12.2.1 and Fig. 12.1
2) It becomes flatter.
3) Refer to Sub-section 12.2.2.

1) Refer to the Fig. 12.5 and Fig. 12.6.
2) Refer to Sub-Section 12.3.1.
3) Refer to Sub-Section 12.3.2.
162
UNIT 13 EQUILIBRIUM IN THE MONETARY
SECTOR*
Structure
13.0 Objectives
13.1 Introduction
13.2 Real and Nominal Demands
13.3 Demand for and Supply of Money
13.4 Money Market Equilibrium
13.5 LM Curve
13.5.1 Slope of the LM Curve
13.5.2 Position of the LM Curve
13.6 Let Us Sum Up
13.7 Answers/Hints to Check Your Progress Exercises
13.0 OBJECTIVES
 explain nominal and real demand for money;
 derive the LM curve with the help of demand for and supply of money;
 explain the slope of the LM curve and the factors affecting it; and
 explain the position of the LM curve and the factors affecting it.
13.1 INTRODUCTION
In the previous Unit we discussed about the equilibrium in the goods market.
Knowledge of the goods market and its equilibrium alone however is not
sufficient to understand how the economy works. The money market or the assets
market is equally important.
The assets market affects the level of income and output. As you might have
observed, large volume of trading occurs every day in the assets market. For
simplicity, we group all the assets into two categories, viz., a) money (cash in
hand), and b) interest-bearing assets such as bonds. A bond is a promise to pay an
agreed amount of money to its holder at some future date. For example, suppose
a borrower (usually the government or a corporate firm) borrows Rs.100 in the
form of a bond. She promises to pay Rs.4 each year to the lender (who actually
owns the bond) and will repay Rs.100 to the lender at a future specified date, say
after 2 years. The interest rate is 4 per cent per year.
*
163
IS-LM Analysis Wealth of an individual is allocated between various types of assets. If an
individual decides to have more number of bonds, she will receive more amount
of interest income accordingly. Holding more money grants her liquidity and she
can make transactions to purchase anything she wants. In the case of bonds, her
liquidity is compromised. Such decisions are called portfolio decisions. The total
wealth of an individual would either be held in the form of money or in the form
of bonds. In other words, the wealth of an individual should add up to the money
held in different types of assets.
State of the economy depends on both goods market and assets market, and there
is an important link between the two. The complete picture emerges only after we
study both goods and assets markets. In the present Unit we will be largely
discussing about money, bonds, stocks, houses, etc., as forms of wealth. In Unit
14 we will combine both the goods and the assets markets to find out equilibrium
rate of interest and equilibrium level of output.
13.2 REAL AND NOMINAL DEMANDS
Let us begin with the distinction between ‘the nominal demand for money’ and
‘the real demand for money’. Nominal demand for money is the amount of
money (in India, for example, the number of rupees) demanded by an individual.
The real demand for money is also the demand for money but in terms of the
number of units of goods that money will buy. This real demand is equal to the
nominal demand for money divided by the price level. For example, nominal
demand for money (also called Nominal Wealth, WN) is Rs.500, and the price
level is Rs.5. Then the real demand for money will be equal to 100 units of goods
(= 500/5). It is important to note that if the nominal demand for money and the
price level doubles, then the real demand for money remains unchanged. Real
demand for money is also known as ‘demand for real money balances' or real
balances. Real bond holdings will be equal to the sum of money and the bond
holding divided by the price level. Real financial wealth of an individual should
be equal to the sum of demand for real balances (L), and real bond holdings
(BH). Also, another way to look at the real financial wealth is the nominal wealth
(WN) divided by the price level (P):
So,
WN
L + BH = …(13.1)
P
Decision of holding more real balances would mean a decision to hold less real
wealth in the form of bonds. It means, if we consider the money market only, we
can have understanding on the assets market. If the money market is in
equilibrium, the bond market will also be in equilibrium because real wealth is
distributed in these two markets only.
164
The real financial wealth available at a given time, in an economy, will be the Equilibrium in the
Monetary Sector
sum of the real money balances and the available real bonds. So, the total
financial wealth will be equal to:
WN M
  SB
P P …(13.2)
where M is the stock of nominal money balances, SB is the real value of the
supply of bonds and P is the price level.
The amount of real wealth an individual wish to hold should be equal to the
amount of real wealth available in the economy. We equate (13.1) and (13.2) to
obtain
M
L + BH =  SB
P
 M
Or,  L    (BH  SB)  0
 P …(13.3)
If the demand for real balances (L) is equal to the existing stock of the real
 M
balances, we find that  L    0 . This leads to the interesting observation,
 P
i.e., BH should be equal to SB. If the real money demand is equal to the real
money supply, then the demand for real bonds should be equal to the supply of
real bonds. Now, let us consider a situation where the money market is not in
equilibrium, and see its implications for the asset market. Suppose real money
demand is more than real money supply. Given the wealth budget constraint
M
given at equation (13.3), the excess demand in the money market (i.e., L  )
P
there needs to be neutralized by excess supply in the bond market (i.e., BH <
SB). With this behaviour, we reinforce the fact that studying only the money
market would help us in comprehending the bond market also.
13.3 DEMAND FOR AND SUPPLY OF MONEY
Individuals require money to make transactions such as purchase of goods and

services. At a given time, people will hold some cash in hand which is known as
‘money balances’. The amount of physical units that money can buy, tells us the
‘real balances’ an individual demands at that point of time. If the price level rises,
an individual will require more (nominal) money balances to keep continuing to
afford the same amount of goods and services.
The decision of how much money to be held as nominal balance or in the form of
cash is dependent on the income or real income of an individual and the interest
rate on various assets available for investment. The cost of holding money is
165
IS-LM Analysis
nothing but the foregone interest rate on the assets in which the investor could
have invested. Higher interest rate increases the cost of holding money.
Individuals make transfers from money to bonds whenever their money holdings
become large. But if an individual holds her majority of wealth in the form of
bonds, then she needs to be ready for the inconvenience which low level of
liquidity brings. We can say that at high levels of income, an individual demands
more of money (means more liquidity) and at high rate of interest, the individual
demands more bonds (means less money or less liquidity).
Keeping the above in view, we can write the money demand function as
L = kY – h i k, h > 0 …(13.4)
where k is the sensitivity of money demand to the level of income (Y) and h is
the sensitivity of money demand to the interest rate (i). An increase in the income
by Re.1 increases the real money demand (L) by Rs. k. An increase in the interest
rate by 1 per cent decreases the real money demand by Rs. h. The quantity
demanded is a decreasing function of the rate of interest and increasing function
of the income. In Fig. 13.1 we depict such a demand curve for money.
Interest
Rate
L
L
O
Quantity of Money
Fig. 13.1: Demand for Money
The supply of money is generally taken as fixed. The nominal quantity of money
supply is controlled by the Central Bank of the country. So, we take it as given at
M . We also assume that the price level is constant ( P ). Thus, the real money
supply would be ( ).
In Fig. 13.2 we show that money supply in the economy is constant; represented
by a vertical line. An implication of the vertical money supply curve is that it is
independent of interest rate. Thus any change in interest rate does not lead to a
change in money supply.
166
Equilibrium in the
Monetary Sector
i M
P
Interest Rate
L
O
Quantity of Money
Fig. 13.2: Money Supply
13.4 MONEY MARKET EQUILIBRIUM

When demand equals supply in the money market, we achieve equilibrium in the
money market. In Fig. 13.3 we combine the money demand curve given at Fig.
13.1 and money supply curve given at Fig. 13.2. The money demand curve is
downward sloping while the money supply curve is vertical. The equilibrium
takes place at E1. This equilibrium is achieved at a given income level (𝑌 ). The
rate of interest is i1.
i
Interest rate
E1
i1
L1
L
O M
P Quantity of Money
Fig. 13.3: Money Market Equilibrium
Now suppose that the level of income increases from (𝑌 ) to (𝑌 ). From equation
(13.4) we find that money demand (L) will increase. Accordingly, the money
demand curve will observe a rightward shift from 𝐿 (𝑌 ) to 𝐿 (𝑌 ) and the
equilibrium point will shift from 𝐸 to 𝐸 . In Fig. 13.4, the new equilibrium is at
E2 which corresponds to the equilibrium level of income, Y2, and the interest rate,
i 2.
167
IS-LM Analysis
E2
i2
Interest
Rate E1
i1
i3 E3
L2 (Y2)
L1 (Y1)
L3 (Y3)
Fig. 13.4: Change in Money Market Equilibrium
With the new equilibrium, we have received another combination of income and
rate of interest where money market is in equilibrium. At the rate of interest i1,
there exists excess demand for money due to increase in income level (Y). This
excess demand pushes up the rate of interest to i2 to achieve the new equilibrium
where demand for money equals supply of money.
If the income level decreases to Y3, the money demand curve will shift leftwards
(see Fig. 13.4) and this will lead to excess supply of money. This excess supply
of money pushes the interest rate down and the equilibrium rate of interest is
realized at i3 so that the supply of and the demand for money are equal. We
observe that a lower level of income (𝑌 ) is associated with a lower rate of
interest (𝑖 ).
1) Distinguish between real and nominal demands for money.
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2) Write down the equation of the demand for money and interpret it.
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168
Equilibrium in the
13.5 LM CURVE Monetary Sector
The combinations of income (Y) and interest rate (i) which we discussed in the
previous sections are important for understanding the LM curve. A series of such
combinations eventually generates the LM curve. The LM curve shows the
combinations of interest rates and levels of income such that the demand for real
balances is equal to the supply of real balances. All the points on the LM curve
indicate the money market equilibrium and all the points outside the LM curve
indicate the disequilibrium in the money market. The LM curve is positively
sloped, i.e., as Y increases, the rate of interest increases.
In Fig. 13.4 we obtained three equilibrium points, as the level of income changed,
viz., 𝐸 , 𝐸 and 𝐸 corresponding to (𝑌 𝑖 ), (𝑌 𝑖 ), and (𝑌 𝑖 ) respectively. We
plot these points in Fig. 13.5. In Fig.13.5 we take output on the x-axis and
interest rate (i) on the y-axis. When we plot the three combinations (𝑌 𝑖 ), (𝑌 𝑖 ),
and (𝑌 𝑖 ) we obtain an upward sloping curve. It is called the LM curve; ‘L’
representing liquidity and ‘M’ representing money supply.
i
Rate of Interest
i2 LM
E2
i1
E1
P
i3 Q
E3
0 Y
Y3 Y1 Y2 Income and Output
Fig 13.5: LM Curve
You should note that on each and every point of the LM curve, the demand for
real balances is equal to the supply of real balances. Thus the money market is in
equilibrium if the economy is operating at any combination of output and interest
rate, which are on the LM curve. An implication of the above is that the money
market is not in equilibrium condition if the economy is operating at any point
outside the LM curve. Let us consider two such points, P and Q in Fig. 13.5. At
point P, which is to the left and above the LM curve, there is excess supply of
money for given level of income. This will push the interest rate down and the
money market will be in equilibrium. At point Q, which is to the right and below
the LM curve, there is excess demand for money. This will push the interest rate
up so that there is equilibrium in the money market.
Now let us derive the equation for the LM curve. In equation (13.4) we have the
demand for real balances. The supply of real balances is given by . By
169
IS-LM Analysis equating the demand for real balances with the supply of real balances we obtain
the equation for the LM curve. Algebraically it can be shown as follows:
M
= kY – ℎ𝑖
P
M
Or, ℎ𝑖 = kY –
P
1 M
Or, 𝑖 =  kY   …(13.5)
h  P 
where, h = the responsiveness of the demand for money to income, and

k = the responsiveness of the demand for money to the interest rate.
13.5.1 Slope of the LM Curve
The slope of LM curve can be derived from the LM equation, given by (13.5).
You should note that the slope of the LM curve denotes the change in rate of
Δi
interest due to change in income, i.e., , where ‘∆’ represents a small change
Δy
in a variable. Thus,
Δi k
 …(13.6)
Δy h
Those of you, who are familiar with the concept of differentiation, will find that
slope of a curve is given by the first derivative of a function. We obtain the slope
of the LM curve by taking partial derivative of equation (13.5) such that = .
From (13.6) we find that the slope of the LM curve is given by the ratio of k and
h. An implication of the above is that greater the responsiveness of the demand
for money to income (k) and lower the responsiveness of the demand for money
to the interest rate (h), the steeper will be the LM curve.
LM1
Interest Rate
LM2
0
Quantity of Money
Fig. 13.6: Slope of LM Curve
170
In Fig. 13.6 we present two LM curves with different slopes. If the demand for Equilibrium in the
Monetary Sector
money is relatively insensitive to the interest rate (i.e., h is close to zero), then the
LM curve will be nearly vertical (LM1). On the other hand, if the demand for
money is very sensitive to the interest rate (i.e., h is large), then the LM curve
will be nearly horizontal (LM2).
13.5.2 Position of the LM Curve

M 
Along the LM curve, the real money supply   is held constant. So if there is

 P 
a change in real money supply, the LM curve will shift. If the real money supply
increases, LM curve will shift to the right. Remember that an increase in real
money supply can take place in three ways, viz., (i) there is an increase in
nominal money supply while price level is unchanged, (ii) there is a decrease in
price level while nominal money supply is constant, and (ii) there is such change
in both M and P that the ratio increases. In this Unit, for simplicity, we assume
that the price level is constant so that an increase in nominal money supply
implies an increase in real money supply.
M M'
Let us describe a situation where real money supply increases from to .
P P
This will shift the money supply curve (the vertical line in Fig. 13.3). Such a shift
in the money supply curve will result in a decrease in the rate of interest for each
level of income. Thus there will be a rightward shift in the LM curve.
In Fig. 13.7 the rate of interest changes from 𝑖 to 𝑖 for each level of income. We
have kept the income level unchanged at Y1 to highlight the fact that at each level
of income, the equilibrium interest rate has to be lower to induce people to hold
larger real balances. Similarly, at each level of the interest rate, the level of
income has to be higher so as to raise the transactions demand for money (kY)
and thereby absorbing the higher real money supply.
If there is a decrease in real money supply, the LM curve will shift to the left.
i LM1 LM2
Rate of interest
i1 E1
i2 E2
Y
O0 Y1
Fig 13.7: Shift in the LM Curve
171
IS-LM Analysis

1) Explain how the LM curve is derived.
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2) Interpret the slope of an LM curve.

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3) Explain how the position of LM curve is determined.

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4) Draw a suitable diagram to show the impact of a decrease in money

supply. Explain why the rate of interest will increase.
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13.6 LET US SUM UP
We began the unit with a discussion on the options for individuals to hold money.
We assumed that an individual holds money either in the form of cash or in terms
of interest-bearing assets i.e., bonds. Further, we showed that if we study the
money market, the bond market is also understood side by side. So the focus was
laid on the money market. The demand for and supply of real balances was
explained with the help of diagrams. The LM curve was derived in terms of
equation and diagram. The movements in the rate of interest due to change in the
money demand and money supply were explained. The impact of such
172
movements on the LM curve was discussed. Further, the slope and position of the Equilibrium in the
Monetary Sector
LM curve was discussed. It was observed that the change in nominal money
supply is the major factor that affects the position of the LM curve.

PROGRESS EXERCISES
1) Refer to Section 13.2.
3) L = kY – h i

4) Refer to Fig 13.7 and draw a diagram with left-ward shift in the LM curve.
Rate of interest will increase because supply of real balances will be lower
compared to demand.
173
UNIT 14 NEOCLASSICAL SYNTHESES*
Structure
14.0 Objectives
14.1 Introduction
14.2 Simultaneous Equilibrium
14.3 Equilibrium and Adjustment Process
14.4 Classical and Keynesian Zones
14.5 Let Us Sum Up
14.6 Answers/Hints to Check Your Progress Exercises
14.0 OBJECTIVES
 describe the simultaneous equilibrium in goods market and money market;
 explain the adjustment process in the equilibrium output and interest rate;
and
 distinguish between the classical and the Keynesian zones in the IS-LM
model.
14.1 INTRODUCTION
In Unit 12 we derived the IS curve which indicates the points on which there is
equilibrium in the goods market. In Unit 13 we derived the LM curve, which
indicates the equilibrium in the money market. Now, the problem at hand is to
bring about equilibrium, simultaneously in both the markets. In this unit, we will
discuss the interaction of the IS and the LM curves, shifts in these curves, and the
adjustment process in case disequilibrium exists.
14.2 SIMULTANEOUS EQUILIBRIUM
For simultaneous equilibrium in the goods market and the money market, there
needs to be a single combination of interest rate and income level which satisfies
the equilibrium in both goods and money markets simultaneously. In Fig. 14.1
we super-impose the IS and the LM curves. In the figure, we represent income/
output level (Y) on the x-axis and the interest rate (i) on the y-axis.
*
In Fig. 14.1 we find that the goods market and the money market clear at point Neoclassical
E1. The equilibrium rate of interest is i1 and the equilibrium level of income and Synthesis
output is Y1. You should remember that we assume the price level to be constant
(𝑃). An implication of the above is that firms are willing to supply any amount of
goods and services at that price. At E1, the economy is in equilibrium as both
goods and money markets are in equilibrium. Thus, the firms are willing to
supply Y1 level of output and equilibrium interest rate is i1. Firms are producing
their planned amount of output and individuals have their portfolio composition
according to their plan. There is no unplanned inventory accumulation or
rundown of inventories.
i
LM
interest
rate
E1
i1
IS
i1 output
O Y1
Fig. 14.1: Simultaneous Equilibrium in Goods and Money Markets
If any of the two curves (viz., IS and LM) changes, there will be a change in the
equilibrium levels of income and interest rate. The impact of the shifts in the IS
and the LM curves on equilibrium output and interest rate, however, will be
different.
14.2.1 Shift in the IS Curve

In Fig. 14.2 we describe a situation where the IS curve shifts to the right. Let us
consider the changes an economy goes through if such a shift takes place.
Let us assume that there is an increase in the autonomous investment. This results
in an increase in the autonomous spending(𝐴̅) and hence there is a parallel shift
in the IS curve from IS1 to IS2 (see Unit 12). Correspondingly, the equilibrium
shifts from E1 to E2 which indicates higher equilibrium level of income and
output, and higher rate of interest. In Fig. 14.2 you can see that output increases
from Y1 to Y2, and interest rate increases from i1 to i2.
You should observe that the extent of change in the level of income (=  G  A) is
not the same as the extent of shift in the IS curve. This is because we are dealing
with the money market also. Increase in ∆𝐴̅ leads to increase in income, which
affects the demand for money. Supply of money remains fixed while the demand
for money increases. Consequently the rate of interest increases in the money
market. This has a negative impact on the investment spending. As interest rate
175
IS-LM Analysis rises, investment falls to some extent. Hence, the final change in the income is
less than 𝛼 ∆𝐴̅ .
i
LM
Interest E2
rate i2
E1
i1
IS2
IS1
Y
O Y1 Y2
Income and Output Level
Fig. 14.2: Shift in the IS Curve
14.2.2 Shift in the LM Curve

In Fig. 14.3 we describe a situation where the LM curve shifts to the right. Let us
consider the changes an economy goes through if such a shift takes place.
i
LM1
Interest rate LM2

E1
i1
i2 E2
IS1
0 Y1 Y2 Y
Income and output
Fig. 14.3: Shift in the LM Curve
Let us assume that there is an increase in the money supply in the economy.
Consequently there is a right-ward parallel shift in the LM curve from LM1 to
LM2 (see Unit 13). Consequently, the equilibrium changes from E1 to E2. As we
can see from Fig. 14.3, interest rate decreases from 𝑖 to 𝑖 while output level
increases from Y1 to Y2.
Since we assume price level to be constant, an increase in money supply results

in an increase in the supply of real balances as a consequence of which there is a
decline in the rate of interest. A decline in the rate of interest leads to an increase
in the level of investment in the economy as a result of which there is an increase
in the level of output.
176
Check Your Progress 1 Neoclassical
Synthesis
1) Explain the simultaneous equilibrium in the goods market and the money
market.
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2) Explain the impact of a leftward shift in the IS curve through appropriate
diagram.
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3) Explain the impact of a leftward shift in the LM curve through
appropriate diagram.
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14.3 EQUILIBRIUM AND ADJUSTMENT PROCESS
In the previous Section we found that equilibrium output and interest rate are
realized at the intersection of the IS and the LM curves. In this Section we will
show that there is a tendency of the market to reach back to the equilibrium. If
the economy is outside the IS and the LM curves (when there is no equilibrium in
the economy), an adjustment process in the economy takes place and the
economy moves to a new equilibrium point. Let us appreciate the following two
points:
a) If there is an excess demand for money, the interest rate will increase. The
interest rate will fall in case we observe excess supply in the money
market.
b) Excess demand for goods leads to an increase in output and excess supply
of goods leads to a decline in output. The former involves run down of
inventory with the firms while the latter leads to accumulation of
inventories.
177
IS-LM Analysis Let us consider Fig. 14.4, which shows the adjustment process that market
follows to regain equilibrium if there is some shock/ disturbance. Let us assume
that the economy is operating at a point which is not on the IS and LM curves. In
other words, Fig. 14.4 shows few points (for example F, G, H and K) which do
not reflect the equilibrium in the money market as well as the goods market.
From such points, how does the economy reach towards equilibrium?
i
LM
F
Interest
rate
H E G
i0
Fig. 14.4: Adjustment towards Equilibrium

K
IS
Y
O Y0
Income and Output
Fig. 14.4: Adjustment towards Equilibrium
Any point to the left of the LM curve shows excess supply of money (see Unit
13). On the other hand, any point to the right of the LM curve shows excess
demand for money. Similarly, any point to the left of the IS curve shows excess
demand for goods (see Unit 12). On the other hand, any point to the right of the
IS curve shows excess supply of goods.
Let us take any random point G (it represents excess demand for money and
excess supply of goods). The arrows given at point G specify the direction in
which adjustment takes place. Excess demand for money will cause interest rate
to rise. This is because assets are sold off for money and price of assets decline.
Upward pointing arrow represents rising interest rate. Excess supply of goods
leads to involuntary accumulation. So the firms start reducing the output. The
leftward pointing arrow represents the declining output.
Points F, H and K inn Fig. 14.4 are similarly points of disequilibrium where
adjustment takes place and eventually the economy reaches at E, the point of
equilibrium. Even if only one of these two markets is observing disequilibrium,
the economy reaches back to equilibrium after the adjustment process.
In Fig. 14.5 we have indicated the direction of change by arrow marks. Any point
on the IS curve, apart from E, shows equilibrium in goods market but a
disequilibrium in the assets market.
178
Neoclassical
Synthesis
i
LM
Interest
rate
E
i0
IS
Y
O Y0
Income and Output
Fig. 14.5: Adjustment Process in the Economy
Similarly, any point on the LM curve, except point E, shows disequilibrium in

the goods market (see Fig. 14.5). In case we are above the IS curve and on the
LM curve, then the movement towards the equilibrium point E would mean
lowering interest rates and the lowering of output too. Assets market does not
take time to clear and hence the equilibrium is attained immediately. This kind of
adjustment process will lead to an equilibrium position which is stable till the
concerned economic variables do not change.
14.4 CLASSICAL AND KEYNESIAN ZONES
In Unit 13 we discussed about the slope of the LM curve which shows the
sensitivity of money supply on interest rate and output level. There could be two
extreme cases with respect to the LM curve, viz., i) the LM curve is horizontal,
and ii) the LM curve is vertical. We will see the implications of both the
situations.
In the first situation, when the LM curve is horizontal, the public is prepared to
hold all the money at a given interest rate. It reflects a situation known as
liquidity trap. In such a case, monetary policy has no effect on the rate of interest
and the level of output. A condition of liquidity trap exists when the rate of
interest is very low (for example, nearly zero). Public would not want to hold
bonds at such low interest rate.
Let us now learn about classical and Keynesian positions through the IS–LM
model. Fig. 14.6 shows the classical and the Keynesian ranges in the LM curve.
Let us assume that the economy is operating at Y1. The LM curve is infinitely
elastic at Y1. In case the government exercises an expansionary fiscal policy,
which means government expenditure increases, then the IS1 curve shifts to IS1.
179
IS-LM Analysis
i
IS'
IS
Rate of
Interest
'
IS 2
IS2
IS'1
IS1
' '
O Y1 Y 1 Y2 Y 2 Y3 Y
Income and Output

Fig. 14.6: Classical and Keynesian Ranges
There is nearly no increase in the rate of interest but income level has risen from
Y1 to Y1. Rate of interest does not increase because sufficient idle money is
available in the economy. This is the Keynesian range as individuals are in a
situation of liquidity trap. Under such circumstance monetary policy is
ineffective and government should take up fiscal measures.
If we see the other extreme in Fig. 14.6, where economy is operating at Y 3 level,
we realise that the LM curve is nearly vertical. Rate of interest is too high for
people to hold money. The interest bearing assets are lucrative to invest the
money. Hence, the real money balances are low. When government borrows
(with an intention of increasing the level of investment), in such a situation,
government investment becomes a competitor of private investment and there is
no increase in total investment in the economy. Due to this high competition, the
rate of interest rises but not the income level. This range of the LM curve is
known as the classical range. Under such circumstances, fiscal policy is not
much effective. We have already discussed the distinction between classical and
Keynesian views in Unit 9.
The moderate range seems to be more realistic vis-à-vis the Keynesian and the
classical ranges of the IS-LM model. Such a moderate range is depicted in Fig.
14.6 by the income level Y2. When government investment increases, the
complete ‘crowding out’ of the private investment does not take place. There is
an increase in the rate of interest but there is an increase in the level of output
also. In Fig. 14.6 we find that the output level increases from Y2 to Y2 due to the
shift in the IS curve from IS2 to IS2.
180
Neoclassical
Check Your Progress 2 Synthesis
1) Explain how the adjustment process takes place in the IS-LM model.
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2) In what respects the classical range of the LM curve is different from the
Keynesian range?
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14.5 LET US SUM UP
We started this unit with a discussion on the simultaneous equilibrium in the

goods market and the money market. It led to the unique combination of interest
rate and the output level which indicates simultaneous equilibrium in both the
markets. Any point away from the IS curve and/or the LM curve indicates the
state of disequilibrium. In case of any disequilibrium, the adjustment process
starts and the equilibrium in both the markets are restored.
Further, we discussed about the Classical and Keynesian ranges with respect to
the LM curve. When the LM curve is vertical, it reflects a situation similar to the
classical model where the output level does not change as a result of government
borrowing. On the other hand, when the LM curve is nearly flat, it reflects a
situation similar to the Keynesian model because the public investment leads to
shifts the income level only and not the interest rate.

PROGRESS EXERCISES

2) Refer to Section 14.2.1.
181
IS-LM Analysis Check Your Progress 2
182
GLOSSARY
: According to classical economists, the aggregate supply curve is
Aggregate Supply
Curve vertical, implying that total output is always at the full employment
level. In the short run, according to Keynes, the aggregate supply
curve will be horizontal if the economy has under-utilised
resources.
Automatic Stabilizers : Revenue and expenditure items in the budget that automatically
change with the state of the economy and tend to stabilize GDP
Autonomous : Investment spending which is not dependent on income or interest

investment rate.
Autonomous spending : A part of AD that is independent of the income and output level.
Average Propensity to : C 
Consume The ratio of consumption expenditure to income i.e.,  .
Y 
Balance of Trade : It refers to the export and import of only visible items.
Balanced Budget : Equilibrium income rises by the same amount by which the
Multiplier government spending rises. It is assumed that the change in
government spending is equal to the change in taxes. Taxes are
taken as autonomous taxes.
Bank Rate : Rate at which the central bank lends funds to the commercial
banks.
Bond : In economics, it is an instrument of indebtedness. It is a promise to

pay its holder certain agreed upon amount of money at specified
dates in the future.
Broad Money : M3 is known as ‘broad money’ since it includes time deposits as

well.
Budget Deficit : When government receipts fall short of government expenditure,

we encounter the problem of budget deficit.
Budget Surplus : Excess of government revenue over government spending.
183
: Periodical ups and downs in economic activity in an economy.
Business Cycle
There are four phases of a business cycle, viz., expansion,
recession, depression, and recovery. During expansion phase the
economy grows while during recession there is a deceleration in
growth rate. Depression is much severe and the economy may
witness negative economic growth. During recovery, as the name
suggests, the economy recovers from depression.
Capital Goods : These are goods which help in further production of goods.
Example could be machineries.
Cash Reserve Ratio : It is the percentage of bank deposits that the banks are required
(CRR) keep with the central bank. In India, in 2019 the CRR is 4 percent.
Thus, if Rs. 100 is deposited in a bank, the bank needs to keep Rs.
4 with the RBI. The RBI can vary the CRR between 3 per cent and
15 per cent.
Change in Inventories : Inventories are stocks of finished goods/ semi-finished goods/

intermediate goods. Change in inventories is total inventories at
the end of the year minus total inventories at the beginning of the
year for an economy.
Circular Flow : It is a flow of goods or services or money from one (set of)
transactor to another (set).
Classical Economists : Economists who subscribe to classical point of view. Eminent

classical economists include Adam Smith, David Ricardo, J B Say,
and A C Pigou.
Classical Model : A model of the economy derived from ideas of the pre-Keynesian
economists. It is based on the assumption that prices and wages
adjust instantaneously to clear markets and that monetary policy
does not influence real variables such as output and employment.
: It is a model based on the assumption that prices and wages adjust

Classical Model
quickly to clear the markets.
: It is the policy prescription of bring down inflation rate rapidly.

Cold Turkey
Compensation of : Remuneration given by enterprises to employees for rendering
Employees labour services.
Consumer Price Index : Consumer Price Index represents the rate of increase in the
consumer prices of a basket of goods and services.
Core Inflation : Core inflation is a measure of inflation that excludes items that
face volatile price movement, notably food and energy.
184
: Cost-push inflation is a sustained rise in the general price level due
Cost-push inflation
to a rise in the cost of production in the economy.

Cost-push inflation
Crowding Out : It reflects a situation when increase in public investment is

possible at the cost of private investment.
Deflation : Deflation is a sustained decrease in the general price level.
: Demand-pull inflation is a sustained rise in the general price level

Demand-pull inflation
due to an increase in aggregate demand.
Departmental : Part of t h e government sector. It consists of those enterprises,

Enterprises which run as a part of government departments producing goods
and services. Examples could be railways, Post and T elegraph,
etc.
Depreciation : It is the loss in the value of capital asset because of normal wear
and tear and expected obsolescence.
Direct Personal Taxes : These are the taxes imposed on households in the form of
income tax or wealth tax. Those on whom they are imposed pay
them.
Disposable income : Amount of income received by the households after taxes

Yd = Y – T
Double Counting : It refers to the problem of counting the same good more than once.
In order to avoid the problem, we consider the final goods and
services only.
Economic Agents : These are groups of transactors, which indulge in economic

activities like production/ income generation/ addition to capital
stock. Economic agents can be classified into producers,
households, capital sector, rest of the world, and government.
Economic : These are the transactions consisting of production, income

Transactions generation and addition to capital stock.
Enterprises : These are economic agents, which employ factors of production

to generate a flow of goods and services in the economy.
185
External Commercial : ECB are loans which are raised by a country’s corporate sector
Borrowings (ECB) from external financial organizations on commercial terms.
Factor Cost : It is the total cost incurred to employ factors of production to give
rise to a flow of goods and services in an economy. It is equal to
value of market price minus Net Indirect T axes.
Factor Services : These are the services rendered by factors of production such
as land, labour, capital and enterprise.
Final Consumption : This is an expenditure incurred by households, enterprises and

Expenditure rest of the world to purchase final consumer goods, capital
goods and net exports respectively.
Financial Sector : This sector of the economy mops up savings of various sectors and
uses it for lending to other sectors of the economy.
Fiscal Policy : Government’s taxes and spending behaviour.
Fractional Reserve Under this system, banks are required to hold a certain fraction of
Banking System their demand and time liabilities in the form of cash balances with
the central bank.
Goods Market : When AD and AS interact with each other. All points on the IS
Equilibrium curve reflects equilibrium in the goods market.
Government Final : It is the expenditure incurred by government on the purchase of

Consumption intermediate goods plus compensation of government employees.
Expenditure This expenditure is incurred to meet the collective consumption
of the economy.
Government Sector : It is the sector, which produces goods and services that are not
sold at a price. Such goods are meant to meet collective
consumption requirements of an economy. The expenses of these
goods are met by tax and non-tax revenue of the government.
: The time duration when the over production and unemployment

Great Depression
made it impossible for the world economies to operate at
equilibrium. It started in 1929 and went on for a good 7-8 years.
Gross Domestic : It is the sum of final goods and services produced in a country
Product (GDP) during a period of time, usually a year. We do not include
intermediate goods and income acquired through illegal activities
in the GDP. In most countries, including India, estimated value of
GDP is available on a quarterly basis as well as on a yearly basis.
186
Gross National : It is the value of goods and services produced in an economy
Product (GNP) over a year, without duplication but gross of depreciation. It is the
goods and services produced by the normal residents of an
economy.
High-powered Money : M0 is known as monetary base or central bank money or high-

powered money.
Hot Money : Money which quickly moves from one nation to another in search
of speculative gains.
Household Sector : It is the sector that supplies factor services to firms or

enterprises. The factor incomes received by households are used
to meet their final consumption requirements and the balance is
used for savings, which are passed on to the capital sector.
Hyper-Inflation : Inflation is a persistent increase in general price level. When the

rate of inflation is very high, it is said to be hyper-inflation. Many
countries have seen episodes of hyper-inflation. In recent years, for
example, Zimbabwe has witnessed inflation rate to the extent of
175 per cent per year.
Hyper-inflation : Hyper-inflation is a very rapid growth in the rate of inflation in

which money loses its value to a point where alternative mediums
of exchange.
Income from Domestic : It is the factor income enjoyed by households and private sector
Product accruing to over a year in an economy.
Private sector
: Change in income leading to a change in leisure/ labour due to
Income-Leisure trade
off change in the wage rate.
Inflation : Inflation is a persistent increase in the general level of prices.
: The objective of the monetary policy in many countries is inflation

Inflation Targeting
targeting, where the central bank targets to achieve certain
inflation rate. For example, in India, the Reserve Bank of India
targets an inflation rate of 4 per cent with a tolerance band of 2 per
cent.
: Financing government expenditure by printing money increases
Inflation Tax
prices for everyone, reducing their spending power just as a tax to
finance the spending would. This is called an inflation tax.
Intermediate : It is the purchase of raw materials and services by a firm from
Consumption other firms to produce goods or services.
187
Inventories : The stock of goods maintained by producers to tide over
unexpected fluctuation in demand.
: Demand varies periodically but production is fixed. Thus a firm

Inventory
maintains certain stock of goods to meet uncertainties in demand,
supply and movement of goods. If demand exceeds current
production there is decline in the stock. Similarly, if demand falls
short of production there is accumulation of inventory.
Investment : It is the creation of capital goods in an economy over a year. It can

be for replacement of worn out capital or for addition to total
capital stock of an economy.
Investment Multiplier : It is the multiple by which income or output of an economy

increase when investment increases by certain amount. It is given
by the formula 𝛼 = where c stands for marginal propensity to
consume.
: The term coined by Adam Smith, meant that government should

Invisible Hand
not intervene in the running of an economy too often and too
strongly.
Involuntary : In indicates a situation where unemployment is not voluntary; a

Unemployment person is looking for a job but cannot find one.
IS Curve : Investment – Saving curve showing inverse relationship between

interest rate and income.
Keynesian Model : A model based on the ideas contained in Keynes’ General Theory.
It assumes that demand creates its own supply so long as
unemployment exists, and that prices and wages do not adjust
instantaneously to clear markets.
Liquidity Preference : People are willing to hold whatever amount of money is supplied
Region to them such that the monetary policy becomes completely
ineffective.
Liquidity Trap : At a very low rate of interest (nearly zero), people wish to hold any
amount of money and not interested in the interest-bearing assets.
LM Curve : Locus of the points which show the money market equilibrium at
various combinations of income and rate of interest.
188
: Change in the output due to an additional unit of labour employed.
Marginal Product of
Labour
Marginal Propensity : The increase in consumption due to one-rupee increase in income.
to consume (mpc) Y
It is arrived at by calculating .
C
Marginal Propensity : Increase in saving due to one-rupee increase in the income. It is
to Save written as ‘s’ or mps.
Market Price : It is the price at which a commodity or service is actually

purchased by a households or a firm.
Mixed Income of Self- : It is the factor income generated by unincorporated enterprises

employed where it is not possible to distinguish between compensation of
employees and operating surplus.
Money : It is the stock of assets which is used for transaction purposes.
Money Flows : These are the flows, which are normally a consequence of real
flows between various sectors of an economy.
Money Multiplier : The money multiplier is the ratio of the stock of money to the
stock of high powered money.
Money Transactions : These are the transactions between one transactor and another or
between one group of transactors and another in terms of money to
money without being backed by real transactions.
Multiplier : The amount by which the equilibrium output changes when

autonomous spending increases by one unit.
Narrow Money : M1 is also known as ‘narrow money’.
National Income : It is the same aggregate as net national product at factor cost
(NNPFC).
National Wealth : Total wealth of the residents of a country.
Net Current Transfers : It is the difference between unrequited transfers from the rest of the
from the Rest of the world, over a year, and such transfers from the economy to the
World rest of the world.
Net Domestic Capital : It is that part of total production of capital goods and inventories
Formation which are meant to add to total capital stock of an economy
over a year in an economy.
189
Net Domestic : It is the value of goods and services produced in an economy,
Product (NDP) over a year, without duplication, net of depreciation.
This concept is related to the concept of domestic territory.
Net Exports (NX) : It is the difference between total value of exports and imports over
a year.
Net Factor Income : It is the difference between factor incomes earned by the normal
from Abroad residents of an economy stationed abroad temporarily and the
factor incomes earned by normal residents of the rest of the
world stationed in the economy temporarily.
Net Indirect Taxes : It is the difference between indirect taxes and subsidies.
Net National : It is the total income at the disposal of a c ou n t r y by way of

Disposable Income factor income as well as transfer incomes from t he rest of the
(NNDP) world. It is identical to NNP at market price plus net current
transfers from abroad.
Non-departmental : These are the government enterprises for which autonomous

Enterprises corporations are set up. The goods or services produced by
these enterprises are sold for a price. They are the profit making
enterprises set up in the public sector.
Normal Residents : They are the households or institutions, which have their centre
of interest in the economy but some of them may temporarily be
stationed aboard.
Open Economy : It is an economy, which has economic transactions with t he

rest of the world.
Open Market : Sale/ purchase of government securities by the central bank to/
Operations from the public and the banks.
Operating Surplus : It is the factor income generated by ownership and management

of property. It consists of rent, interest, and profits.
Per Capita GDP : The ratio of Gross domestic Product (GDP) to total population of a
country.
Personal Disposable : It is the factor income and transfer incomes left at the disposal of
Income the households after paying direct personal taxes and
miscellaneous receipts of government administrative departments
from personal income.
Personal Income : It is the factor income and transfer incomes enjoyed by the
households of an economy over a year.
190
: It shows the relationship between inflation and unemployment.
Phillips Curve
Phillips curve is downward sloping in the short-run, implying a
trade-off between the two. In the long-run the Phillips Curve is
vertical, implying that unemployment rate cannot be brought down
below natural rate of unemployment.
Price Level : It is the average of prices of all the goods and services produced in
a country.
Private Final : It is the expenditure incurred by the households of an economy,

Consumption over a year, on the purchase of goods and services meant for
Expenditure final consumption.
Private Income : It is the factor income and transfer incomes enjoyed by

households and private sector of an economy over a year.
: It is the relationship between factors of production (inputs) and the

Production Function
available technology with the quantity of output produced.
: The quantity theory of money states that there is a direct

Quantity Theory of
Money relationship between the quantity of money in an economy and the
level of prices of goods and services sold.
Quid Pro Quo : It is a Latin phrase which means an exchange relationship

between persons/ economic agents. When you get something
from a transactor in return for (in exchange of) something, it is
called quid-pro-quo.
Rate of Gross : It is defined as gross domestic capital formation divided by

Domestic Capital GDPMP multiplied by 100.
Formation
Rate of Gross : It is equal to gross domestic savings divided by GDP at MP
Domestic Saving multiplied by 100.
Rate of Net Domestic : It is net domestic capital formation divided by NDP at

Capital Formation market price (MP) multiplied by 100.
Rate of Net Domestic : It is equal to net domestic savings divided by NDP at MP

Saving multiplied by 100.
Rate of Net Foreign : It is the difference between rate of gross domestic capital
Capital Inflow formation and rate of gross domestic savings.
191
Real Flows : These are the flows of goods or services from one set of
transactors to another.
Real Money Balances : Quantity of nominal money divided by the price level.
Real Transactions : Those transactions, which are related to exchange of goods and
services between two transactors or two groups of transactors.
Recession : In business cycle, recession indicates the phase when there is an

economic slowdown; economic growth is in a decelerating phase.
Replacement : It is that part of currently produced capital goods, which are

Investment meant to replace the capital stock arising out of normal wear
and tear, and expected obsolescence.
Repo Rate : Rate at which the central bank lends funds to the commercial
banks against submission of collateral such as securities by the
banks.
Residential Investment : Investment incurred on construction of new houses and buildings
is called as residential investment.
Rest of the World : This sector deals with economic transactions of an economy
Sector with the rest of the world.
Reverse Repo Rate : Rate at which the commercial banks can deposit their excess
liquidity with the central bank, by purchasing securities.
: It refers to the percentage loss of output for bringing down

Sacrifice Ratio
inflation by one per cent.
Simultaneous : Equilibrium in the goods market as well as in the money market at

Equilibrium the same time.
Slope of Investment : It indicates the sensitivity of investment to changes in the interest

Function rate.
Stagflation : Stagflation refers to economic condition where economic growth is

very slow or stagnant and prices are rising.
Statutory Liquidity : Banks are required to hold a certain percentage of their demand
Ratio (SLR) and time deposits in the form of government securities. Currently
(in 2019) the SLR is 19.5 per cent in India.
: The supporters of structural theories believed that inflation arises

Structural theory of
Inflation due to structural maladjustments in the county or due to certain
192
institutional features of the business environment.
Transfer Payments : One-way payment of money for which no goods or services are
received in exchange.
: The value of money is its purchasing power, the amount of goods

Value of Money
and services it can buy. Value of money is inversely related to
price level. When price level increases, value of money declines.
Velocity of Money : The number of times the money stock of turns over per year in
order to finance the annual flow of transactions or income.
Wealth Budget : Sum of individual’s demand for money and demand for bonds is
Constraint the individual’s total financial wealth.
Wholesale Price Index : Wholesale Price Index represents the rate of increase in the
wholesale prices of products.
193
GLOSSARY
: According to classical economists, the aggregate supply curve is
Aggregate Supply
Curve vertical, implying that total output is always at the full employment
level. In the short run, according to Keynes, the aggregate supply
curve will be horizontal if the economy has under-utilised
resources.
Automatic Stabilizers : Revenue and expenditure items in the budget that automatically
change with the state of the economy and tend to stabilize GDP
Autonomous : Investment spending which is not dependent on income or interest

investment rate.
Autonomous spending : A part of AD that is independent of the income and output level.
Average Propensity to : C 
Consume The ratio of consumption expenditure to income i.e.,  .
Y 
Balance of Trade : It refers to the export and import of only visible items.
Balanced Budget : Equilibrium income rises by the same amount by which the
Multiplier government spending rises. It is assumed that the change in
government spending is equal to the change in taxes. Taxes are
taken as autonomous taxes.
Bank Rate : Rate at which the central bank lends funds to the commercial
banks.
Bond : In economics, it is an instrument of indebtedness. It is a promise to

pay its holder certain agreed upon amount of money at specified
dates in the future.
Broad Money : M3 is known as ‘broad money’ since it includes time deposits as

well.
Budget Deficit : When government receipts fall short of government expenditure,

we encounter the problem of budget deficit.
Budget Surplus : Excess of government revenue over government spending.
183
: Periodical ups and downs in economic activity in an economy.
Business Cycle
There are four phases of a business cycle, viz., expansion,
recession, depression, and recovery. During expansion phase the
economy grows while during recession there is a deceleration in
growth rate. Depression is much severe and the economy may
witness negative economic growth. During recovery, as the name
suggests, the economy recovers from depression.
Capital Goods : These are goods which help in further production of goods.
Example could be machineries.
Cash Reserve Ratio : It is the percentage of bank deposits that the banks are required
(CRR) keep with the central bank. In India, in 2019 the CRR is 4 percent.
Thus, if Rs. 100 is deposited in a bank, the bank needs to keep Rs.
4 with the RBI. The RBI can vary the CRR between 3 per cent and
15 per cent.
Change in Inventories : Inventories are stocks of finished goods/ semi-finished goods/

intermediate goods. Change in inventories is total inventories at
the end of the year minus total inventories at the beginning of the
year for an economy.
Circular Flow : It is a flow of goods or services or money from one (set of)
transactor to another (set).
Classical Economists : Economists who subscribe to classical point of view. Eminent

classical economists include Adam Smith, David Ricardo, J B Say,
and A C Pigou.
Classical Model : A model of the economy derived from ideas of the pre-Keynesian
economists. It is based on the assumption that prices and wages
adjust instantaneously to clear markets and that monetary policy
does not influence real variables such as output and employment.
: It is a model based on the assumption that prices and wages adjust

Classical Model
quickly to clear the markets.
: It is the policy prescription of bring down inflation rate rapidly.

Cold Turkey
Compensation of : Remuneration given by enterprises to employees for rendering
Employees labour services.
Consumer Price Index : Consumer Price Index represents the rate of increase in the
consumer prices of a basket of goods and services.
Core Inflation : Core inflation is a measure of inflation that excludes items that
face volatile price movement, notably food and energy.
184
Cost-push inflation

Cost-push inflation
Crowding Out : It reflects a situation when increase in public investment is

possible at the cost of private investment.
Deflation : Deflation is a sustained decrease in the general price level.
: Demand-pull inflation is a sustained rise in the general price level

Demand-pull inflation
due to an increase in aggregate demand.
Departmental : Part of t h e government sector. It consists of those enterprises,

Enterprises which run as a part of government departments producing goods
and services. Examples could be railways, Post and T elegraph,
etc.
Depreciation : It is the loss in the value of capital asset because of normal wear
and tear and expected obsolescence.
Direct Personal Taxes : These are the taxes imposed on households in the form of
income tax or wealth tax. Those on whom they are imposed pay
them.
Disposable income : Amount of income received by the households after taxes

Yd = Y – T
Double Counting : It refers to the problem of counting the same good more than once.
In order to avoid the problem, we consider the final goods and
services only.
Economic Agents : These are groups of transactors, which indulge in economic

activities like production/ income generation/ addition to capital
stock. Economic agents can be classified into producers,
households, capital sector, rest of the world, and government.
Economic : These are the transactions consisting of production, income

Transactions generation and addition to capital stock.
Enterprises : These are economic agents, which employ factors of production

to generate a flow of goods and services in the economy.
185
External Commercial : ECB are loans which are raised by a country’s corporate sector
Borrowings (ECB) from external financial organizations on commercial terms.
Factor Cost : It is the total cost incurred to employ factors of production to give
rise to a flow of goods and services in an economy. It is equal to
value of market price minus Net Indirect T axes.
Factor Services : These are the services rendered by factors of production such
as land, labour, capital and enterprise.
Final Consumption : This is an expenditure incurred by households, enterprises and

Expenditure rest of the world to purchase final consumer goods, capital
goods and net exports respectively.
Financial Sector : This sector of the economy mops up savings of various sectors and
uses it for lending to other sectors of the economy.
Fiscal Policy : Government’s taxes and spending behaviour.
Fractional Reserve Under this system, banks are required to hold a certain fraction of
Banking System their demand and time liabilities in the form of cash balances with
the central bank.
Goods Market : When AD and AS interact with each other. All points on the IS
Equilibrium curve reflects equilibrium in the goods market.
Government Final : It is the expenditure incurred by government on the purchase of

Consumption intermediate goods plus compensation of government employees.
Expenditure This expenditure is incurred to meet the collective consumption
of the economy.
Government Sector : It is the sector, which produces goods and services that are not
sold at a price. Such goods are meant to meet collective
consumption requirements of an economy. The expenses of these
goods are met by tax and non-tax revenue of the government.
: The time duration when the over production and unemployment

Great Depression
made it impossible for the world economies to operate at
equilibrium. It started in 1929 and went on for a good 7-8 years.
Gross Domestic : It is the sum of final goods and services produced in a country
Product (GDP) during a period of time, usually a year. We do not include
intermediate goods and income acquired through illegal activities
in the GDP. In most countries, including India, estimated value of
GDP is available on a quarterly basis as well as on a yearly basis.
186
Gross National : It is the value of goods and services produced in an economy
Product (GNP) over a year, without duplication but gross of depreciation. It is the
goods and services produced by the normal residents of an
economy.
High-powered Money : M0 is known as monetary base or central bank money or high-

powered money.
Hot Money : Money which quickly moves from one nation to another in search
of speculative gains.
Household Sector : It is the sector that supplies factor services to firms or

enterprises. The factor incomes received by households are used
to meet their final consumption requirements and the balance is
used for savings, which are passed on to the capital sector.
Hyper-Inflation : Inflation is a persistent increase in general price level. When the

rate of inflation is very high, it is said to be hyper-inflation. Many
countries have seen episodes of hyper-inflation. In recent years, for
example, Zimbabwe has witnessed inflation rate to the extent of
175 per cent per year.
Hyper-inflation : Hyper-inflation is a very rapid growth in the rate of inflation in

which money loses its value to a point where alternative mediums
of exchange.
Income from Domestic : It is the factor income enjoyed by households and private sector
Product accruing to over a year in an economy.
Private sector
: Change in income leading to a change in leisure/ labour due to
Income-Leisure trade
off change in the wage rate.
Inflation : Inflation is a persistent increase in the general level of prices.
: The objective of the monetary policy in many countries is inflation

Inflation Targeting
targeting, where the central bank targets to achieve certain
inflation rate. For example, in India, the Reserve Bank of India
targets an inflation rate of 4 per cent with a tolerance band of 2 per
cent.
: Financing government expenditure by printing money increases
Inflation Tax
prices for everyone, reducing their spending power just as a tax to
finance the spending would. This is called an inflation tax.
Intermediate : It is the purchase of raw materials and services by a firm from
Consumption other firms to produce goods or services.
187
Inventories : The stock of goods maintained by producers to tide over
unexpected fluctuation in demand.
: Demand varies periodically but production is fixed. Thus a firm

Inventory
maintains certain stock of goods to meet uncertainties in demand,
supply and movement of goods. If demand exceeds current
production there is decline in the stock. Similarly, if demand falls
short of production there is accumulation of inventory.
Investment : It is the creation of capital goods in an economy over a year. It can

be for replacement of worn out capital or for addition to total
capital stock of an economy.
Investment Multiplier : It is the multiple by which income or output of an economy

increase when investment increases by certain amount. It is given
by the formula 𝛼 = where c stands for marginal propensity to
consume.
: The term coined by Adam Smith, meant that government should

Invisible Hand
not intervene in the running of an economy too often and too
strongly.
Involuntary : In indicates a situation where unemployment is not voluntary; a

Unemployment person is looking for a job but cannot find one.
IS Curve : Investment – Saving curve showing inverse relationship between

interest rate and income.
Keynesian Model : A model based on the ideas contained in Keynes’ General Theory.
It assumes that demand creates its own supply so long as
unemployment exists, and that prices and wages do not adjust
instantaneously to clear markets.
Liquidity Preference : People are willing to hold whatever amount of money is supplied
Region to them such that the monetary policy becomes completely
ineffective.
Liquidity Trap : At a very low rate of interest (nearly zero), people wish to hold any
amount of money and not interested in the interest-bearing assets.
LM Curve : Locus of the points which show the money market equilibrium at
various combinations of income and rate of interest.
188
: Change in the output due to an additional unit of labour employed.
Marginal Product of
Labour
Marginal Propensity : The increase in consumption due to one-rupee increase in income.
to consume (mpc) Y
It is arrived at by calculating .
C
Marginal Propensity : Increase in saving due to one-rupee increase in the income. It is
to Save written as ‘s’ or mps.
Market Price : It is the price at which a commodity or service is actually

purchased by a households or a firm.
Mixed Income of Self- : It is the factor income generated by unincorporated enterprises

employed where it is not possible to distinguish between compensation of
employees and operating surplus.
Money : It is the stock of assets which is used for transaction purposes.
Money Flows : These are the flows, which are normally a consequence of real
flows between various sectors of an economy.
Money Multiplier : The money multiplier is the ratio of the stock of money to the
stock of high powered money.
Money Transactions : These are the transactions between one transactor and another or
between one group of transactors and another in terms of money to
money without being backed by real transactions.
Multiplier : The amount by which the equilibrium output changes when

autonomous spending increases by one unit.
Narrow Money : M1 is also known as ‘narrow money’.
National Income : It is the same aggregate as net national product at factor cost
(NNPFC).
National Wealth : Total wealth of the residents of a country.
Net Current Transfers : It is the difference between unrequited transfers from the rest of the
from the Rest of the world, over a year, and such transfers from the economy to the
World rest of the world.
Net Domestic Capital : It is that part of total production of capital goods and inventories
Formation which are meant to add to total capital stock of an economy
over a year in an economy.
189
Net Domestic : It is the value of goods and services produced in an economy,
Product (NDP) over a year, without duplication, net of depreciation.
This concept is related to the concept of domestic territory.
Net Exports (NX) : It is the difference between total value of exports and imports over
a year.
Net Factor Income : It is the difference between factor incomes earned by the normal
from Abroad residents of an economy stationed abroad temporarily and the
factor incomes earned by normal residents of the rest of the
world stationed in the economy temporarily.
Net Indirect Taxes : It is the difference between indirect taxes and subsidies.
Net National : It is the total income at the disposal of a c ou n t r y by way of

Disposable Income factor income as well as transfer incomes from t he rest of the
(NNDP) world. It is identical to NNP at market price plus net current
transfers from abroad.
Non-departmental : These are the government enterprises for which autonomous

Enterprises corporations are set up. The goods or services produced by
these enterprises are sold for a price. They are the profit making
enterprises set up in the public sector.
Normal Residents : They are the households or institutions, which have their centre
of interest in the economy but some of them may temporarily be
stationed aboard.
Open Economy : It is an economy, which has economic transactions with t he

rest of the world.
Open Market : Sale/ purchase of government securities by the central bank to/
Operations from the public and the banks.
Operating Surplus : It is the factor income generated by ownership and management

of property. It consists of rent, interest, and profits.
Per Capita GDP : The ratio of Gross domestic Product (GDP) to total population of a
country.
Personal Disposable : It is the factor income and transfer incomes left at the disposal of
Income the households after paying direct personal taxes and
miscellaneous receipts of government administrative departments
from personal income.
Personal Income : It is the factor income and transfer incomes enjoyed by the
households of an economy over a year.
190
: It shows the relationship between inflation and unemployment.
Phillips Curve
Phillips curve is downward sloping in the short-run, implying a
trade-off between the two. In the long-run the Phillips Curve is
vertical, implying that unemployment rate cannot be brought down
below natural rate of unemployment.
Price Level : It is the average of prices of all the goods and services produced in
a country.
Private Final : It is the expenditure incurred by the households of an economy,

Consumption over a year, on the purchase of goods and services meant for
Expenditure final consumption.
Private Income : It is the factor income and transfer incomes enjoyed by

households and private sector of an economy over a year.
: It is the relationship between factors of production (inputs) and the

Production Function
available technology with the quantity of output produced.
: The quantity theory of money states that there is a direct

Quantity Theory of
Money relationship between the quantity of money in an economy and the
level of prices of goods and services sold.
Quid Pro Quo : It is a Latin phrase which means an exchange relationship

between persons/ economic agents. When you get something
from a transactor in return for (in exchange of) something, it is
called quid-pro-quo.
Rate of Gross : It is defined as gross domestic capital formation divided by

Domestic Capital GDPMP multiplied by 100.
Formation
Rate of Gross : It is equal to gross domestic savings divided by GDP at MP
Domestic Saving multiplied by 100.
Rate of Net Domestic : It is net domestic capital formation divided by NDP at

Capital Formation market price (MP) multiplied by 100.
Rate of Net Domestic : It is equal to net domestic savings divided by NDP at MP

Saving multiplied by 100.
Rate of Net Foreign : It is the difference between rate of gross domestic capital
Capital Inflow formation and rate of gross domestic savings.
191
Real Flows : These are the flows of goods or services from one set of
transactors to another.
Real Money Balances : Quantity of nominal money divided by the price level.
Real Transactions : Those transactions, which are related to exchange of goods and
services between two transactors or two groups of transactors.
Recession : In business cycle, recession indicates the phase when there is an

economic slowdown; economic growth is in a decelerating phase.
Replacement : It is that part of currently produced capital goods, which are

Investment meant to replace the capital stock arising out of normal wear
and tear, and expected obsolescence.
Repo Rate : Rate at which the central bank lends funds to the commercial
banks against submission of collateral such as securities by the
banks.
Residential Investment : Investment incurred on construction of new houses and buildings
is called as residential investment.
Rest of the World : This sector deals with economic transactions of an economy
Sector with the rest of the world.
Reverse Repo Rate : Rate at which the commercial banks can deposit their excess
liquidity with the central bank, by purchasing securities.
: It refers to the percentage loss of output for bringing down

Sacrifice Ratio
inflation by one per cent.
Simultaneous : Equilibrium in the goods market as well as in the money market at

Equilibrium the same time.
Slope of Investment : It indicates the sensitivity of investment to changes in the interest

Function rate.
Stagflation : Stagflation refers to economic condition where economic growth is

very slow or stagnant and prices are rising.
Statutory Liquidity : Banks are required to hold a certain percentage of their demand
Ratio (SLR) and time deposits in the form of government securities. Currently
(in 2019) the SLR is 19.5 per cent in India.
: The supporters of structural theories believed that inflation arises

Structural theory of
Inflation due to structural maladjustments in the county or due to certain
192
institutional features of the business environment.
Transfer Payments : One-way payment of money for which no goods or services are
received in exchange.
: The value of money is its purchasing power, the amount of goods

Value of Money
and services it can buy. Value of money is inversely related to
price level. When price level increases, value of money declines.
Velocity of Money : The number of times the money stock of turns over per year in
order to finance the annual flow of transactions or income.
Wealth Budget : Sum of individual’s demand for money and demand for bonds is
Constraint the individual’s total financial wealth.
Wholesale Price Index : Wholesale Price Index represents the rate of increase in the
wholesale prices of products.
193
SOME USEFUL BOOKS FOR FURTHER READING
Abel Andrew B, Ben Bernanke, and Dean Croushore, 2017, Macroeconomics, Ninth Edition, Pearson
Education
Case Karl E., Ray C. Fair, and Sharon E. Oster, 2017, Principles of Economics, Twelfth Edition, Pearson
Education
Dornbusch Rudiger, Stanley Fisher, and Richard Startz, 2018, Macroeconomics, Thirteenth Edition,
McGraw Hill
Froyen Richard T., 2012, Macroeconomics: Theories and Policies, Tenth Edition, Person Education
Sikdar Shoumyen, 2011, Principles of Macroeconomics, Second Edition, Oxford University Press
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UNIT 12 EQUILIBRIUM IN THE REAL

After going through this Unit, you should be in a position to

In Unit 6 we learnt that equilibrium rate of interest is determined by the demand

12.2 GOODS MARKETS

where two determinants of equilibrium income are A and marginal propensity to

12.2.1 Interest Rate and Investment

I= I –bi where b > 0 …(12.1)

b = responsiveness of investment to interest rate

Fig. 12.1: Investment Function

A change in the level of autonomous investment ( I ) will result in a parallel shift

Fig. 12.4: Shift in Investment Curve

12.2.2 Aggregate Demand and the Interest rate

Suppose there is a decrease in the rate of interest from 𝑖 to 𝑖 . The intercept of

Income and Output

If you see logically, a decrease in interest rate will lead to an increase in

Check Your Progress 1

2) In what way the investment curve is affected when the sensitivity of

12.3 DERIVATION OF THE IS CURVE

Income and Output

Fig 12.6: IS Curve

Fig 12.7: Points off the IS Curve

12.3.1 Slope of the IS Curve

Or, 𝑌 = 𝛼 (𝐴̅ − 𝑏𝑖) …(12.3)

sector and 𝑐̅ = c(1 – t).

Income and Output

Fig 12.8: Multiplier and IS Curve

Income and Output

Fig. 12.8: Impact of Interest Rate on Aggregate Demand

We find that 𝛼 is affected positively by 𝑐̅ because 𝛼 = ̅

12.3.2 Position of the IS Curve

Income and Output

Fig 12.9: Shift in IS Curve

In case the government spending decreases, the AD curve will experience a

Check Your Progress 2

3) What affects the position of an IS Curve?

12.4 LET US SUM UP

12.5 ANSWERS/HINTS TO CHECK YOUR

Check Your Progress 2

13.2 REAL AND NOMINAL DEMANDS

13.3 DEMAND FOR AND SUPPLY OF MONEY

Individuals require money to make transactions such as purchase of goods and

Fig. 13.1: Demand for Money

Fig. 13.2: Money Supply

13.4 MONEY MARKET EQUILIBRIUM

Fig. 13.3: Money Market Equilibrium

Fig. 13.4: Change in Money Market Equilibrium

Fig 13.5: LM Curve

where, h = the responsiveness of the demand for money to income, and

13.5.1 Slope of the LM Curve

Fig. 13.6: Slope of LM Curve

13.5.2 Position of the LM Curve

Check Your Progress 2

2) Interpret the slope of an LM curve.

3) Explain how the position of LM curve is determined.

4) Draw a suitable diagram to show the impact of a decrease in money

13.6 LET US SUM UP

13.7 ANSWERS/HINTS TO CHECK YOUR

Check Your Progress 2