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    The IS - LM Curve

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    Vikku Agarwal
    The IS-LM model shows how the level of national income and interest rate are jointly determined by equilibrium in the goods and money markets. [1] The IS curve represents goods market equilibrium and shows different combinations of income and interest rates where spending equals output. [2] The LM curve shows money market equilibrium where the demand for money equals the supply of money for different income-interest rate combinations. [3] The intersection of the IS and LM curves indicates the overall general equilibrium in the economy, with both markets clearing simultaneously.

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    The IS - LM Curve

    Uploaded by

    Vikku Agarwal
    464 views28 pages
    The IS-LM model shows how the level of national income and interest rate are jointly determined by equilibrium in the goods and money markets. [1] The IS curve represents goods market equilibrium and shows different combinations of income and interest rates where spending equals output. [2] The LM curve shows money market equilibrium where the demand for money equals the supply of money for different income-interest rate combinations. [3] The intersection of the IS and LM curves indicates the overall general equilibrium in the economy, with both markets clearing simultaneously.

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    The IS- LM Curve

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    The IS-LM model shows how the level of national income and interest rate are jointly determined by equilibrium in the goods and money markets. [1] The IS curve represents goods market equilibrium and shows different combinations of income and interest rates where spending equals output. [2] The LM curve shows money market equilibrium where the demand for money equals the supply of money for different income-interest rate combinations. [3] The intersection of the IS and LM curves indicates the overall general equilibrium in the economy, with both markets clearing simultaneously.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    464 views28 pages

    The IS - LM Curve

    Uploaded by

    Vikku Agarwal
    The IS-LM model shows how the level of national income and interest rate are jointly determined by equilibrium in the goods and money markets. [1] The IS curve represents goods market equilibrium and shows different combinations of income and interest rates where spending equals output. [2] The LM curve shows money market equilibrium where the demand for money equals the supply of money for different income-interest rate combinations. [3] The intersection of the IS and LM curves indicates the overall general equilibrium in the economy, with both markets clearing simultaneously.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
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    At a glance
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    The IS-LM model uses the IS and LM curves to show how equilibrium in the goods market and money market simultaneously determine the equilibrium level of income and interest rate in an economy.

    The IS-LM model shows that the level of national income and interest rate are jointly determined by the simultaneous equilibrium in the goods market (represented by the IS curve) and money market (represented by the LM curve). The point of intersection of the IS and LM curves gives the equilibrium levels of national income and interest rate.

    The IS curve relates the equilibrium levels of national income to interest rates by showing combinations of income and interest rate where the goods market is in equilibrium. It slopes downward because a lower interest rate is associated with a higher level of national income and vice versa.

    The IS- LM Model

    Introduction
    Developed by J.R. Hicks In this model, variables such as investment, national income, rate of interest, demand and supply of money are interrelated and mutually interdependent and are represented by the ISLM curve model. This model shows how the level of national income and rate of interest are jointly determined by the simultaneous equilibrium in the goods and money market.

    Goods market equilibrium IS curve


    Goods market equilibrium : Y = C+I (AD) or Investment=Savings at different rates of interests or Planned spending= Planned output Therefore, it is called I equal S (Investment equal Savings)or I-S function.

    For the derivation of IS curve, rate of interest is an important determinant of investment making the latter an endogenous variable. There exists an inverse relationship between the interest rate and investment. When firms borrow to purchase investment goods, they have to pay an interest rate. When interest rate increases, the cost of borrowings increases. This decreases the profitability of the firms and thus,planned investment decreases.
    .

    Increase in investment demand(I) increases aggregate demand(AD) and thus raises the equilibrium level of income. In the derivation of the IS curve, we seek to find out the equilibrium level of Y as determined by the equilibrium in goods market by a level of investment determined by a given rate of interest. IS curve relates the equilibrium levels of national income with rates of interest. (explained in the following graphs)

    In fig (a), the fall in interest rate increases the investment level and shifts the AD curve upwards resulting in equilibrium at a higher level of national income.(fig.b)

    Thus IS curve is a locus of those combinations of rate of interest and the level of national income at which good market is in equilibrium. (fig.c)

    Slope of IS curve : Decline in interest rates causes increase in investment expenditure This causes an increase in the aggregate demand moving the AD curve upwards. This leads to an increase in the equilibrium level of national income. Thus a lower rate of interest is associated with a higher level of national income and vice versa. This makes the IS curve slope downwards.

    Steepness of IS curve
    Depends upon 1. Elasticity of the investment demand curve i.e. responsiveness of investment to the rate of interest. 2. The size of the multiplier.- Multiplier depends on mpc. Higher mpc means steeper AD curve (c=a+by). It also means highier multiplier i.e. greater increase in equilibrium level of national income and a steeper IS curve.

    Shift in IS curve
    The level of autonomous expenditure determines the position of the IS curve and changes in autonomous expenditure cause shift in it. Autonomous expenditure means the expenditure be it investment expenditure, government expenditure or consumption exp. Which does not depend on level of income or rate of interest.

    Graphical explanation

    Rate of int We illustrate the shift in the IS curve by making changes in government exp (G)

    Since the increase in the income to OY2 has not been brought about by the changes in the interest rate but autonomous of it, I does not imply movement along the previous IS curve but will cause an upward shift in it (IS)

    Money Market Equilibrium- The LM Curve


    As per keynes, demand for money to hold depends upon transactions motive and speculative motive. Money held for transactions motive is a function of income. Greater the level of income, greater the money held for transaction motive and therefore higher the level of money demand curve.

    Graph- LM curve

    Slope of LM curve
    Depends on two factors : 1) The responsiveness of demand for money(liquidity preference) to the changes in income. With the increase in income, demand curve for money moves up disturbing the equilibrium . For the equilibrium to be restored, rate on interest moves up. Hence the speculative demand for money goes down. Given the speculative demand, higher the rise in the rate on interest, steeper the LM curve.

    2)Responsiveness of demand for money to the changes in the rate of interest : Lower the elasticity of liquidity preference with respect to the changes in interest rate, the steeper will be the LM curve and vice versa.

    Shift in the LM curve


    The shift happens when there is a change in the money supply given the demand function. When there is an increase in the money supply, the rate of interest drops causing the LM curve to shift down and to the right. Alternatively, with the increase in the money supply, at the given rate of interest, the demand for transaction motive must increase for the income level to go up. (Illustrated in the following graph)

    Shift in the LM curve due to change in money supply

    Rate of int

    Shift in LM curve due to change in money demand function


    The other factor causing shift of the LM curve is the change in liquidity preference function at a given level of income. This will lead to the rise in the rate of interest and a shift in the LM curve to the left. If, with the given situations, the rate of interest has to be maintained, the income should be reduced and the money demand function must shift back to its original level.

    Intersection of IS- LM curves

    At the point of intersection of the IS and Lm curves, the rate of interest and the income are related in such a way that : 1) The goods market is in equilibrium i.e Agg demand= aggregate output. 2) The money market is also in equilibrium i.e. demand for money is in equilibrium with the supply of money.

    The IS- Lm curve analysis has succeeded in synthesizing the monetary and fiscal policies. With the IS-LM curve analysis, we are better able to explain the effect of changes in certain important economic variables such as desire to save, the supply of money, investment, demand for money on the rate of interest and level of income.

    Effect of changes in the supply of money on the rate of interest and income level: When supply of money increases, rate of interest falls and Y increases. When supply of money decreases, the rate of interest increases and Y decreases.

    Changes in the desire to Save or propensity to consume: The increase in mpc moves the AD curve up increasing the national income. This moves the IS curve to the right and moves up the rate of interest at the equilibrium level.

    Changes in autonomous investment and government expenditure: Increases the investment expenditure increasing the agrregate demand. IS curve moves to the right and increases the rate of interest and national income.

    Changes in demand for money or liquidity preference: Affects the LM curve. Increase in money demand moves the LM curve to the left. Thus the equilibrium rate of interest will rise and national income will fall. ___________________________

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