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IS-LM Model 2

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93 views4 pages

IS-LM Model 2

Uploaded by

kzakiya17
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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The IS-LM Model

The Goods Market and the IS Curve:


The IS curve reflects the goods market equilibrium. It shows combinations of interest rates and
levels of output where savings-investment equality takes place.

Derivation of IS Curve:

The diagram shows how the IS curve is derived. At an interest rate, r1 equilibrium in the goods
market is at point E in the upper part of the figure, with an income level of Y1. In the lower part
of this diagram, we show point E’. Now a fall in the interest rate to r2 raises aggregate demand in
upper part, increasing the level of spending at each income level.

The new equilibrium income is Y2. In the lower part, point F’ shows the new equilibrium in the
goods market corresponding to an interest rate r2. The IS curve is a locus of points showing
alternative combinations of interest rates and income (output) at which the commodity market
clears. That is why the IS curve is called the commodity market equilibrium schedule.

The IS curve is the schedule of combinations of the interest rate and the level of income such that
the goods market is in equilibrium.

Slope of the IS Curve:


The IS is negatively sloped because an increase in the interest rate reduces planned (desired)
investment spending and therefore reduces aggregate demand, thereby lowering the equilibrium
level of income.

As shown in the figure below, the IS curve is shifted by changes in autonomous spending. An
increase in autonomous spending, such as investment spending or government expenditure, shifts
the IS curve to the right.

Money Market Equilibrium and the LM Curve:


The money market is concerned with demand for and supply of money. The money market is
in equilibrium when the demand for money equals the supply of money. The LM curve
shows the different combinations of interest rates and income at which the money market is
in equilibrium. Along the LM curve the demand for real money balances is equal to the
supply of real money balances. LM curve represents the points where liquidity preference
equals money supply.

Derivation of LM Curve:
The diagram on the left shows equilibrium in the money market with a given supply of real
balances of M. The demand curve for a real money balance L1 is drawn for a given real
income Y1. The money market is in equilibrium at E1 and the equilibrium interest rate is i 1.
When income rises to Y2 the demand curve for money shifts to L2. E2 is the new equilibrium
in the money market and i2 is the equilibrium interest rate. Many such points of
correspondence between different levels of income and rate of interest are joined together to
derive LM curve. This, LM curve is the locus of pairs of interest rate and income level which
are compatible with money market equilibrium.
Slope of LM Curve:
It will be noticed from Diagram (b) that the LM curve slopes upward to the right. This is because
with higher levels of income, demand curve for money is higher and consequently the
money-market equilibrium, that is, the equality of the given money supply with money
demand curve occurs at a higher rate of interest. This implies that rate of interest varies
directly with income. An increase in money supply shifts the LM curve to the right, as shown in
the figure below.

In the left diagram, as money supply increases from Ms to Ms1, LM curve shifts from LM to LM1,
resulting into an increase in income.

Equilibrium in the Goods Market and in the Money Market


The goods market is in equilibrium at all points on the IS curve and the money market is in
equilibrium at all the points on LM curve. At point E, both the markets are in equilibrium, with r 0
and Y0 being equilibrium rate of interest and equilibrium level of income respectively.

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