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Modern Theory of Interest or Is

# Modern Theory of Interest or Is

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03/21/2014

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Modern Theory of Interest (or) IS-LM Model in Closed Economy
This theory integrates Money, Interest and income into a general equilibrium model. Hicks and Hanson diagrammaticframe work known as IS-LM model. The term IS is the equality of I and S which represents product market equilibrium. On the other hand the term LM of the equality of Money Demand (L) and Money Supply (M) represents money market equilibrium. In order to analyse the general equilibrium of product and money markets the study of IS-LM functions is an important one.
Derivation of IS Curve:
The derivation of the IS Curve shown in Fig in Panel (A) of this fig, the saving curve S in relation to Income is drawn in a fixed position on the Keynesian
assumption ‘that the rate of interest has a little effect on Saving’. The saving curve
shows that saving increases as Income Increases, so S = f (Y): I = f (Y, R) so if R remain constant Y increases and I also increases.

Derivation LM Curve:
The LM curve shows all combinations of interest rate and levels of income at which the DM and SM are equal. In other words, the LM schedule shows the combinations of interest rates and levels of income. Where the DM (L) and SM (M) are equal such that the money market equilibrium.

Schedule in part ‘C’ of the diagram represents Td for Money, assuming demand to
be proportional to Y. the schedule
B
is simply an identity line that mechanically divides the total MS into Td & Sd components. Schedule
D
is the LM curve. Beganing
A
with a known interest r, the volume of Sd is L2. Given the total MS, that potion not held as speculative balances must be held in transaction balances (T1) as shown in
B
. the schedule
C
shows that level of real income (Y1) must  prevail in order to get the public to willingly absorb the money available for TD in that form. Thus, as we see in
D
for interest rate r, the only possible money market equilibrium volume of Y is Y1.  Now we study how these markets are brought into simulateneous equilibrium. It is only when the equilibrium pairs of interest rates and income of the IS Curve equal the pairs of interest rate & Income levels of the LM curve that the general equilibrium is established. If there is any deviation from equilibrium certain forces will act and react in such a manner that the equilibrium will be restored.