THE IS-LM ANALYSIS

In any economy, there are two key markets through which both the fiscal
and monetary policies operate – viz., the goods market and the money market.
The Fiscal Policy operates directly in the goods market. In the case of the
money market, it is the Monetary Policy, which directly operates by affecting the
supply of money or the ROI. In the Keynesian analysis, these two markets are
treated as if they were mutually independent of each other. It was the Post-
Keynesian economists (especially Prof. J.R. Hicks and Prof. Hansen) who
pointed out to the fact that these two markets interact with each other.

The changes in one market would cause changes in the other market. For
instance:

An expansionary fiscal policy would cause an injection into the goods

market and then through the multiplier process income would increase. Due to
the increase in income, the demand for money for transaction increases. This
increase in the demand for money would cause the interest rate to rise, leading
to a dampening of investments and income.

Again, an expansionary monetary policy, by increasing the money supply,

would reduce interest rates. This would then, via an increase in investment (or a
reduction in the exchange rate and a resulting increase in exports and a
reduction in imports), lead to a multiple rise in income in the goods market. This
in turn would have an effect on the money market by causing the interest rates to
rise.

Hick, in 1937, through his article ‘ Mr. Keynes and the Classics’ gave birth
to the IS-LM approach.

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 THE IS CURVE

a) What is meant by the IS Curve

The IS Curve shows combinations of interest rates and the levels of output
such that planned (desired) spending (expenditure) equals income. The IS
Curve can be defined to be the locus of those combinations of the rates of
interest and the levels of national income at which the goods market is in
equilibrium.

b) Deriving the IS Curve

Panel A Panel B

R OI E2
AD C + I2
I
R0 C + I1
E1
R1 ∆ I1
C + I0
R2 ∆ I2 E0
I

∆ I1 ∆ I2
45°

I0 I1 I2 Invst. Y0 Y1 Y2 Income

Panel C
In Panel A of the
accompanying figure, the
ROI
relationship between ROI and
planned investment is depicted R A
o
through the II investment curve. B
When the ROI is OR0 the planned R1
investment is equal to OI0. With OI0 C
as the amount of planned R2
investment, the aggregate demand IS Curve
curve is ( C + I0 ) which as will be
seen in Panel B equals aggregate
Output at OY0 level of national Y0 Y1 Y2 Income
income.

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 Hence, in Panel C, against interest OR0, the level of income is equal to
OY0. Now if the ROI falls to OR1, the planned investment increases from OI0 to
OI1. With this increase in planned investment, the aggregate demand curve
shifts upward to the new position ( C + I1 ) and the goods market is in equilibrium
at OY1 level of national income. Thus, in Panel C the level of income OY 1 is
plotted against the interest rate OR1. We can similarly explain the various
impacts when the ROI falls to OR2. By joining the points A, B and C representing
the various interest-income combinations at which the goods market is in
equilibrium, we obtain the IS Curve.

The IS Curve is downward sloping since when the ROI declines, the
equilibrium level of national income increases. The increase in investment
spending causes the aggregate demand curve to shift upward and therefore
there is an increase in the national income.

The steepness of the IS Curve depends on:

 The elasticity of the investment demand curve. A positive relationship

exists between the elasticity of investment and the elasticity of the IS Curve. If
the investment demand is highly interest elastic, then a given fall in the ROI
will cause a large increase in investment demand leading to a large upward
shift of the AD curve. This would bring about a large expansion in the level of
national income and this would make the IS Curve relatively flatter. Similarly,
when the interest-elasticity is low, the IS Curve would be steeper.

 The size of the multiplier. A positive relationship would exist between the
multiplier size and the elasticity of the IS Curve. A higher MPC would cause
the AD curve to be steeper and the magnitude of the multiplier would be
large. Now, if the ROI falls, there would be a large increase in investment
and consequently an increase in the national income. This would make the IS
Curve flatter. A low multiplier magnitude would make the IS Curve steeper.

The position of the IS Curve would depend on;

 The level of autonomous (independent of the ROI) government

expenditure. As this is settled by the government’s policies, the ultimate
position of IS Curve would be determined by these policies. If the policies are
favourable the IS Curve would shift upward to the right.

 The level of the autonomous consumption expenditure – the higher the

level of the autonomous consumption, the higher would be the position of the
IS Curve.

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 The autonomous changes in private investment caused by a rising
population size, the introduction of an innovation and so on. Greater the
increase in such investments, higher will be the position of the IS Curve.

Panel D
B C0 + I0 + G 1
AD
C0 + I1 + G 1

C C0 + I0 + G 0

45°

Y0 Y2 Y1 Income

Panel E

ROI
R1 C
R0 B
A
IS1

IS0

Y0 Y2 Y1 Income

At any given ROI, if there is an autonomous change in any one of the

autonomous components such as government expenditure, then the entire IS
schedule will shift. In Panel D, the effects of an increase in government
expenditure from G0 to G1 are shown. Holding ROI constant, the old AD curve
shifts from C0+I0+G0 to C0+I0+G1. The equilibrium income increases via the
multiplier process from Y0 to Y1 (i.e., from A to B along the 45° line). In panel E,
this leads to a shift in the IS curve from IS0 to IS1.

However, if the increase in G causes the ROI to increase from R 0 to R1,

then I0 falls to I1 and the AD curve falls to the lower position C0+I1+G1 and B
moves to C along IS1 and the income falls to Y2 from Y1.

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 THE LM CURVE

a) What is meant by the LM Curve

The LM Curve shows combinations of interest rates and the levels of

output such that the demand for money equals the supply of money. The LM
Curve can be defined to be the locus of those combinations of the rates of
interest and the levels of national income at which the money market is in
equilibrium.

b) Deriving the LM Curve

LM Curve
Ms
ROI ROI

R0 R0
Md2(Y2)
R1 R1
Md1(Y1)
R2 R2
Md0(Y0)

Ms Qty of Money. Y0 Y1 Y2 Income

Panel F Panel G

The LM Curve can be derived from the Keynesian analysis of the money
market equilibrium. The money held as active cash balances is a positive
function of income. The demand for money is also dependent on the ROI, which
is the cost of holding money. Thus, the demand for money (Md) can be
expressed as: Md = f ( Y, r )

A number of money demand curves can be drawn at various levels of

income. The intersection of this money demand curves with the given money
supply curve, would give us the equilibrium ROI. By plotting these ROIs with
their corresponding income sizes, we can derive the LM Curve.

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 In Panel F, when the income level is Y0, the demand for money is given by
the curve Md(Y0) and the corresponding interest rate is R0. Similarly we can
account for the other interest rates R1 and R2. By plotting the corresponding ROI
with its income size, we get points in Panel G, which are points on the LM Curve.
By joining these points, we can derive the LM Curve.

The LM Curve is upward sloping since at higher levels of income, the

demand for money is higher and so the ROI increases as the supply curve of
money is given and constant.

The steepness of the LM Curve depends on:

 The liquidity preference of the community. The lower the elasticity of

liquidity preference for speculative motive with respect to changes in the
interest rate, the steeper would be the LM Curve. Similarly, when the liquidity
preference is high, the LM Curve would be flatter.

 The stock of money held under the transaction motive. When the amount
of money held for transactions increases the amount of money held for
speculation decreases. Given the demand for money for speculative motive,
the higher the rise in the ROI and so the steeper the LM Curve.

The position of the LM Curve would depend on:

 The quantum of the money supply. The greater the money supply, the
demand remaining constant, the lower would be the ROI and so the LM
Curve would shift downwards to the right.

 The level of the liquidity preference – for a given level of income and
money supply, if the liquidity preference shifts upward, then the LM Curve
would shift to the left.
Panel H Panel J LM0
LM1
ROI Ms0 Ms1 ROI

A

A
R0 R0

R1 B R1 B

→ Md0(Y0)

Ms0 Ms1 Qty of Money. Y0 Income

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 At any given ROI, if there is a change in the supply of money, then the
entire LM curve will shift. Panel H shows the effect of an increase in the supply
of money from Ms0 to Ms1. The effect of the increase in the money supply is to
reduce equilibrium ROI from R0 to R1. There is a movement along the money
demand curve from A to B. The increase in the money supply does not change
the aggregate income, which remains at Y0 (as shown in Panel J); but this
causes a shifting of the LM Curve from LM0 to LM1. The equilibrium point shifts
from A on LM0 to B on LM1, with the ROI falling from R0 to R1, but income
remains unchanged at Y0.

INTERSECTION OF THE IS AND LM CURVES

ROI LM Curve

Re E

IS Curve

Ye Income

The IS and LM Curves relate to income and the ROI. The equilibrium rate
of interest and the equilibrium income size is determined at the point where the
IS and LM curves intersect. This intersection point will therefore show indicate
the simultaneous equilibrium of the goods and money markets. In the above
situation, point E is the point of equilibrium. The equilibrium ROI thus determined
is ORe and the equilibrium income level determined is OYe.

At this equilibrium point:

a) The goods market is in equilibrium, i.e., the aggregate demand equals the
level of aggregate output.

b) The demand for money is in equilibrium with the supply of money and so the
money market is in equilibrium.

c) The ROI and the level of income is such that there is a general equilibrium
existing in the economy, whereby the money available is just sufficient to
produce the required amount – i.e., all that is demanded is supplied.

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 The IS-LM model is based on:

1. The investment-demand function.

2. The consumption function.
3. The money demand function.
4. The quantity of money.

We see, therefore, that according to the IS-LM model both the real factors,
viz., productivity, thrift and the monetary factors, i.e., the demand for money
(liquidity preference) and the supply of money play a part in the joint
determination of the ROI and the level of income. Any change in these factors
will cause a shift in the IS or LM curves and will therefore change the equilibrium
levels of the rate of interest and the level of income.

This model has succeeded in synthesizing the monetary and fiscal

policies. Further, with the IS-LM analysis, we are better able to explain the effect
of changes in certain important economic variables such as the desire to save,
the supply of money, investment demand for money on the ROI and the level of
income.

However, the model has been criticized on the following counts:

1) It assumes that the ROI is quite flexible and so it is free to vary with the
intervention of the Monetary Authority. If this were true then the Monetary
Policy would become an impotent weapon with the Central bank of the
economy.

2) It is based on the assumption that investment is interest-elastic. Hence, if the

investment becomes interest-inelastic, the model cannot make the required
adjustments and so the model breaks down.

3) According to Prof. Don Patinkin and Prof. Milton Friedman, the division of the
economy into two sectors (the Monetary and the Real sectors) is artificial and
unrealistic. According to them these to sectors are inherently interwoven and
act and interact on each other without the need of mediating factors like the
ROI. These two sectors exist to influence each other naturally from the
economic point of view.

4) Patinkin also points out that the model fails to consider the influence of prices
on the income dynamics. He points out that a more integrated and general
equilibrium approach would involve the simultaneous determination of not
only the ROI and the level of income, but also of the prices of goods and
services.

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References: (For THE IS-LM ANALYSIS)

Ahuja H.L. Macroeconomics – S.Chand, New Delhi,

Theory and Policy 2002
Chapter 15
Begg, Fisher & Economics – 5th Edition McGraw-Hill Companies,
Dornbusch Chapter 25 Part 5 UK, 1997
Blake D. A short course of McGraw-Hill London,
Economics 1993
Chapter 5
Gupta R.D. Keynes and Post Kalyani Publishers, New
Keynesian Economics Delhi , 1984
Chapter 23
Harvey J. & Johnson M. Introduction to Macro- Macmillan, London, 1973
Economics
Chapter 10 Part IV
Jhingan M.L. Macro-economic Theory Vani Educational Books,
Chapter 29 Delhi 1985
Lipsey R. & Chrystal K. An Introduction to Oxford University press,
Positive Economics Oxford, 1996
Chapter 36
Misra S.K. & Puri V.K. Modern macroeconomic Himalaya Publishers,
Theory New Delhi 1997
Chapter 12
Mukherjee S. Modern Economic Wishwa Prakashan, New
Theory Delhi,
3rd Edition Chapter 23 1996
Shapiro E. Macroeconomic Analysis Galgota Publication,
Chapters 12 & 18 Delhi, 1984
Sloman J. Economics – 4th Edition Prentice – Hall, UK, 2000
Chapter 20
Stonier and Hague A Text book of Economy Longman, London, 1980.
Theory – 5th Edition
Chapter 23

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 THE IS-LM MODEL (SYNOPSIS)
IS CURVE LM CURVE
WHAT
The IS Curve can be defined as the locus or The LM Curve can be defined as the locus or
schedule of those combinations of the rates of schedule of those combinations of the rates of
interest and the levels of national income at interest and the levels of national income at
which the goods market is in equilibrium. which the money market is in equilibrium.

C = Y DERIVATION
RoI
AD AD2
I
R1 AD1 LMC
S
R2 D RoI D2 (Y2) RoI

I2 R2 R2 M2
I1 Y1 Y2 Income D1 (Y1)
D, S (Invt)
RoI R1 R1
M1
R1 S1
R2 S2 ISC
Q Y1 Y2 Income
D, S
(Money)
Y1 Y2 Income

SLOPE
The IS curve is negatively sloped and so it slopes The LM curve is positively sloped and so it is
downwards from left to right. slopes upwards from left to right.

STEEPNESS
It depends on: It depends on:

1. The elasticity of demand for investments. 1. The Liquidity Preference of the community.
Greater the elasticity of demand for Greater the elasticity of demand for liquidity,
investments, gentler would be the slope of the greater would be the demand for money
the IS curve. for speculative investments and so bigger
would be the income changes. This would
cause the LM curve to become flatter.

2. The size of the Multiplier Effect. Higher the 2. The stock of money held under the
MPC, higher the Multiplier Effect and so Transactionary Motive. The greater this
steeper the slope of the IS curve. stock, the lesser would be the quantity of
money demanded as idle cash balances. This
would lead to lesser speculative investments,
which in turn would lead to a smaller change in
income. Hence, LM curve would be steeper.

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 IS CURVE LM CURVE
SHIFTS
1) Changes in the Fiscal Policy causes the IS 1. Changes in the Monetary Policy
curve to shift. causes the LM curve to shift.
a) An expansionary Fiscal Policy causes a) An easy Monetary
the IS curve to shift upwards to the right. Policy causes the LM curve to shift
b) A contractionary Fiscal Policy causes downwards to the right.
the IS curve to shift downwards to the left. b) A tight Monetary Policy
2) If the consumption expenditure and causes the LM curve to shift upwards to
investment levels increase, the IS curve the left.
shifts upwards to the right.
2.If the liquidity preference of the
community increases, the LM curve shifts
downwards to the right.
POSITION (INTENSITY OF THE SHIFTS)
1. Bigger the increments in C, I and G, 1) Bigger the increase in money
higher would be the position of the IS curve – supply, higher would be the position of the LM
ie., greater would be the intensity of the IS curve – ie., greater would be the intensity of
curve’s shift. the LM curve’s shift.
2) Greater the liquidity preference of
the community, lower would be the position of
the LM curve – ie., greater would be the
intensity of the LM curve’s shift.
EQUILIBRIUM & ITS RESTORATION IN THE IS-LM MODEL
ROI

R1 I1 L1 LM Curve

Re E
L2 I2
R2
IS Curve

Ye Income
 At the equilibrium point (pt E), the rate of interest is ORe and the national income is OYe. At this
national income, the quantity of money demanded and supplied in the goods market is equal to the quantity
of money demand and supplied in the money market.
 If the rate of interest is higher than the equilibrium one (say, OR1), the quantity of money demanded
and supplied in the goods market is lesser than the quantity of money demand and supplied in the money
market. This surplus in the availability of money in the money market would cause the RoI to fall and shift
towards equilibrium.
 If the rate of interest is lower than the equilibrium one (say, OR 2), the quantity of money demanded and
supplied in the goods market is greater than the quantity of money demand and supplied in the money
market. This deficit in the availability of money in the goods market would cause the RoI to rise and shift
towards equilibrium.

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