By:

Isha jain (2921)

Pavi gupta(2925)
Megh Anand(2945)
Chayan kurra(2930)
The Goods Market
What is IS Curve ?
● The IS Curve is the locus of those combinations of
interest rate and level of income at which the real or
commodity economy is at equilibrium.
● IS relation is written as:

Y = C(Y-T) + I(y,i) + G
 Investment,Sales and Interest Rate

● The level of sales: Increase in sales with increase in production leads to

more investment in fixed asset.

● The interest rate: Higher the interest rate, less will be the investment and
vice-a-versa.

● Investment: The investment relation is given by I=I(Y,i) .There is a direct

relationship of investment and income whereas there is inverse relationship
of investment and interest rate.
Derivation of IS Curve ZZ
A

Demand
(a) An increase in the interest rate decreases
A’ ZZ’
the demand for goods at any level of output,
leading to a decrease in the equilibrium level
of output.
Y’ Y
(b) Equilibrium in the goods market implies Output

that an increase in the interest rate leads to

a decrease in output. The IS curve is

Interest Rate
therefore downward sloping.
i’ A’
i A

Y’ Y
Shift of the IS Curve

Consider an increase in taxes, from T to T’.

At a given interest rate, say i, disposable
income decreases, leading to a decrease in
consumption, leading in turn to a decrease in
the demand for goods and a decrease in
equilibrium output. The equilibrium level of i
output decreases from Y to Y’. Put another

Interest Rate
way, the IS curve shifts to the left: At a
given interest rate, the equilibrium level of
output is lower than it was before the IS( for T)
IS’(for T’)
increase in taxes.

Y’ Y Y
Output
What is LM curve?
● The LM Curve is a locus of points showing alternative combinations of
the rate of interest and level of income that brings about equilibrium in
the money market.
● LM relation is written as:

M/ P = Y L(i)
Real money, Real income and the Interest rate
Nominal income divided by the price level equals real income, Y. Dividing
both sides of the equation by the price level P gives:

M/P=YL(i)

Hence, we can restate our equilibrium condition as the condition that the
real money supply—that is, the money stock in terms of goods, be equal to
the real money demand, which depends on real income, Y, and the interest
rate, i.
Derivation of LM curve
(a) An increase in income leads, at M
r ve
a given interest rate, to an Cu
increase in the demand for LM
A’

Interest Rate
money. Given the money supply, A’
this increase in the demand for

Interest Rate
money leads to an increase in the
equilibrium interest rate. M’
A
A
(b) Equilibrium in the financial
M’
markets implies that an increase
M/P Y Y’
in income leads to an increase in
the interest rate. The LM curve
(Real) Money,M/P Income,Y
is therefore upward sloping.
Shift of LM curve
LM

LM’

X
Consider an increase in the nominal money
supply, from M to M’. Given the fixed price
level, the real money supply increases from
M>P to M’>P. Then, at any level of income, i
say Y, the interest rate consistent with
equilibrium in financial markets is lower,

Interest Rate
going down from i to, say, i’. The LM curve
shifts down, from LM to LM’. By the same i’
reasoning, at any level of income, a decrease
in the money supply leads to an increase in
the interest rate. It causes the LM curve to
shift up. Output Y
The IS-LM Model
Putting IS-LM Relations Together
● The IS relation follows from the condition that the supply of goods
must be equal to the demand for goods.

IS relation: Y = C(Y - T) + I(Y, i) + G

● The LM relation follows from the condition that the supply of money
must be equal to the demand for money.

LM relation: M/ P = Y L(i)
IS-LM Model
Equilibrium in the goods market implies

X
that an increase in the interest rate leads
LM
to a decrease in output. This is
represented by the IS curve. Equilibrium
in financial markets implies that an
increase in output leads to an increase in A

Interest Rate
the interest rate. This is represented by
the LM curve. Only at point A, which is on
both curves, are both goods and financial
IS
markets in equilibrium.

Output Y
 What is Fiscal Policy?
Fiscal policy is the means by which a government adjusts its spending
levels and tax rates to monitor and influence a nation's economy.

Two types are

Fiscal Expansion Fiscal Contraction

(Increase in G, (Decrease in G,

Decrease in T) Increase in T)
 The effects of increase in tax on IS-LM
X

LM
Due to increase in taxes
from T to T’, i decreases to
i i’ and Y to Y’ due to
A reduced purchasing power.
Interest Rate

i’
This makes IS shifts
A’
towards left.
IS
There is no change in LM
IS’
Output
curve as taxes are not
Y’ Y Y
related to money supply.
The effects of decrease in tax on IS-LM

Due to decrease in taxes

X
from T to T’, i increases to LM

i’ and Y to Y’ due to A’
i’
enhanced purchasing
i A
power. This makes IS

Interest Rate
shifts towards right. IS’ FOR
T’>T)
There is no change in LM IS FOR T

curve as taxes are not Y Y’

Output
related to money supply
 The effects of increase in Government spending on IS-LM

LM

Due to increase in government

X
spending(G to G’), i increases to i’ and
i’ A’
Y to Y’. This makes IS shifts towards
A
right. i

Interest Rate
There is no change in LM curve as IS’
IS
taxes are not related to money supply.

Output Y Y’
The effects of decrease in Government spending on IS-LM

Due to decrease in

X
government spending( G LM
to G’), i decreases to i’
and Y to Y’. This makes i A
IS shifts towards left.

Interest Rate
A’
i’
There is no change in LM IS
curve as taxes are not IS’

related to money supply Output Y’ Y Y

Crowding out
What is Crowding Out?
The crowding out effect suggests rising public sector spending
drives down private sector spending.
For example, if the government buys more stuff, it may have
to borrow more. By borrowing more there will be a higher
interest rate. This will make it harder for other companies
and people to borrow. The government is said to "crowd out"
the market.[
How ‘crowding out’ works if government spending is increased?

G is increased due to which Y

increases to Y” only if impact of LM

X
E’
interest rate is neglected.
i’
If increasing i is taken into
E E”
account then it would dampen

Interest Rate
i
the effect of fiscal
expansionary and then IS’

equilibrium would be achieved at IS

E’ Y Y’ Y”
Output
What is Monetary policy?
Monetary policy refers to the actions undertaken by a
nation's central bank to control money supply and achieve
sustainable economic growth.

Two types are

Monetary Expansion Monetary Contraction

(Increase in Money supply) (Decrease in Money supply)

 Monetary Expansion
When money supply is increased
LM
from M to M’ , then output increases
from Y to Y’ due to increased A LM’
purchasing power which ultimately

Interest Rate
i
results in reduction of interest rate A’
from i to i’ and LM shifts downward.
i’

No change in IS curve as money IS

supply has no role in it.

Y Y’
Output
Monetary Contraction
When money supply is X
LM’
decreased from M to M’ , then
output decreases from Y to Y’ LM

due to decreased purchasing

Interest Rate
A’
power which ultimately results i’

in increment in interest rate i A

from i to i’ and LM shifts
IS
upward.
Y’ Y
No change in IS curve as money Output
Y

supply has no role in it.

Policy M i x
What is Policy mix?

The policy mix is the combination of a country's monetary

policy and fiscal policy. These two channels influence
growth and employment

Monetary policy Fiscal policy

By By

Central Bank Government of country

U.S. Recession of 2001( An example of policy mix)
The decrease in investment demand led to a
sharp shift of the IS curve to the left, from
IS to IS”

The increase in the money supply led to a

downward shift of the LM curve, from LM to
LM’.

The decrease in tax rates and the increase in

spending both led to a shift of the IS curve
to the right, from IS” to IS’.

And both the policies helped to control

recession.
 CONCLUSION
Through this, we came to know about
- How through IS-LM model financial and goods
market can be at an equilibrium.
- How governments and central bank could control
economy with help of policies.