Topic Notes – 5

Product market vs Money market are interconnected

IS curve is exclusive about Product Market Equilibrium
 any factor that makes Product market change is reflected on the IS curve
LM curve is exclusive about Money Market Equilibrium
 any factor that makes Money Market change is reflected on the LM curve

IS curve (if r changes, what happened next?)

 the relationship between national output (Y) and interest rate (r) from the perspective of
product market
1. interest rate increases => Saving increases => Consumption decreases
2. interest rate increases => Investment decreases
(1) + (2) => AE decreases => The national output decreases
 There is a negative relationship between national output (Y) and interest rate (r) in
the product market (looking the Investment (I))
Plot on a graph
Id : demand for the investment curve
Note: all these points along the IS curve all represent millions of the equilibrium in the product
market
Slope of the IS curve (“flatter”, “steeper”, “45 degree”)
 Determined by how much Aggregate Expenditure will change
 Specifically determined by how investment is beneficial to the change of the interest rate
+ “Flatter” when Interest rate ® decreases/increases, Aggregate Expenditure increases/decreases
very large amount

+ 45 degree when Interest rate ® decreases/increases, Aggregate Expenditure increases/decreases

in a normal way
+ “Steeper” when Interest rate ® decreases/increases, Aggregate Expenditure increases/decreases
very small amount
Shift of the IS curve (not affected by the change of interest rate)
 Focus on Co and Go but Go is the most important

Points off the IS curve

 all these points off the IS curve all represent millions of the disequilibrium in the
product market
Explaination:
+ Point X and all lefthand side points of the IS curve: at the same interest rate (ro), the
economy produces less outputs than its aggregate expenditure => Excess demand for goods (=
purchases too much)
+ Point Y and all righthand side points of the IS curve: at the same interest rate (ro), the
economy produces more outputs than its aggregate expenditure => Excess supply for goods (=
produces too much)

LM curve (if Y changes, what happened next?)

 the relationship between national output (Y) and interest rate (r) from the perspective of
money market

Ms = Md = k.Y (MT) + h.r (MA)

1. National output increases (Y) => We need more cash holding => Demand for money will
increase => Market interest rates ® will increase
2. National output decreases (Y) => We need less cash holding => Demand for money will
decrease => Market interest rates ® will decrease
  There is a positive relationship between national output (Y) and interest rate (r) in
the money market (looking the Income (I))
Plot on a graph

Note: all these points along the LM curve all represent millions of the equilibrium in the money
market

Slope of the LM curve (“flatter”, “steeper”, “45 degree”)

 Determined by the slope of Money Demand Curve
 Slope of Monney Demand Curve (or cash holdings) depends on how sensitive to the
change of interest rate
Same distance shift method
Note: assume that Y increases
Shift of the LM curve (not affected by the change of National output (Y))
 LM curve shift whenever there is a change of Money Supply (MS)
Points off the LM curve

Explaination:
+ Point X and all lefthand side points of the LM curve: at the same interest rate (ro), the
economy has too much supply of money => Excess supply of money
+ Point Y and all righthand side points of the LM curve: at the same interest rate (ro), the
economy produces has too much demand for money=> Excess demand for money
IS and LM curve combined

Explaination:
Point E: only single combination between interest rate and national output that satisfies both the
product market representing by IS curve and the money market representing by LM curve
 In the money market, interest rate ® is determined => Investment (I) is determined =>
Aggregate Expenditure (AE) is determined => National output (Y) is determined =>
Money demand is affected => (Back to the interest rate)

Explaination:
+ Fiscal policy happens, IS curve shifts to the right.
+ Monetary policy happens, LM curve shifts to the right.
Explaination:
+ Point A: Excess supply of Money => Interest rates will fall
+ Point B: Excess supply for Goods => Fim needs to decrease the output
+ Point C: Excess supply of Money => Interest rates will fall
+ Point D: Excess demand of Goods => Firm needs to increase the output
+ Point E: Excess demand for Money => Interest rate must increase
… until reach the equilibrium