General Equilibrium of Product and Money Markets (IS-LM

Model)
Introduction
Keynes has analyzed the equilibrium of goods market and money market separately by ignoring the
effect of one market to another. So, his analysis is partial equilibrium analysis. But, J.R. Hicks has
analyzed the simultaneous equilibrium of both markets which is called IS-LM model. Later, it is
popularized by Alvin Hansen. Therefore, this analysis is also known as the Hicks-Hansen model. Hicks
had developed IS-LM model in 1937 , just one year after the publication of Keynes' "The General Theory
of Employment, Interest and Money". This model explains how product and money market attain
equilibrium simultaneously at the same level of income and interest rate.
The term "IS" is the shorthand expression of the equality of investment (I) and saving(S) which
represents the product market equilibrium. On the other hand, the term "LM" is the shorthand
expression of the equality of demand for money/liquidity (L) and supply of money (M) and represents
the money market equilibrium. Graphically the point of intersection of IS and LM curves establishes the
equilibrium level of income and rate of interest at which both goods/product market and money market
of the economy are simultaneously in equilibrium.
Equilibrium in Goods Market (IS Curve)
The IS curve represents all combinations of income (Y) and interest rate(r) such that market for goods
and services is in equilibrium. That is every point on the IS curve is an income and interest rate pair (Y, r)
such that the aggregate demand for goods is equal to the their aggregate supply, which equivalently
means that desired national saving is equal to desired investment, and it is a state of equilibrium in the
goods/product market (the real or of the economy).
IS curve (or schedule) represents product market equilibrium. According to this model, investment is a
negative function of rate of interest (i.e. higher the rate of interest, lower the investment and vice versa.
Income is a positive function of investment (i.e. higher the investment, higher the income and vice
versa) and saving is a positive function of income (i.e. higher the income, higher the saving and vice
versa).
Derivation of IS Curve
According to Keynes, the goods market is in equilibrium when aggregate demand (AD) equals aggregate
supply (AS) i.e.
AD = AS
In two sector economy
AD = C+ I
AS = C+S
⇒C+I=C+S
Linear Consumption function can be defined as,
C = a + bY
S = f(Y), f’>0
I = f(r), f’<0
Now,
S = Y-C
Or, S = Y-( a +bY)
S = -a+ (1-b)Y……………………………(i)
Linear Investment function can be expressed as,
I =β-θr-------------------------(ii)
Where,
C = Aggregate Consumption
S = Aggregate Saving
a = Autonomous Consumption
b = Marginal Propensity to Consume
Y = National Income
I = Aggregate Investment
f = Relation
β = Autonomous Investment
θ = Coefficient of Induced Investment
r = Rate of Interest
In equilibrium,
S=I
From equation(i) and (ii), We get
Y = a+β/1-b-θr/1-b------------------(iii)

Equation (iii) represents the IS equation.

The IS equation in terms of ‘r’ can be expressed as,
∴ r = β+a/θ-(1-b/θ) Y
Diagrammatic Representation of IS
 In the above figure,Panel A shows the inverse relationship between interest and investment or
investment function. Panel B shows the equality between S and I Panel C shows the saving function.
Panel D shows the IS-curve or goods market equilibrium.
Let, initial interest rate is r 1 in panel A. At r1interest rate, investment is l 1. In order to maintain product
market equilibrium saving should be S1 as shown in Panel B. In Panel C, income must be maintained at Y 1
level for S1 level of saving. In Panel D, interest rate is r 1 and income level is Y1 which gives product market
equilibrium. This equilibrium point is marked by point C. Again, suppose that interest rate falls from r 1 to
r2,then the investment also increases I 1 to I2, and thereby saving increases S 1 to S2, for product market
equilibrium in Panel B. Income must be Y 2 level in order to maintain saving at S 2 amount. In Panel D,
interest rate is I1; and income level is Y1 that gives product market equilibrium. This equilibrium point is
indicated by point H. By joining equilibrium points G and H, we get negatively sloped IS-curve.
Features of IS Curves
 IS curve is a locus representing various equilibrium points at which equality between saving and
investment is maintained at various level of income and rate of interest.
 It slopes downwards to the right. It is because an increase in the interest rate reduces planned
(desired) investment spending and therefore reduces aggregate demand, thereby lowering the
equilibrium level of income.
 The smaller the multiplier and the less sensitive investment spending is to changes in the
interest rate, the steeper the IS curve and vice versa.
 When autonomous spending. An increase in autonomous spending, such as investment
spending or government expenditure, shifts the IS curve to the right and vice -versa.
 At points to the right of the IS curve, there is excess supply in the goods market: at points to the
left of the curve, there is excess demand for goods.
Why IS curve is negatively sloped?
The IS curve is the set of combinations of interest rate r and national income Y that keep the goods
market in equilibrium. If the interest rate r increases, business demand for investment will decline, and
so (in most models) will consumer demand. That will create excess supply at the original value of
national income; to restore equilibrium in the goods market, national income must fall. If you map out
those changes graphically, you’ll see that they create a downward-sloping curve. Mathematically,
r = β+a/θ-(1-b/θ) Y
Differentiating IS equation with respect to Y.
dr/dY = -(1-b)/θ< 0
⇒Slope of IS curve is negative.
Equilibrium in the Money Market(LM Curve)
LM curve is the locus of various combinations of the level of income and output and rate of interest
which shows the equilibrium in money market. Equilibrium in money market signifies that demand for
money (L) equals to the supply of money (M). Supply of money is determined by central bank. On the
other hand, economic units make demand for money for transaction purpose, precautionary purpose
and speculative purpose. The equality between demand for money and supply of money gives money
market equilibrium.

Derivation of LM Curve
Keynes' theory of demand for money or liquidity preference provides a family of liquidity preference
schedules at different levels of income. These together with the supply of money curve give the LM
curve. The supply of money is fixed by the monetary authority and remains interest-inelastic as
represented by a vertical line. Liquidity preference (or demand for holding money in cash) is an
increasing function of income implying that as income increases, the liquidity preference also increases
and vice versa. Given the supply of money, the family of liquidity preference schedules gives different
points of equilibrium between rate of interest and levels of income. Money demand function can be
expressed as,
Mt= f(Y), f’>0
M p= f(Y), f’>0
M s p = f(r), f’<0
Total demand for money can be expressed as,
Md = Mt+Mp+M s p
Md= f(Y,r)
The money demand equation can be expressed as,
Md= eY –λr---------------(i)
The money supply equation can be expressed as,
MS= M/P---------------------(ii)
Where,
MS = Supply of Money
Md = Demand for Money
Mt = Transaction Demand for Money
M p = Precautionary Demand for Money
M s p = Speculative Demand for Money
Y = National Income
e = The rate of change in demand for money due to change in Y
λ = The rate of change in demand for money due to change in r
M = Quantity of Money
M/P = Real Money Supply
In equilibrium,
MS = Md
From equation(i) and equation (ii), we get
eY –λr = M/P
∴r = e/λY- 1/λM/P------------------(iii)
Equation (iii) represents the LM equation.

Diagrammatic Representation of LM

In the above figure,Panel A shows the speculative demand for money which is the inverse function of
rate of interest. Panel B shows exogenously determined money supply. Panel C shows transactions
demand for money. Panel D shows money market equilibrium or LM-curve.
Suppose that i1 is the initial rate of interest. At this interest rate, the speculative demand for money is
Msp0 in Panel A. In Panel B, speculative demand for money is Ms p, and transaction demand for money is
Mto In Panel C, income level must be Yo in order to maintain M to transaction demand for money. In Panel
D, interest rate is io and income level Yo. By the relation of interest rate is and income level Yo, we get
point C in Panel D. At this point, money demand equals money supply. Hence, at point C, money market
is in equilibrium.
Again, suppose that rate of interest falls to i 1. Due to fall in interest rate the speculative demand for
money increases to Msp1. Since, money supply is fixed, transaction money demand decreases to Mt 1,
due to the increase in speculative demand for money. Income must be Y 1, in order to maintain the Mt 1
transaction demand for money. In Panel D, at is interest rate, income level is Y₁ which is marked by point
D where money demand equals money supply. Hence, at point D, money market is in equilibrium. By
joining these equilibrium points C and D, we get positively sloped LM-curve.
Features of LM Curves
 The LM curve is the schedule of combinations of interest rates and levels of income such that
the money market is in equilibrium.
 The LM curve is positively sloped. Given the fixed money supply, an increase in the level of
income, which increases the quantity of money demanded, has to be accompanied by an
increase in the interest rate. This reduces the quantity of money demanded and thereby
maintains money market equilibrium.
 An increase in money supply shifts the LM curve to the right and vice versa.
 At all points to the right of the LM curve, there is an excess demand for money, and at points to
its left, there is an excess supply of money.
Why LM – Curve is Upward Sloping?
The LM curve slopes positively which indicates that in a money market, the income level(Y) and the
interest rate(r) vary directly. This is due to the reason that when the rate of interest increases, the
speculative demand declines leaving more money for transaction purposes. When spending on
transaction demand increases, the level of demand also increases. Mathematically,
r = e/λY- 1/λM/P
Differentiating LM equation with respect to Y.
∴ dr/dY = e/λ>o
⇒Slope of LM is positive.
General Equilibrium of the Economy (IS-LM Equilibrium)
IS-curve shows the product market equilibrium which is negatively sloped. LM-curve shows the money
market equilibrium which is positively sloped. The interaction point of these two curves gives the
equilibrium interest rate and income level where both product and money market are in equilibrium.
This is known as general equilibrium or general equilibrium in the product market and money market.
This can be shown by the help of the given figure.

In figure, both IS and LM-curves intersect each other at point E. Therefore, at this point, both product
and money markets are in equilibrium. This point is known as the general equilibrium point or general
equilibrium in the product market and money market. The general equilibrium rate of interest is or 0 and
general equilibrium income level is oy0.
Shift in IS-LM Curves
The general equilibrium of the product and money markets is based on the static equilibrium analysis. It
started from a point of disequilibrium and again reached the equilibrium point of combination of level of
income (Y) and rate of interest (r) may change either due to shift in the IS function or the LM function or
by both the function shifting simultaneously. Here, we explain the effectiveness of changes in fiscal and
monetary policy on equilibrium income or general equilibrium. IS-curve represents fiscal policy and LM-
curve represents monetary policy. Therefore, IS-curve shifts due to change in fiscal policy and LM-curve
shifts due to change in monetary policy.
Shift in IS Curve
The IS curve shifts to the right with a reduction in saving. Reduction in saving may be the result of one or
more factors leading to increase in consumption. Consumers may like to buy a new product even by
reducing saving. The community's wealth may increase due to government's policy and the wealth
holders do not like to save same amount than before. Consumers may start buying more in anticipation
of shortages or price rise thereby reducing saving. The IS function also shifts to the right by an
autonomous increase in investment. The increase in investment may result from expectations of higher
profits in the future, or from innovation, or from expectations. Concerning increase in the future
demand for the product, or from a rise of optimism in general.
The government can influence investment, employment, output and income in the economy through
fiscal policy. Under expansionary fiscal policy, the government increases its expenditure or reduces
taxes. When government uses expansionary fiscal policy, the IS-curve will shift rightward. Under
contractionary fiscal policy, the government decreases its expenditure or increases taxes. When
government uses contractionary fiscal policy, the IS curve will shift leftward. Both interest rate and
income level will increase with the rightward shift in IS-curve, LM-curve remaining the same. On the
contrary, both interest rate and income level will decrease with the leftward shift in IS-curve, LM-curve
remaining the same. The shift in IS-curve can be explained from the given figure.

In the above figure, X-axis represents income level and Y-axis represents interest rate. The initial IS-
curve ISo and LM-curve are intersecting each other at point E o. Therefore, point Eo is the initial
equilibrium position where both product market and money market are in equilibrium. The initial
equilibrium interest rate is Oi0, and the initial equilibrium income level is OY 0. If the government uses
expansionary fiscal policy, i.e. increase in government expenditure and reduces the tax rate, the initial
IS-curve IS0 will shift rightward to the position IS 2, which intersects LM-curve at point E 2. The point E2 is
the new equilibrium position where interest rate rises from Oi o to Oi2 and income level increases from
OY0 to OY2. On the contrary, if the government uses contractionary fiscal policy, i.e., decrease in
government expenditure and increase in tax rate, the initial IS-curve IS 0 will shift leftward to the position
IS1, which interests LM-curve at point E 1. Therefore, the point E1 is another new equilibrium position
where interest rate reduces from Oi0 to Oi1 and income level decreases from OY0 to OY1.
Factors causing shift in IS curve
Changes in Autonomous Consumer Expenditure
 A rise in autonomous consumer expenditure due to rise in the stock of wealth or expected future
income and output shifts aggregate demand upward and shifts the IS curve to the right. For example,
when more oil fields containing more oil or new gold mines are discovered, consumers of that particular
country become more optimistic about the future health of the economy, and autonomous consumer
expenditure rises. A decline in autonomous consumer expenditure has opposite effect. For any given
interest rate, the decrease in autonomous consumer spending, shifts the aggregate demand function
downward, aggregate demand declines and the IS curve shifts to the left.
Change in Saving Rate
Consumer can change their saving rate which will affect consumption and cause shift in the IS curve.
 If consumers decide to save more (PMC falls and MPS rises), then consumer spending declines
and the IS curve shifts to the left.
 If consumers decide to save less (MPS falls and MPC rises), then consumer spending increases
and the IS curve shifts to the right.
Changes in Private Investment
Change in private fixed investment which is unrelated to the interest rate will cause shift in the IS curve.
 If firms feel more confident about the future (for example because of the discovery of new oil
field or gold mine, business confidence and profitability increases), they may invest more in
spite of the interest rate. The increase in autonomous investment will shift the IS curve to the
right.
 If firms feel less confident about the future (e.g., due to growing political instability, internal
conflict, national or global economic down turn etc.), they will invest less regardless of the
interest rate. This will cause a decrease in investment, decrease in aggregate demand and the IS
curve will shift to the left.
Changes in Taxes
Changes in tax by the government will affect the size of disposable income (after tax income) which in
turn will affect household’s consumption. This will have effect on the IS- curve.
 If the government increases tax, it will lower consumers spending by lowering be disposable
income. So, a rise in tax will shift the IS curve to the left. If government increases taxes on
business sector's capital investment expenditure, desired investment falls, and the IS curve
shifts down and to the left lowering the real interest rate that clears the goods market.
 If the government reduces tax, it will increase disposable income causing an increasing in
consumption at the given rate of interest. Therefore, a reduction in taxes will shift the IS curve
to the right.
Changes in Net Exports
Change in net exports unrelated to the interest shift the IS curve. But changes in net exports arising from
a change in merely cause a movement along the IS curve and not a shift.
 If export (net export) of an economy increases (due to currency depreciation), we see the IS
curve shift to the right. For example, if Nepal-made readymade clothes become more
fashionable in USA than Bangladesh-made, it will shift the aggregate demand function of Nepal
upward and cause the IS curve to shift to the right.
 If export (net export) decreases (due to currency appreciation), we see the IS curve shift to the
left.
Shift in LM-Curve
The LM function shifts to the right with the increase in the money supply given the demand for money,
or due to the increase in the demand for money, given the supply of money. The government can
influence investment, employment, output and income through monetary policy. Monetary policy is
formulated and implemented by the monetary authority/central bank. There are two types of monetary
policy: expansionary and contractionary. Expansionary monetary policy is related to the increase in
money supply and contractionary monetary policy is related to the decrease in money supply. If the
central bank uses expansionary monetary policy, the LM-curve will shift rightward. It causes decrease in
interest rate and increase in income level. On the contrary, if the central bank uses contractionary
monetary policy, the LM-curve shifts leftward. It causes rise in interest rate and fall in income level. The
shift in LM-curve can be explained from the given figure.

In the above figure, X-axis represents income level and Y-axis represents interest rate. Initial LM-curve
LM0, and IS-curve are intersecting each other at point E 0, where both product market and money market
are in equilibrium. Therefore, the point E 0 is the initial equilibrium position. The initial equilibrium
interest rate is Oi0, and initial equilibrium income level of OY 0. If the central bank uses expansionary
monetary policy, i.e., increase in money supply, the initial LM-curve LM 0, will shift rightward to
LM2position which intersects IS-curve at point E 2. The point E2, is the new equilibrium position where
interest rate falls from Oi0 to Oi2 and increase in income level from OY 0 to OY2. On the contrary, if the
central bank uses contractionary monetary policy, i.e. decrease in money supply, the initial LM-curve
LM0 will shift leftward to LM1 position which intersects IS-curve at point E₁. The point E 1, is another new
equilibrium position where interest rate rises from Oi0 to Oi1and fall in income level from Oy0 to OY1.
Factors causing shift in LM curve
The LM curve shifts due to changes in exogenous variables (variables the value of which come from
outside the model, not determined in the model) or a behavioral shift in the demand for money. The
factors that cause possible shift of the LM are given as below:
Changes in the Money Supply.
Change in the money supply will shift the LM Curve.
If the Central Bank decides to increase the money supply (e.g. by buying Treasury bills of the
Government, or by reducing the bank rate/discount rate, or by lowering the required reserve ratio),
then the LM curve shifts to the night. Increase in money supply reduces the equilibrium interest rate.
If the Central Bank decides to reduce the money supply (e.g., by selling Treasury bills of the
Government, or by raising the bank rate/discount rate, or by increasing the required reserve ratio), then
the LM curve shifts to the left. Decrease in money supply increases the equilibrium rate of interest. The
condition of excess demand for money can be eliminated by a rise in the interest rate, which reduces
the quantity of money demanded until it again equals the quantity of money supplied.
Autonomous Changes in Money Demand
The theory of financial asset demand suggests that there can be an autonomous rise in money demand
(i.e., change in money demand not caused by a change in the price level, aggregate output, the interest
rate). For example, an increase in the instability of bond returns would make bonds riskier relative to
money and would increase the quantity of money demanded at any given interest rate, price level, or
amount of aggregate output. Therefore, money supply remaining constant, the increase in autonomous
money demand shuts the money demand curve up and LM curve to the left and interest rate rises. For
example, suppose in an economy there emerges a very big financial fear that many companies are going
into bankruptcy (i.e., in insolvency or liquidation). Because bonds have become a riskier asset, people
want to shift from holding bonds to holding money they will hold more money at all interest rates and
output levels. The resulting increase in money demand at the given level of output causes the interest
rate to rise.
Change in Transaction Technologies
Changes in transaction technology, for example. the introduction of credit cards, will have effect on the
velocity of money which will ultimately affect the LM curve. If improvement in the velocity of money
occurs suck that people require less money to carry out all of their transactions, the LM curve will shift
to the right. This is because of the decrease in the opportunity cost of holding money as there is now an
alternative available.
Change in Overall Price Level
Although in deriving the IS-LM model it is that price level remains constant, we can introduce the "price
level change” in the model to see its effect on money demand and on the LM curve. (a) If the prior in
rises, the LM curve shifts to the left. This happens because people need more money's pay the higher
prices, but the resulting-higher interest rates lower the demand in money (b) If the price level falls the
LM curve shifts right. This happens because people need less money to pay the lower prices, and the
lower interest rates their demand for holding money.
Simultaneous Shift in IS-LM Curves
If the government uses expansionary fiscal policy by increasing expenditure and reducing tax rates in
order to increase investment, IS-curve will shift rightward. It will cause rise in both interest rate and
income level. On the other hand, if central bank uses expansionary monetary policy by increasing money
supply in order to increase investment, LM-curve will shift rightward.
Based on above explanation it is concluded that when the IS curve shifts to the right (or shifts to the left)
due to increase (or decrease) in investment or decrease (or increase) in saving, both the rate of interest
and the level of income tend to rise and vice versa, given the LM curve. On the other hand, when LM
curve shifts to the right (or shifts to the left) due to an increase (or decrease) in money supply or
decrease (or increase) in demand for money rate of interest tends to fall (or rise) and level of income
tends to rise (or fall), given the IS curve. The simultaneous shift in IS and LM can be explained from the
given figure.
In the above figure, X-axis represents income level and Y-axis represents interest rate. IS 1 is the initial IS-
curve and LM1, is the initial LM-curve. Both curves are intersecting each other at point E 1, where both
product and money markets are in equilibrium. Therefore, point E 1, is the initial equilibrium position
where interest rate is Oi1 and income level is OY1. If the government adopts expansionary fiscal policy in
the form of increase in expenditure or decrease in tax rate, this will shift IS-curve from IS 1 to IS2. As a
result, interest rate rises to Oi 2, if an expansionary monetary policy is not adopted simultaneously. If the
central bank adopts expansionary monetary policy by increasing money supply in order to reduce
interest rate and increase in investment, this will shift LM-curve from LM 1 to LM2 to the right. New IS
curve IS2 and new LM-curve LM 2 are intersecting each other at point E 2. Therefore, new equilibrium is
established at point E2, where interest rate reduces to Oi2, and income level increases to OY2.