You are on page 1of 21

IS-LM Model

Interdependence of product and money


markets
 Product Market  Money Market
Y=C+I+G+(X-M) Ms=Md

I = f(i) Md =Mt+Msp

i = Determined in Mt = f (Y)

money market Msp = f (i)

Unless “i” is
Unless “Y” is

determined, “I” determined in the


cannot be product market “Md”
determined and cannot be determined
unless “I” is and therefore “i”
determined “Y” cannot be determined
cannot be
determined
Income Determination Including Money
and Interest Rates
 Interest rates and money supply has major
role to play in the economy
 Role of monetary policy in regulating
economy
 Interest rate as additional determinant of
aggregate demand
 IS Curve – Goods market (Investment =
Savings)
 LM Curve – Money market (Money demand
= Money Supply)
Goods Market – IS curve
 IS curve shows the combinations of
interest rates and level of output such
that planned spending equals income
 Investment is not autonomous but
function of interest rates
 Lower is the interest rate higher is the
planned investment and vice versa

I =I −θi; θ〉0
Investment schedule
I
Interest Rate

O
Planned Investment Spending
Derivation of IS Curve
AD =C +I +G +NX
[ ] [
= a +b(Y −tY +J ) + I −θi + G + NX ] [ ] [ ]
= A + b(1 − t )Y −θi
E q u ilib riu m in G o o d s m a rke t : Y = A D
Y = A +b(1 −t )Y −θi

Y =
A− θi
1−b(1 − t)

i =
A

[1 −b(1 −t ) ]
Y ( IScurve )
θ θ
Graphical derivation of IS
AD
Curve
AD=Y
θi2
1 - t)Y –
A+b(
E2
– θi1
1 - t)Y
A+b (

A-θi2
E1

A-θi1

O Y
Y1 Y2
IS Curve
i

i1 E1

i2 E2

IS

O Y
Y1 Y2
IS Curve
C(Y) = 10+0.5Y
I(i) = 200-2000i

Product market equilibrium Y = C+I

Y=10+0.5Y + 200-2000i

Y = 420-4000i


Asset Markets – LM Curve
 Asset markets are the markets in which
money, bonds, stocks, houses and other
forms of assets are traded
 Money market
 Nominal demand for money is the
individual’s demand for a given number
of rupees
 Real demand for money is the demand for
money expressed in terms of number of
units of goods that money will buy. It is
equal to nominal demand for money
divided by the price level
Demand for Money
 Demand for money is demand for real
balances because people holds money
for what it will buy
 Higher the price level, more nominal
balances in order to be able to buy the
same amount of goods
 Demand for real balances depends on level
of real income and interest rate
 L =kY-hi: k,h>0
 Parameters k and h reflects the sensitivity
of the demand for real balances to the
level of income and interest rates
Demand of Money
 Equilibrium in money market = Dm =Sm
(real)
 Nominal quantity of money M and Price
level P are assumed constant

Interest Rate

K▲Y

L2=kY2 - hi

L1=kY1 - hi

O Demand for Money


Derivation of LM curve

LM

i2 E2 i2 E2

i2 E1 E1
i2
L2

L1

O O
Y1 Y2 M/P

LM curve gives the combinations of income and interest rates which


produces equilibrium in money market. For all points on LM curve demand
for real balances equal the supply of real balances
LM Curve
 Ms = 150
 Mt =0.5Y

 Msp= 150-1500i

 Md = 0.5Y+150-1500i

 Equilibrium in money market = Md =Ms

 150=0.5Y+150-1500i

 Y = 3000i
Equilibrium - IS LM
 Points on IS curve indicates equilibrium
in the goods market. Points on the LM
curve indicates equilibrium in the
money market.
 Simultaneous equilibrium in goods and
money market is possible at a point of
intersection between IS and LM curves

IS LM
 IS = Y = 420-4000i
 LM = Y = 3000i

 IS=LM

 420-4000i = 3000i

 i = 0.06

 i = 6%
Equilibrium
i
I LM
ESG
ESM
II EDG ESG IV
i ESM EDM
EDG
EDM
III IS
O Y Y
Region Goods Market Money Market
Disequilibri Output Disequilibri Output
I um
ESG Falls um
ESM Falls
II EDG Rises ESM Falls
III EDG Rises EDM Rises
IV ESG Falls EDM Rises
The Transmission mechanism
 The mechanism by which the changes in
monetary policy affect aggregate demand is
called transmission mechanism
 Increase in real money supply causes a portfolio
disequilibrium at prevailing interest rates and
the level of income i.e. people are holding
more assets than they want. They tries to get
rid of excess money by buying financial
assets and thus causes interest rates to fall
 Fall in interest rates induces an increase in
investment expenditure and also possibly
consumption expenditure, thereby increasing
the aggregate demand and ultimately income

Transmission Mechanism
 Increase in real money supply
 Excess Mt
 More money supply for Msp
 Low Interest rates
 High consumption
 High investment
 More output
 Increase in national income