IS –LM Model

• The terms IS and LM are shorthand

representations,respectively,of the
relationship Investment(I) equals Savings(s)-
the goods market equilibrium and the money
demand (L) equals money supply(M) – the
money market.
 Derivation of the IS Curve
• IS curve is the locus of those combinations of
rate of interest and the level of national
income at which the goods market is in
equilibrium.
• The lower the interest rate, the higher will be
the equilibrium level of national income.
 Slope of the IS Curve
The steepness of the IS curve depends on :

• The elasticity of the investment demand

• The steepness of the Is curve depends upon
the magnitude of the multiplier
 Shift in the IS Curve
• Shift in the IS curve
• The level of autonomous expenditure and
changes in it determines the position and
shifts in the IS curve.
 The IS Curve
Recap
• The IS Curve is the schedule of combinations of the
interest rate and the level of income such that the
goods market is in equilibrium.

• The IS curve is negatively sloped because an increase

in the interest rate reduces planned investment
spending and therefore reduces aggregate demand,
thus reducing the equilibrium level of income.
 The IS Curve
• The smaller the multiplier and the less sensitive
investment spending is to changes in the interest
rate, the steeper is the IS curve.

• The IS curve is shifted by changes in

autonomous spending. An increase in
autonomous spending, including an increase in
government purchases, shifts the IS curve out to
the right.
 The money market and the LM Curve

• According to Keynes, demand for money to

hold depends upon transactions motive and
speculative motive. It is the money held for
transactions motive which is a function of
income.
• The greater the level of income, the greater
the amount of money held for transactions
motive and therefore higher the level of
money demand curve.
 LM Curve
• Thus the demand for money (Md) can be expressed as:
• Md = L(Y,r)
• The intersection of these various money demand
curves corresponding to different income levels with
the supply curve of money fixed by the monetary
authority would give us the LM curve.
• The LM curve tells what the various rates of interest
will be (given the quantity of money and the family of
demand curves for money) at different levels of
income.
 LM Curve
• LM curve slopes upward to the right as with
higher levels of income, demand curve for
money(Md )is higher and consequently the
money market equilibrium, that is the equality
of the given money supply with money
demand curve occurs at a higher rate of
interest.
 Slope of the LM Curve
The slope of the LM curve depends on two factors.
• First, the responsiveness of demand for money (i.e , liquidity
preference) to the changes in income.
• The second factor which determines the slope of the LM Curve
is the elasticity or responsiveness of demand for money to the
changes in the interest rate. The lower the elasticity of liquidity
preference for speculative motive with respect to changes in
the rate of interest, the steeper will be the LM curve.
• On the other hand, if the elasticity of liquidity preference to the
changes in the interest rate is high, the LM curve will be flatter
or less steep.
 Shift in the LM Curve
• The LM curve shifts to the right when the stock of
money supply is increased and when there is a
decrease in the money demand function which
lowers the amount of money demanded at given
level of interest rate and income.
• LM curve shifts to the left if the stock of money is
reduced and if there is an increase in the money
demand function which raises the quantity of
money demanded at the given interest rate and
income level.