IS-LM Model of

determination of
interest rates
Link between goods market and
money market
Criticism of Keynesian theory-
 In the Keynesian model, changes in the
interest rate in the money market affect
investment and hence the level of income,
however there is seemingly no inverse
influence of changes in goods market on
the money market equilibrium.
J.R. Hicks –
 Changes in income caused by changes
in inv or mpc in the goods market, also
influence the determination of interest in
the money market.
 Extended Keynesian model known as
IS-LM curve model.
 Level of national Income and Rate of
interest are jointly determined by the
two interdependent goods market and
money market.
Goods Market Equilibrium –
IS curve
 AD = C+I
 Equilibrium when AD = NI
 Introduction of rate of interest as a
determinant of investment.
  roi => inv 
 Hence, changes in roi affect AD by causing
changes in Inv.
roi I Derivation of IS curve Y=C+S
AD C+I2
E2
Figure 2 C+I1
r0 E1 C+I0
r1 E0
r2
I
NI
I0 I1 I2 Y0 Y1 Y2
Planned inv roi
r0 A
Figure 1
r1 B
Figure 3 r2
IS

Y0 Y1 Y2
National Income
 IS curve
 Figure 1 – Relation between roi and inv.
 At interest rate r0, inv = I0. With I0 amount of inv the AD
curve is C+ I0 which equals Agg output at OY0 level of
income.
 If interest rate falls to r1, investment increases to I1.
 With increase in investment, AD curve shifts upward and
the goods market is in eqlm at OY1level of income.
 Thus, OY1 is plotted against r1 rate of interest.
 By joining points A and B representing various interest-
income combinations at which goods market is in
equilibrium, we obtain the IS curve.
Money market equilibrium – LM
curve
 The LM curve can be derived from the
Keynesian theory from its analysis of money
market equilibrium.
 demand for money – Transactions and
speculative motive.
 Money held for transactions motive – function of
income
 Greater the level of income – greater the
amount of money held for transactions purposes
– higher the level of money demand curve
 Derivation of LM Curve
roi Ms roi LM
r2 r2

r1 M2 (Y2) r1

r0 M1 (Y1)
r0
M0(Y0)

Y0 Y1 Y2
Quantity of Money Level of income
Essential features of LM Curve
1. LM curve is a schedule that describes the
combinations of roi and level of income at
which money market is in equilibrium
2. LM curves upward from left to right.
3. LM Curve shifts to the right when the stock
of money is increased and to the left with a
decrease in stock of money.
Simultaneous eqlm of goods
market and money market
IS and LM curve relate the two variables:
a. Income
b. Rate of interest
 Income and roi are determined together at
the point of intersection of these two
curves.
IS and LM combined
Roi
LM

r* E

IS

Y*
National income
 Equilibrium roi is determined at r* and
the equilibrium income is determined
at Y*.
 At this point, income and roi stand in
relation to each other such that
1. Goods market is in eqlm
2. Demand for money is in eqlm with ss
of money
Summary
 IS-LM model is based on-
1. Investment demand function (I)
2. Savings Function (S)
3. Money demand function (liquidity pref.
L)
4. Money supply(M)
Contd..
 Acc. to the IS-LM curve model, both the
real factors, Saving and investment,
productivity of capital and mpc and mps,
and the monetary factors play a part in
the joint determination of the roi and the
level of income.Any change in these
factors will cause a shift in IS or LM
curve and will therefore change the
eqlm levels of roi and income