Equilibrium in product and

money market: IS-LM curves

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After studying the topic, we will learn about
 Product Market Equilibrium
 Derivation of IS Curve
 Money Market Equilibrium
 Derivation of LM Curve
 General Market Equilibrium: Combining Money
Market and Product Market
 Shifts of the IS and LM Curves
 Effect of Fiscal and Monetary Policy on IS and LM
Curve
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 Product Market Equilibrium
• Market characterized by selling and buying of goods is called product or
goods market.
• Product market is in equilibrium when demand for product and supply of
product are equal.
• Product market is in equilibrium when saving and investment are equal.
• S=I
• In the goods/product market equilibrium, we have:
• (a) The saving function
• (b) The investment function
• (c) An equilibrium condition.

 .

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 IS-CURVE
• IS-CURVE : The IS curve shows equilibrium
combinations of income and interest rate
where along IS curve product or good market
is in equilibrium.

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 Derivation of IS-Curve
• (a) The saving function
S = f (Y), where S is saving and Y is income.
(b) The investment function
I =f (r), I is investment and r is general rate of
interest.
In equilibrium, S=I
For the derivation of IS curve, we have to find
combinations of interest rate, r, and the level of
income, Y, that equate investment with saving.
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Derivation of IS-Curve

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 Explanation
• The derivation of IS curve can be made in
terms of the four-part diagram (Fig. 10.28). In
part (a), we have drawn investment function
that shows the inverse relationship between
investment and the rate of interest. Part (c)
plots the saving function that represents
direct relationship between income and
saving. Part (b) is simply a 45° identity line,
and part (d) plots the IS curve.
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 Explanation
• Suppose the rate of interest is r0. At this rate
of interest, investment must be I0 and, thus,
the volume of saving must be S0, necessary for
equilibrium. This volume of saving implies an
equilibrium income of Y0 necessary for
equilibrium. This establishes one point on part
(d), say point M. If the rate of interest rises to
r1; investment declines to I1. This results in a
decline in national income to Y1.
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 Explanation
• With this level of income the volume of saving becomes S1. This
establishes another point on part (d), say point N. The procedure
may be repeated for each level of income (interest) to obtain
corresponding values of interest rate (income value) that ensure
equality between saving and investment. By joining all these
equilibrium points we get an IS curve drawn in part (d).
• Thus, the IS curve shows various combinations of income and
interest rate that brings the commodity market in equilibrium. The
IS curve is negatively sloped. Its slope depends on the nature of
saving and investment functions.
• The IS curve may shift if there is a change in autonomous private
investment and government expenditure.

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• Thus the effect of an increase in r is:
• r ↑→ I↓→ AD ↓→Y↓, and the effect of a
fall in r is:
• r ↓→ I ↑→ AD↑→ Y↑
• The IS curve slopes downwards to the right. Or
it has a negative slope.

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 Properties of the IS Curve: A Summary

• i. The IS curve is the equilibrium combinations of income and interest

rate such that the product market or goods market is in equilibrium.
• ii. The IS curve slopes downward to the right because an increase in
interest rate causes investment expenditure to decline, therefore,
reduces aggregate demand and, hence, equilibrium national income.
• iii. Its slope depends on the saving and investment functions. The IS
curve will be relatively steep (flat) if investment is less (more) sensitive to
interest rate changes.
• iv. This IS curve will shift by an autonomous change in investment
spending or government spending.
• v. Any point on the IS curve shows that there is neither excess supply nor
excess demand for goods. Any point off the IS curve shows either excess
supply of goods or excess demand for goods.

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LM CURVE

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 Money Market
• Technically, a money mar­ket is market
characterized by demand for money and
supply of money.
• It concerns on borrowing and lending of short-
term funds.
• It is a market for short-term loans in the sense
that it provides money for working capital or
cir­culatory capital.

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• The main building blocks of money market
are:
• (i) Central bank,
• (ii) Commercial banks, and
• (iii)Development Banks, …………

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 Money Market Equilibrium
• Money market is in equilibrium when demand for
and supply of money are equal at given rate of
interest.
Money market equilibrium occurs when
• M = Md
• Demand for Money
•  The demand for money is the desired holding of
financial assets in the form of money: that is, cash
or bank deposits. 
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Demand for Money

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• Thus, Keynes’ money demand function is
written as
• Md = f (Y,r) where Y is income level, r is rate of
interest and Md is demand for money.

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 Supply of Money
• The concept of money supply can be defined as the total quantity of currency
that can be included in a nation's economy. Money supply includes the total
money both in the form of cash as well as deposits that can be used as cash
easily.

• Supply of money (M) is institutionally given. Since it is exogenously

determined by monetary authority of any country, it is assumed to be
constant for certain period of time. So it is vertical.
• MS ↑ →r ↓ I ↑→ AD ↑→ Y ↑ and P ↑
• Where MS = supply of money
• r = rate of interest
• I = amount of investment
• AD = aggregate demand
• Y = level of national income, that is, aggregate output
• P = price level

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• The money supply, meaning the total cash
present under a nation's economy, is bound to
influence the economics of the market.

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 Derivation of LM Curve
• The LM curve shows different combina­tions of
r and Y where along LM curve money market
is in equilibrium.

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• The LM curve, "L" denotes demand for money and "M" denotes supply of money, is a
graph of combinations of real income, Y, and the real interest rate, r, such that the money
market is in equilibrium .The graphical derivation of the LM curve is illustrated below.

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• The left-hand side of the graph illustrates money market equilibrium for a given
level of Y. For example, when Y = Y0 the equilibrium real interest rate is 5%. The
right-hand-side of the graph gives the LM curve. The LM curve is plotted with the
real interest rate on the vertical axis and real income (GDP) on the horizontal axis.
Each point on the LM curve represents a money market equilibrium for a
particular real interest rate and income pair (r, Y). For example, the money market
equilibrium at (r=5%, Y=Y0) is given by the black (middle) dot on the LM curve.
• At a higher level of income, Y1 > Y0, the money demand curve shifts up and right
and a new equilibrium occurs at r = 7%. This equilibrium is represented by the
blue (upper) dot on the LM curve. Similarly, at a lower level of income Y 2 < Y0 the
money demand curve shifts down and left and a new equilibrium occurs at r = 3%.
This equilibrium is given the by the red (lower) dot on the LM curve.

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• The above analysis shows that the LM curve is an upward
sloping curve in the graph with r on the vertical axis and Y on the
horizontal axis.
• Every point on the LM curve represents an intersection between
the real money supply (M/P) and real money demand (Ld).
• The LM curve will shift whenever the variables we hold fixed,
other than Y, in the money-supply/money-demand diagram
change.
• These variable are M/P and e. In particular, if M/P increases
holding expected inflation fixed then r falls in the money market
and so the LM curve shifts down and right.
• Similarly, if expected inflation increases real money demand
falls, lowering the interest rate, and the LM curve shifts down
and to the right.
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• Properties of the LM Curve: A Summary:
• i. The LM curve consists of equilibrium combinations of
income and interest rate for the money market.
• ii. The LM curve slopes upward to the right.
• iv. The LM curve shifts due to changes in money supply
and money demand.
• v. All points on the LM curve show money market
equilibrium such that there is neither excess demand
for money (EDM) nor excess supply of money (ESM).
Any point off the LM curve exhibits either EDM or ESM.
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Combining Goods Market and Money
Market: General Equilibrium:

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 Description
• Above figure shows the general equilibrium in terms of IS and LM
curves. Here, when both the curves are plotted on the same axes, the
equilibrium level of income, Ye, and the equilibrium interest rate, re,
are determined simultaneously.
• This is known as the synthesis of monetary analysis and income
analysis or macroeconomic general equilibrium. Point E is the (only)
point of general equilibrium for both the markets. Point E is a stable
equilibrium point.
• If we take any other points in the LM curve except point E, money
market is in equilibrium leaving good market in disequilibrium.
Similarly, if we take any other points in the IS curve except point E,
good market is in equilibrium leaving money market in disequilibrium.
So, point E is the point for general equilibrium.
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