Unit 5- IS-LM Framework

• Introduction, Goods and Money market:

• Link between them, Goods market equilibrium-

• derivation of the IS curve, Shifts in the IS curve.

• Money market equilibrium- the LM curve, Shifts in LM curve,

• Simultaneous Equilibrium of IS-LM model

 
 IS – LM Frame Work Links between them
• In Keynes analysis National income is determined at the level where Aggregate
demand for consumption and investment goods equals aggregate output.
• NI is determined by the goods market equilibrium, and investment is
determined by MEC and rate of interest.
• The rate of interest is determined by money market equilibrium due to
demand for money and supply of money will affect the determination of
national income and output in the goods market through causing changes in
the level of Investment.
• Thus changes in money market equilibrium influence the determination of
national income and output in the goods market.
• In the Keynes model changes in the rate of interest in the money market affect
investment and therefore the level of income and output in the goods market.
• But the great flaw is there is no such inverse influence of changes in goods
market on the money market equilibrium.
• Group of economists Hicks, Hansen, Lerner and Johnson have put
forward a complete and integrated model based on Keynes
framework.
• In this variables like Investment, NI ,rate of interest, Demand and
supply of money are interrelated and mutually interdependence and
is represented by IS – LM Frame work.
• In this model they have shown that the level of national income and
rate of interest are jointly determined by the simultaneous
equilibrium, in the two interdependent goods and money markets
 Goods Market Equilibrium

• IS – LM model emphasizes the interaction between the goods and money

market .
• The goods market is in equilibrium when aggregate demand is equal to
income.
• The aggregate demand is determined by Consumption demand and
investment demand.
• In the Keynes model of equilibrium now we introduce rate of interest as an
important determinant of Investment.
• Due to this investment becomes an endogenous variable in the model.
• When the rate of interest falls Investment increases and vice versa.
• The lower the rate of interest, the higher will be the equilibrium level of national
income.
• Thus the IS curve is the locus of those combinations of rate of interest and the
level of national income at which goods market is in equilibrium.
• Changes in the rate of interest affects Agg.demand by causing
changes in investment demand.
• At a lower rate of interest more invest takes place due to more
profits.
• The increase in investment demand will bring an increase in
aggregate demand which in turn will raise in the equilibrium level
of income.
• In the derivation of the IS curve we can find out the equilibrium
level of national income as determined by the equilibrium in
goods market by a level of NI with various rates of interest.
• This curve relates different levels of NI with various rates of
interest. This is presented in the below diagram.
• The lower the rate of interest higher will be the equilibrium level of National
Income.
• The IS curve is the Locus of those combinations of rate of interest and level of
National income at which goods market is in equilibrium.
• In panel a the relationship between rate of interest and planned investment is
shown.
• At a higher rate of interest less investment is made. Corresponding to lower
investment Aggregate demand curve is C+I0, in panel b and c
• Aggregate output is OY0 level of National Income corresponding to higher interest
rate.
• Similarly for different rates of interest (Lower) & Investment will rise thereby
National Income increases which is observed in the fig.
• It is analysed IS curve is negatively sloped, implies when the rate of interest
declines equilibrium level of national Income increase.
Why does IS slope downward

• The lower interest rate is associated with Higher level of National

income and vice-versa. This makes IS curve, which relates to the level
of income with the rate of interest to slope downward.
• Steepness of the IS curve depends on
1. The elasticity of investment demand curve and
2. The size of the Multiplier
 Derivation of LM Curve
• Money Market equilibrium: The LM Curve is derived from Keynes theory from its
analysis of Money market equilibrium.
• According to JM. Keynes Demand for money to hold, depends on Three motives.
• Transactions demand for money(MT)
• Precautionary demand for money (MP) and
• Speculative demand for money. (MS)

• The money held for transactions is a function of Income.

• The demand for money depends on the level of income because we have to
finance our expenditure, that is related to Transactions like MT, MP and MS.
• The demand for money also depends on the rate of interest which is cost of
holding money. Because holding money rather than lending it and buying
other financial assets one has to forgo interest.
• Demand for money is expressed as

• MD = L (Y,r), where MD is demand for money, Y is real income and r is rate of

interest.
• A family of demand curves at various levels of income.
• The intersection of the various money demand curves corresponding to different
income levels with the supply curve of money fixed by monetary authority will give
us LM curve.
• LM curve relates the level of income with the rate of interest which is determined
by money market equilibrium corresponding to various levels of demand for
money.
• LM tells what the various rates of interest will be at different levels of income,
• Money demand curve is Liquidity Preference for money which is presented below
slide.
• So, as income increases, money demand curve shifts outward therefore the rate
of interest which equates supply of money with demand for money rises.
• In the slide the equality of demand for money and supply of money with various
interest is shown as LM.
• The slope of LM Curve: LM curve is upward sloping to right, because at higher
levels of income, demand curve for money 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.
• This implies that the rate of interest varies directly with income.
• The factors on which the slope of LM curve depends.
• The responsiveness of demand for money(LP) to the changes in income. As
income increases demand for money increases
L1 or MD = f (Y)
The second factor which determines the slope of the LM curve is the elasticity o
f demand for money to the changes in rate of interest
 Essential Features of LM Curve

• LM is a schedule describes the combinations of rate of interest and

level of income at which money market is in equilibrium.
• It Slopes upwards to right.
• It is flatter if interest elasticity of demand for money is high and is
steep if the interest elasticity demand for money is low.
• It shifts to right when the stock of money supply is increased and
shifts to the left if the stock of money supply is reduced.
 Simultaneous equilibrium of Money Market & Goods Market
The IS & LM Curve relates to Two Things
1. Income
2. Rate of interest
Income and the rate of interest are determined at the point of
intersection of these two curves.
The equilibrium rate of interest is determined at or2 and the level of
income is oy2.
At this point the goods market is in equilibrium ( Agg.Demand is equal
to Agg output).
The demand for money is in equilibrium with the supply of money .
The combined IS & LM Curves
• Thus the IS & LM Model is based on
• Investment Demand function
• Consumption function
• The money demand function
• Quantity of money.
• Thereby the real factors saving and investment, productivity of capital and
propensity to consume and save and the monetary factors that is the
demand for money and supply of money play a part in the joint
determination of the rate of interest and the level of income.
• Any changes in these factors will cause a shift in IS or LM curve will
therefore change the equilibrium levels of the rate of interest and income.