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IS-LM Model – IS Curve and LM Curve

The Goods Market and the IS Curve

  1. The goods market is in equilibrium when the output or income is equal to the aggregate demand in the economy.
  2. At this point, savings and investment are equal.
  3. Investment depends on the rate of interest and is inversely related to it.
  4. Savings depend on the level of income and are directly related to it.
  5. The IS curve shows the goods market equilibrium.

Derivation of the IS curve

Derivation of the IS curve

  • Given the interest rate i1, we have aggregate demand curve AD1 in the (A) part of the figure.
  • It intersects the 45° line at point E1 at which the goods market is in equilibrium; the equilibrium level of income is Y1.
  • In the (B) part of the figure, we plot point E1 corresponding to i1 and Y1.
  • If the interest rate falls to i2, aggregate demand will rise and the aggregate demand curve will shift upwards to AD2.
  • The new equilibrium point is E2, and the equilibrium level of income rises to Y2.

Derivation of the IS curve - 2

  • Point E2 is plotted on the (B) part of the figure, which shows that the combination of i2 and Y2 also leads to goods market equilibrium.
  • Repeating this exercise for all possible interest rates, we get a series of combinations of interest rates and levels of income at which the goods market is in equilibrium.
  • We obtain the IS curve by joining these points.
  • Thus, the IS curve is the locus of pairs of interest rates and income levels that are compatible with the goods market equilibrium.
  • The goods market is in equilibrium only on the IS curve.
  • All points to the right of the IS curve denote excess supply, while the points on the left of the IS curve denote excess demand in the goods market.

Slope of IS Curve

  1. The IS curve slopes downwards, that is, it is negatively sloped.
  2. This downward slope is because a decrease in interest rates causes investment spending to rise which shifts the aggregate demand curve upwards and raises the equilibrium income level.
  3. The Steepness of the IS curve depends on the sensitivity of investment spending and autonomous consumption expenditure to changes in interest rates.
  4. If investment spending and autonomous consumption expenditure are very sensitive to interest rate, a given change in interest rate will produce a large change in aggregate demand and hence, a large change in the equilibrium income level.
  5. Thus, the IS curve will be flatter. In the opposite case, the IS curve will be steep.

Shifts in the IS curve

Shifts in the IS curve

Changes in some factors shift the aggregate demand and therefore, the IS curve.

  • The initial IS curve is IS0.
  • If there is an increase in autonomous spending, the IS curve shifts rightwards to IS1.
  • Conversely, if there is a fall in autonomous sending, the IS curve shifts leftwards to IS2.
  • This means that for each level of interest, there is a high real income consistent with equilibrium in the goods market.

The Money Market and the LM curve

  • Moving on to the money market and LM curve,
  • The money market is in equilibrium when the demand for money equals the supply of money.
  • The LM curve shows the different combinations of interest rates and income at which the money market is in equilibrium.
  • Along the LM curve, the demand for real money balances is equal to the supply of real money balances.

Derivation of the LM Curve

Derivation of the LM Curve

  • The demand for real balances depends on the real income and interest rate.
  • The demand curve for money, L1, is plotted for a given level of real income.
  • As income increases to i2, the demand curve for money will shift to the right (that is, L2)
  • The nominal supply of money (M) is controlled by the central bank and is assumed to be constant at a given time. If the price (P) is constant, the real money supply is equal to M/P and is assumed to be fixed.

Derivation of the LM Curve - 2

  • Part (A) of the figure shows equilibrium in the money market with a given supply of real balances of M at point E1 and the equilibrium interest rate of i1.
  • The demand curve for real money balances, L1,is drawn for a given real income Y1.
  • Point E1 is marked in part (B). At point E1, the money market is in equilibrium with the combination of income Y1 and interest rate i1.

Derivation of the LM Curve - 3

  • When income rises to Y2, L1 shifts to L2.
  • Point E2 denotes the new equilibrium in the money market, and i2 is the new equilibrium interest rate.
  • Point E2 is marked in part (B). At this point, the money market is in equilibrium corresponding to income Y2 and interest rate i2.
  • This exercise can be repeated for different levels of income, and corresponding equilibrium points can be plotted.
  • By joining these points, we get the LM curve.
  • Thus, the LM curve is the locus of pairs of interest rates and income levels that are compatible with the money market equilibrium.
  • The money market is in equilibrium only along the LM curve.

Shift in the LM Curve

Shift in the LM Curve

An increase in the money supply will shift the LM curve rightwards to LM1, while a decrease in the money supply will shift the LM curve leftwards to LM2.

Equilibrium in the Goods and Money Markets

Equilibrium in the Goods and Money Markets

  • The goods market is in equilibrium at all points on the IS curve, and the money market is in equilibrium at all points on the LM curve.
  • At point E, the goods and money markets, both, are in equilibrium.
  • The goods and money markets interact to determine the equilibrium interest rate i0and the equilibrium level of income Y0.
  • The IS-LM model is helps understand the effects of monetary and fiscal policies on income and interest rate.

Impact of Monetary Policy Changes

Impact of Monetary Policy Changes

  • Monetary policy is perfectly elastic during its initial impact on the money market.
  • An increase in the quantity of money reduces the interest rate, which leads to an increase in investment spending and aggregate demand, thereby increasing the income level and output in the economy.
  • The initial IS and LM schedules are IS0 and LM0 respectively, and the initial equilibrium point is E0.
  • The initial equilibrium interest rate and income level are r0 and y0, respectively.
  • An increase in the quantity of money will shift LM0 rightwards to LM1.
  • The equilibrium point shifts to E1, the interest rate falls to r1 and income rises to y1.
  • A decline in the quantity of money has the opposite effect.

Two extreme cases of the effects of monetary policy in the economy are

1. Liquidity Trap: It is a situation where the demand for money is perfectly elastic at the ongoing interest rate. In this situation, the monetary policy fails to affect the interest rate and income level.

2. Classical Case: According to the classical quantity theory, the demand for money depends only on the income level and is not responsive to changes in interest rate. In this case, monetary policy has a maximum impact on the level of income.

Impact of Fiscal Policy Changes

Impact of Fiscal Policy Changes - 1

Fiscal policy involves the use of government spending and tax policies to influence the total desired expenditure and achieve specific goals set by the government.

1. Effects of Increased Government Spending

An increase in government spending increases aggregate demand and therefore, tends to increase income and output in the economy. Increase in income raises the interest rate in the money market, which reduces the level of investment spending and dampens the effect of fiscal policy on income and output.

The initial equilibrium point corresponds to interest rate r0 and income level y0. An increase in government spending shifts the IS curve rightwards from IS0 to IS1. At constant interest rate r0, income rises by multiplier times the government spending (aΔG times), and economy moves from initial equilibrium point E0 to E2.

At E2, the goods market is in equilibrium because planned spending equals output; however, the money market is not in equilibrium. Finally, the economy is in equilibrium at point E1 at which the goods and money markets are in equilibrium. Here, the interest rate rises to r1 and income rises to y1.

E1 takes into account the expansionary effects of increased government expenditure and dampening effects of higher interest rate on spending. The dampening effect of higher interest rate on spending is called crowding out.

2. Effects of Increased Taxes

Effects of Increased Taxes

An increase in taxes reduces aggregate demand and tends to decrease income and output in the economy. Reduction in income decreases the demand for money which, in turn, lowers the interest rate in the money market.

A decline in the interest rate leads to an increase in investment spending, which can partially offset the effect of increased taxes on income.

The initial equilibrium is at point E0 which corresponds to interest rate r0and income level y0. An increase in taxes shifts the IS curve leftwards from IS0 to IS1. At the given interest rate r0, the economy moves from y0 to y2 by tax multiplier times the increase in taxes.

At point E2, the goods market is in equilibrium; however, the money market is not in equilibrium. Finally, the economy reaches a new equilibrium at point E1 at which income falls from y0 to y1 and the interest rate falls from r0 to r1.

This decline in income from y0toy1 is less than the fall in income from y0 to y2 at the given interest rate r0, because rising investment owing to a fall in the interest rate partially offsets the dampening effect of increased taxes on income and output in the economy.

3. Fiscal Policy and Crowding Out

  1. Crowding out occurs when an expansionary fiscal policy causes interest rates to rise, thereby reducing spending and increasing aggregate demand.
  2. The extent of crowding out depends on the extent of rise in the interest rate brought about by the expansionary fiscal policy.
  3. If the economy is in liquidity trap, the LM curve will be horizontal and therefore, the fiscal expansion will not have any effect on the interest rate.
  4. In this case, the crowding out effect on fiscal policy is nil. Hence, the fiscal policy has a maximum impact on income.
  5. If the LM curve is vertical, fiscal expansion will not have any effect on income and output in the economy. It only increases the interest rate.
  6. In this case, the interest rate completely crowds out the effect of expansionary fiscal policy on aggregate demand.