is-lm analysis
TRANSCRIPT
IS-LM ANALYSIS
AND
AGGREGATE
DEMAND
DR. LAXMI NARAYAN
ASSISTANT PROFESSOR OF ECONOMICS
GOVT. COLLEGE FOR WOMEN, BHODIA KHERA
Lecture Outline
� Why IS-LM Analysis?
� What IS-LM Analysis?
� Equilibrium in Goods
Market – IS curve.
� Equilibrium in Money
Market – LM curve.
� Simultaneous Equilibrium
� Deriving Aggregate Demand
Why IS-LM Analysis?
Both arguments were challenged because of indeterminacy as:
� Rate of interest affects the level of GDP by its effect on Investment.
� Level of GDP affects the rate of interest via demand for money.
A rise in level of GDP as a result of investment is cut short
when rate of interest rise as a result of increase in GDP
Classical Economist: Rate of
interest is a real phenomenon
determined by saving and
investment
Keynes: rate of interest is
purely a monetary
phenomenon.
Why IS-LM Analysis?
Simultaneous determination of rate of interest and the
real GDP and alternate derivation of AD curve is at the
core of IS-LM analysis.
Hicks and Hensen integrated
both the real parameters of
savings and investment and
monetary parameters of
supply and demand for money
through IS-LM analysis. This
is popularly Known as Hicks-
Hensen Synthesis.
What is IS-LM Analysis?
The term IS refers to the
equality between Investment(I)
& saving(S) the corresponding
equilibrium in the Goods
Market.
The term LM refers to the equality between demand for
money (L)& Supply of money (M) and the corresponding
equilibrium in Money Market.
IS Curve and Product Market Equilibrium?
IS curve is the locus of different
combinations of Interest Rate(r)
and Level of GDP (Y) that are
consistent with equality between
saving and Investment or
Aggregate Output and Aggregate
Expenditure.
The IS curve represents all combinations of income (Y) and
the real interest rate (r) such that the market for goods and
services is in equilibrium. That is, every point on the IS
curve is an income/real interest rate pair (Y, r) such that the
demand for goods is equal to the supply of goods.
IS curve is derived from using three
relationships:
� Investment Demand Function.
� Changes in the Aggregate
Expenditure as a result of change
in investment when r changes.
� Relationship between different level of ‘r’ and ‘GDP’ and the
equality between ‘S’ & ‘I’ that is IS curve.
Derivation of IS Curve
Derivation of IS Curve
The derivation is based on the
following propositions.
� An increase in rate of
Interest leads to a decrease
in the level of Investment.
� An decrease in the level of investment leads to a
decrease in the level of income.
� Therefore, an increase in the rate of interest leads to a
decrease in the rate of interest.
E
F
G
EF
G
0
0I2atr2 I2
I1 I1atr1
I0 I0 atr0
S
S
E
FG
0r0
r1
r2
Y0Y2 Y1
Y0Y2 Y1
Y0Y2 Y1Income
Agg. Exp.
S & I
Rate of Interest
AE0 (I0, r0)Y=AE
AE1 (I1, r1)AE2 (I2, r2)
Income
Income
I = Ia-br, b>0
Y=AE=C(Y-T)+I(r)+G
Good Market Equilibrium
SLOPE OF IS CURVE
The slope of the IS curve depends on:
� The sensitivity of investment (AE) to interest rate changes
�The value of multiplier
0
Rate of Interest
Real GDP(Y)
IS1
IS2
When ‘I’ is more
sensitive to ‘r’ and when
multiplier value is
high(high MPC)
When ‘I’ is less sensitive
to ‘r’ and when multiplier
impact is low(low MPC)
Factors that Shift the IS Curve
A change in autonomous factors
that is unrelated to the interest rate
� Changes in autonomous
consumer expenditure
� Changes in planned investment spending unrelated to
the interest rate
� Changes in government spending
� Changes in taxes
� Changes in net exports unrelated to the interest rate
E
F
0
E
F
0
r0
r1
Y0Y2
Y0Y1
Income
Aggregate. Exp..
Rate of Interest
AE0 (r0)
Y=AE
AE1 (r1)
Income
A1E0 (r1)
F1
E1
E1
A0E0 (r0)
Y1
0
Y1
0
Y1
1
Y1
1
F1
Shifting of IS Curve
�Decrease in Govt. Exp.
�Decrease in Investment
�Increase in Taxes
�Increase in Consumer Exp.
�Decrease in Net Exports
IS0
IS1
LM Curve and Money Market Equilibrium?
The LM curve shows all the
combinations of interest rates i
and outputs Y for which the
money market is in equilibrium.
"L" denotes Liquidity and "M"
denotes money,
The LM curve, is a graph of combinations of real income, Y,
and the real interest rate, r, such that the money market is in
equilibrium (i.e. real money supply = real money demand).
DEMAND FOR MONEY
Transaction Demand for Money(Mt)
Mt = K(y) : 1>K>0K = Proportion of income kept is cash for transaction purpose
Speculative Demand for Money(Ms)M0
K
M1
Y0
Y1
Mt
Y
M1
Liquidity Trap
M2
r2
r1
Ms
r
r0
Ms = L(r) : L`<0
O
O
Supply of Money
M
Rate of Interest
Supply of Money
MS
Total Demand for money
MD = Mt + Ms
orMD = K(y) + L(r)
M0 M1
Demand for Money
Rate of Interest
r1MD (YD)
YD
O
O
Supply and Demand for Money
Rate of Interest
r0
MD (Y0)
MS
M/PDemand for money
when income is Y0
MD (Y1)
Demand for money
when income is Y1MD (Y2)
Demand for money
when income is Y2
MONEY MARKET EQUILIBRIUM
r1
r2
E
E1
E2
O
( , )M P L r Y=
Derivation of LM Curve
The derivation is based on the
following propositions.
� An increase in the level of
income leads to an increase
in the demand for money.
� An increase in the demand for money leads to an
increase in the rate of interest.
� Therefore, an increase in the level of income leads to
an increase in the rate of interest.
Supply and Demand for Money
Rate of Interest
r0
MD (Y0)
MS
M
MD (Y1)
MD (Y2)
DERIVATION OF LM CURVE
r1
r2
E
E1
E2
O
Income(Y)
Rate of Interest
r0
r1
r2
E1
E2
O Y0
E
Y1 Y2
LM Curve
SLOPE OF LM CURVE
The slope of the LM curve depends on:
� The sensitivity of money demand (MD)to interest rate changes
� The sensitivity of money demand (MD)to changes in GDP
0
Rate of Interest
Real GDP(Y)
LM1
LM2
When ‘MD’ is more
sensitive to ‘Y’ and less
sensitive to ‘r’
When ‘MD’ is less
sensitive to ‘Y’ and
more sensitive to ‘r
Supply and Demand for Money
Rate of Interest
MD (Y0)
MS
M0
SHIFTING OF LM CURVE
r0 E0
O
Income(Y)
Rate of Interest
r0 E0
O Y0
LM0
MS
M1
E1
r1 r1E1
LM1
The intersection of the IS and LM curves represents simultaneous
equilibrium in the market for goods and services and in the
market for real money balances for given values of government
spending, taxes, the money supply, and the price level.
Simultaneous Equilibrium in Product and Money Market
IS:
Y
rLM:
r0
Y0
E
Goods Market Equilibrium.
Money Market Equilibrium.
( , )M P L r Y=
( ) ( )Y C Y T I r G= − + +
Excess Demandfor goods
r
Y
D A
C
YC YA
rA
rB
B � At A - Product Market is in
equilibrium.
At B we will have Excess Supply of goods in the goods market. ↑↑↑↑r →→→→ ↓↓↓↓I →→→→ ↓↓↓↓ AD→→→→ ↓↓↓↓ YA>ADB (Excess Supply of goods).
Disequilibrium in Product Market
� At point B, Y=YA, but rB > rA
� Suppose r increases from
rA to rB.
So at a Higher Interest Rate (such as rB), the only way to
return back to equilibrium is to have lower Y (such as YC).
IS
Income(Y)
rCC
O YB
LM0(P0M0)
rA BA
YA
D
� Initially at A: MD = MS).
For the Money Market to return back to equilibrium we need to have an increase in r so as to decrease Md back to the given MS
level. And at this higher Y level (YB) r has to ↑ to C (rC) to ↓ Md to
its old level so that Md=MS again.
rDisequilibrium in Money Market
� Suppose Y Increases from
YA to YB and we move to B. At
B, r = rA but Y increases to YB.
� Increase in Y� increase in
Md � Md> MS (Excess
Demand for money).
Disequilibrium in IS-LM
� If disequilibrium is at the right of LM curve indicating
Excess Demand for Money in money market, only way to
restore equilibrium is to increase rate of interest(r).
Same way for points on the left of the LM, decrease ‘r’
We can conclude:
� If disequilibrium is at the
right of IS curve indicating
Excess Supply in Goods
market, only way to restore
equilibrium is to decrease Y.
same way for point on the
left, increase Y.
Disequilibrium in IS-LM
IS
Y
rLM
r0
Y0
E
� Any point other than point E
is point of disequilibrium.
A
BM
NK
V
L
T
� Point A&B: I=S but L≠ M
� Point K: L<M & S<I
� Point M&N: L=M but I≠ S
� Point K: L>M & S<I
� Point V: L>M & S>I
� Point L: L<M & S<I
How Equilibrium is re-established in IS-LM
IS
Y
rLM
r0
Y0
E
A
When Disequilibrium is in only One Market
At point ‘A’ economy is in equilibrium
in product market and disequilibrium
in money market.
r2
r1
Y2 Y1
At A, excess supply of money reduces r0 to r1
Lower interest rates at r1 , increases
investment which increases income to Y1
Higher Income increase demand for money and interest
rates till economy reaches at point E
How Equilibrium is re-established in IS-LM
IS
Y
rLM
r0
E
D
When Disequilibrium is in only One Market
At point ‘D’ economy is in equilibrium in money
market (L=M) and disequilibrium in Product Market.
r1
Y2 Y0
As D lies right of IS curve, means supply
in good markets, that is S>I or AE<AS
Low demand in good market
reduces income from Yo
This reduces money demand. Lower
demand for money reduces interest rates.
This process continues till equilibrium is resorted at point ‘E’
where both markets are in equilibrium
Shift in the IS and LM curve and Change in Equilibrium
IS0
Y
rLM
r0
Y0
E
IS
Y
rLM
Y0
IS1
IS2E1
Y1
E2
r1
r2
Y2r0 E
E1
Y1
E2
r1
r2
Y2
LM2
Derivation of AD CurveIS
Y
r
Y0
r0 E
E1
Y1
E2
r1
r2
Y2
Y
r
Y0
P0
Y1
P1
P2
Y2
LM at P0
LM 2 at P2
A
B
At new equilibrium income Y1 and price
P1, we have the point B.
Now if price increase to P2 LM curve
shifts left and new equilibrium
corresponding to E2 will be C
C
AD curve
IS
Y
r
Y0
r0 E
E1
Y1
E2
r1
r2
Y2
Y
r
Y0
P
Y1Y2
LM
LM2
AC
BP
ADAD1
AD2
Derivation of AD Curve if LM
curve shift due to factors
other than price level
that is, price level remain
constant For example AD can be
increased by increasing
money supply:
↑↑↑↑M ⇒⇒⇒⇒ LM shifts right
⇒ ↓↓↓↓r
⇒ ↑↑↑↑I
⇒ ↑↑↑↑Y at each
value of P
IS
Y
r
Y0
r0 E
E1
Y1
E2
r1
r2
Y2
Y
r
Y0
P
Y1Y2
LM
LM2
AC
BP
ADAD1
AD2
Monetary Policy
and AD Curve
Expansionary Monetary Policy:
� Shift LM curve right to LM1.
� Increase income to Y1� Shift AD curve to AD1
Contractionary Monetary Policy:
� Shift LM curve Left to LM2.
� Decreases income to Y2� Shift AD curve to AD2.
Y
r
Y0
P
Y1Y2
AC
BP
ADAD1
AD2
Fiscal Policy and
AD Curve
Expansionary Fiscal Policy:
� Shift IS curve right to IS1.
� Increase income to Y1� Shift AD curve to AD1
Contractionary Fiscal Policy:
� Shift IS curve Left to IS2.
� Decreases income to Y2� Shift AD curve to AD2.
IS0
Y
rLM
r0
Y0
E
IS1
IS2E1
Y1
E2
r1
r2
Y2
� Only a Comparative Static
Model.
� Ignores impact of
International Trade.
� Considers price level as
exogenous variable.
� Ignores time lags.
� Does not include labour market equilibrium in the
analysis.
� Ignores impact of future expectations .
Weaknesses of IS-LM Model
Jain, T.R and Majhi, B.D.,
“Macroeconomics” V.K.
Publications.
Rana, K.C. and Verma,
K.N., “Macro Economic
Analysis” Vishaal
Publications.
Rana, A.S., “Advance Macro Economics-Theory and
Policy,” Kalyani Publishers.
Shapiro, E, “Macro Economic Analysis” Galgotia
Publications.
REFERENCES
�Explain the determination of
GDP and rate of interest with
the help of IS-LM curve
Analysis.
� Trace the derivation of IS and
LM curves.
� Derive the aggregate demand curve through IS-LM curve
Model.
� Explain the effect of Monetary and Fiscal policy through IS-LM
Model.
FAQs