Basic Theory Of IS-LM model

1. Basic Cncept Of “IS-LM” Model Presented by “AMITIAN” Amarjeet Kumar

2. CONTENT What is “IS-LM” model and some features of “IS-LM” model? Slope of “IS” curve with suitable diagram. Negative relation of Rate of interest and Income level on the “IS” curve. Slope of “LM” curve with suitable diagram. Positive relation of Rate of interest and Income level on the “LM” curve.

3. “IS-LM” MODEL The “IS-LM” model translates the General Theory of Keynes into neoclassical terms(often called the neoclassical synthesis). It was proposed by John Hicks in 1937 in a paper called “Mr Keynes. The level of demand determines the level of output and employment. The “IS-LM” model is based on : The investment-demand function, The consumption function, The quantity of money.

4. The model rests on two fundamental assumption : All prices (includes wages) are fixed. There exist excess production capacity in the economy. The model examines the combined equilibrium of two markets : The goods market, which is at equilibrium when investment equal saving, hence IS. The money market, which is at equilibrium when demand for liquidity equals money supply, hence LM.

5. SLOPE OF “IS” CURVE Slope of “IS” given by impact of change in interest rates on investment and hence output (through multiplier) – likely steep Location of “IS” changed by autonomous components of aggregate demand ( e.g., autonomous investment, I₀ or fiscal policy, G₀) – Multiplier can also change (taxes, confidence/MPC)

6. r ₁ r ₂ r ₃ a b c IS Income Rate of Interest y ₁ y ₃ y ₂ ∆y₁ ∆y₂ Interest Sensitive Interest Insensitive Diagram of IS curve

7. S E₃ E₂ E₁ Savings & Investment Income Y₁ Y₂ Y₃ I S R₁ R₂ R₃ Rate of Interest Y₁ Y₂ Y₃ Income a b c 45˚ Segment ‘A’ Segment ‘B’ (Equilibrium) I ₃ (R ₃ =4%) I ₂ (R ₂ =5%) I ₁ (R ₁ =6%) NOTE: a , b ,& c denote negative relation of RATE OF INTEREST & INCOME LEVEL on the IS curve .

8. SLOPE OF “LM” CURVE Slope of LM reflects interest and income elasticity of money demand ( likely steep) Location of LM : Expansionary Monetary Policy raises real balances and hence lowers interest rates at a giving level of real income (LM curve shifts down and to right).

9. LM Demand & supply Money Rate of Interest a b c r ₃ r ₂ r ₁ y ₁ y ₂ y ₃ Diagram of LM curve

10. NOTE : a, b, & c denote positive relation of Rate of Interest and the level of Income on the “LM” curve. M S y ₁ y ₂ y ₃ a b c L ₃y₃ L ₂y₂ L ₁ y ₁ E ₃ E ₂ E ₁ r ₁ r ₂ r ₃ (Money supply) Demand & Money supply Rate of Interest M S LM Curve y ₁ y ₂ y ₃ a b c L ₃y₃ L ₂y₂ L ₁ y ₁ E ₃ E ₂ E ₁ r ₁ r ₂ r ₃ (Money supply) Demand & Money supply

11. The End