IS-LM Analysis

1. IS-LM ANALYSIS 
AND 
AGGREGATE 
DEMAND
DR. LAXMI NARAYAN 
ASSISTANT PROFESSOR OF  ECONOMICS
GOVT. COLLEGE FOR WOMEN, BHODIA KHERA

2. 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

3. Why IS-LM Analysis?
Both arguments were challenged because of  
indeterminacy 
as: 
BRate of interest affects the level of GDP by its ef fect on Investment. 
BLevel of GDP affects the rate of interest via deman d 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.

4. 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-
HensenSynthesis.

5. 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.

6. 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.
TheIScurverepresentsallcombinationsofincome
(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
curveisanincome/realinterestratepair(
Y,r
)suchthatthe
demandforgoodsisequaltothesupplyofgoods.

7. IS curve is derived from using three 
relationships:
oInvestment Demand Function. oChanges in the Aggregate 
Expenditure as a result of change 
in investment when r changes.
oRelationship between different level of ‘r’ and ‘GD P’ and the 
equality between ‘S’ & ‘I’ that is IScurve.
Derivationof IS Curve

8. 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
.

9. E
F
G
E
F
G
0
0
I
2atr
2
I
2
I
1
I
1atr
1
I
0
I
0 atr
0
S
S
E
F
G
0
r
0
r
1
r
2
Y
0
Y
2
Y
1
Y
0
Y
2
Y
1
Y
0
Y
2
Y
1
Income
Agg. Exp.
S & I  Rate of Interest
AE
0(I
0, r
0)
Y=AE
AE
1(I
1, r
1) AE
2(I
2, r
2)
Income
Income
I = I
a
-br
,
b>0
Y=AE=
C(Y-T)+I(r)+G
Good Market
Equilibrium

10. 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)
IS
1
IS
2
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)

11. 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 ra te

12. E
F
0
E
F
0
r
0
r
1
Y
0 Y
2
Y
0 Y
1
Income
Aggregate. Exp..
Rate of Interest
AE
0(r
0)
Y=AE
AE
1(r
1)
Income
A
1E
0(r
1)
F
1
E
1
E
1
A
0E
0(r
0)
Y
1
0 Y
1
0
Y
1
1
Y
1
1
F
1
Shifting of IS Curve
.Decrease in Govt. Exp.
.Decrease in Investment
.Increase in Taxes
.Increase in Consumer Exp.
.Decrease in Net Exports
IS
0
IS
1

13. 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,
TheLMcurve,isagraphofcombinationsofrealincome,Y,
andtherealinterestrate,r,suchthatthemoneymarketisin
equilibrium(i.e.realmoneysupply=realmoneydemand).

14. DEMAND FOR MONEY
Transaction Demand for Money(M
t)
M
t
= K(y) : 1>K>0
K = Proportion of income kept 
is cash for transaction purpose
Speculative Demand for Money(Ms)
M
0
K
M
1
Y
0
Y
1
M
t
Y
M
1
Liquidity Trap
M
2
r
2
r
1
M
s
r
r
0
M
s
= L(r) : L`<0
O
O

15. Supply of Money
M
Rate of Interest
Supply of Money
M
S
Total Demand for money
M
D
= M
t
+ M
s
or
M
D
= K(y) + L(r)
M
0
M
1
Demandfor Money
Rate of Interest
r
1
M
D
(Y
D
)
Y
D
O
O

16. Supply and Demandfor Money
Rate of Interest
r
0
M
D
(Y
0
)
M
S
M/P
Demand for money 
when income is Y
0
M
D
(Y
1
)
Demand for money 
when income is Y
1
M
D
(Y
2
)
Demand for money 
when income is Y
2
MONEY MARKET EQUILIBRIUM
r
1
r
2
E
E
1E
2
O
( , )
M P L r Y
=

17. 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
.

18. Supply and Demandfor Money
Rate of Interest
r
0
M
D
(Y
0)
M
S
M
M
D
(Y
1)
M
D
(Y
2)
DERIVATION OF LM CURVE
r
1
r
2
E
E
1
E
2
O
Income(Y)
Rate of Interest
r
0r
1r
2
E
1
E
2
O
Y
0E
Y
1
Y
2
LM Curve

19. SLOPE OF LM CURVE
The slope of the LM curve depends on:
BThe sensitivity of money demand (M
D
)to interest rate changes 
BThe sensitivity of money demand (M
D
)to changes in GDP
0
Rate of Interest
Real GDP(Y)
LM
1
LM
2
When ‘M
D
’ is more 
sensitive to ‘Y’ and less 
sensitive to ‘r’
When ‘M
D
’ is less 
sensitive to ‘Y’ and 
more sensitive to ‘r

20. Supply and Demandfor Money
Rate of Interest
M
D
(Y
0)
M
S
M
0
SHIFTING OF LM CURVE
r
0E
0
O
Income(Y)
Rate of Interest
r
0
E
0
O
Y
0
LM
0
M
S
M
1
E
1
r
1
r
1
E
1
LM
1

21. The intersection of the ISand LM curves represents 
simultaneous 
equilibrium in the market for goods and services an d in the 
market for real money balances 
for given values of government 
spending, taxes, the money supply, and the price le vel.
Simultaneous Equilibrium in Product and Money Marke t
IS:
Y
r
LM:
r
0
Y
0
E
Goods Market Equilibrium.
Money Market Equilibrium .
( , )
M P L r Y
=
( ) ( )
Y C Y T I r G
= − + +

22. Excess Demand
for goods
r
Y
D
A
C
Y
CY
A
r
A
r
B
B
hAt  A -Product Market  is in 
equilibrium. 
At B we will have Excess Supply of goods
in the goods market. 
↑↑↑↑r
→→→→
↓↓↓↓I 
→→→→
↓↓↓↓AD
→→→→
↓↓↓↓Y
A
>
AD
B
(Excess Supply of goods).
Disequilibrium in Product Market
hAt point B, 
Y=Y
A
,
but  
r
B 
>r
A
hSuppose r increases from 
r
A
to r
B
.
So at a 
Higher Interest Rate 
(such as r
B
), the only way to 
return back to equilibrium is to have 
lower
Y (such as Y
C
).
IS

23. Income(Y)
r
C
C
O
Y
B
LM
0(P
0M
0)
r
AB
A
Y
A
D
 Initially at A: M
D
= M
S
).
For the Money Market to return back to equilibrium we 
need to 
have an increasein r
so as to 
decreaseM
d
back to the given M
S
level. And at this higher Y level (Y
B) r has to  ↑to C (r
C) to ↓Md to 
its old level so that M
d=M
Sagain.
r
Disequilibrium in Money Market
 Suppose
Y Increases
from
Y
Ato Y
Band we move to B. At
B,
r = r
A
but Y increasesto Y
B.
 Increase in Y
aincrease in
M
d
aM
d> M
S(Excess
Demand for money).

24. Disequilibrium in IS-LM
If disequilibrium is at the
right of LM curve
indicating
Excess Demand for Money in money market, only way t o
restore equilibrium is
to increase rate of interest(r)
.
Same way for points on the left of the LM, decreas e ‘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.

25. Disequilibrium in IS-LM
IS
Y
r
LM
r
0
Y
0
E
≠Any point other than point E
is point of disequilibrium.
A
B
M
N
K
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

26. How Equilibrium is re-established in IS-LM
IS
Y
r
LM
r
0
Y
0
E
A
When Disequilibrium is in only One Market
At point ‘A’ economy is in equilibrium 
in product market and disequilibrium 
in money market. 
r
2
r
1
Y
2
Y
1At A, excess supply of money reduces r
0to r
1 
Lower interest rates at r
1 
, increases 
investment which increases income to Y
1
Higher Income increase demand for money and interes t 
rates till economy reaches at point E

27. How Equilibrium is re-established in IS-LM
IS
Y
r
LM
r
0
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. 
r
1
Y
2
Y
0
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 Y
o
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

28. Shift in the IS and LM curve and Change
in Equilibrium
IS
0
Y
r
LM
r
0
Y
0
E
IS
Y
r
LM
Y
0
IS
1
IS
2
E
1
Y
1
E
2
r
1 r
2
Y
2
r
0
E
E
1
Y
1
E
2
r
1r
2
Y
2
LM
2

29. Derivation of AD Curve
IS
Y
r
Y
0
r
0
E
E
1 Y
1
E
2
r
1r
2
Y
2
Y
r
Y
0
P
0
Y
1
P
1
P
2
Y
2
LM
at P
0
LM
2 at P
2
A
B
At new equilibrium income Y
1
and price 
P
1
, we have the point B.
Now if price increase to P
2
LM curve 
shifts left and new equilibrium 
corresponding to E2 will be C
C
AD curve

30. IS
Y
r
Y
0
r
0
E
E
1 Y
1
E
2
r
1r
2
Y
2
Y
r
Y
0
P
Y
1
Y
2
LM
LM
2
A C
B
P
AD
AD
1
AD
2
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⇒⇒⇒⇒
LMshifts right
⇒
↓↓↓↓
r
⇒
↑↑↑↑
I
⇒
↑↑↑↑
Yat each
value of P

31. IS
Y
r
Y
0
r
0
E
E
1 Y
1
E
2
r
1r
2
Y
2
Y
r
Y
0
P
Y
1
Y
2
LM
LM
2
A C
B
P
AD
AD
1
AD
2
Monetary Policy 
and AD Curve
Expansionary Monetary Policy:          
gShift LM curve right to LM
1. 
gIncrease income to Y
1
gShift AD curve to AD
1
Contractionary Monetary Policy:
gShift LM curve Left to LM
2. 
gDecreases income to Y
2
gShift AD curve to AD
2.

32. Y
r
Y
0
P
Y
1
Y
2
A C
B
P
AD
AD
1
AD
2
Fiscal Policy and 
AD Curve
Expansionary Fiscal Policy:          
gShift IS curve right to IS
1. 
gIncrease income to Y
1
gShift AD curve to AD
1
Contractionary Fiscal Policy:
gShift IS curve Left to IS
2. 
gDecreases income to Y
2
gShift AD curve to AD
2.
IS
0
Y
r
LM
r
0
Y
0
E
IS
1
IS
2
E
1
Y
1
E
2
r
1 r
2
Y
2

33. .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

34. Jain, T.Rand 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,” KalyaniPublishers.
Shapiro, E, “Macro Economic Analysis” Galgotia
Publications.
REFERENCES

35. BExplain the determination of 
GDP and rate of interest with 
the help of IS-LM curve 
Analysis.
BTrace the derivation of IS and 
LM curves.
BDerive the aggregate demand curve through IS-LM cur ve 
Model.
BExplain the effect of Monetary and Fiscal policy th rough IS-LM 
Model.
FAQs