IS LM analysis

describes meaning of IS and LM curve and derivation of IS and LM curve through diagrammatic explanation.

1. IS-LM ANALYSIS: Part-1 Sonam Sangwan Assistant Professor,Economics GCW Bawani Khera Why IS-LM Analysis What is IS -LM Analysis IS Curve and its Derivation LM Curve and its Derivation Simultaneous equilibrium in Goods Market and Money Market.

2. Classical economists argued that rate of interest is real phenomenon determined by saving and investment and Keynes opined that rate of interest is purely a monetary phenomenon. IS-LM ANALYSIS: Part-1 Both arguments were challenged because of indeterminancy as: R ate of interest affects the level of GDP by its effect on investment. S →Y → I→r Level of GDP affects the rate of interest via demand for money.

3. WHY 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.The model was developed by John Hicks in 1937, and later extended by Alvin hansen , as a mathematical representation of Keynesian macroeconomic theory. Simultaneous determination of rate of interest and the real GDP and alternate derivation of AD curve is at the core of IS-LM analysis.

4. 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: The Goods market equilibrium schedule LM Curve: The money market equilibrium schedule

5. What is IS Curve? 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. 

6. Thus, 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 Is curve shows the causation from interest rates to planned investment to national income and output.

7. Derivation of IS Curve Investment Demand Function Level of Investment Rate of interest o Investment Function F I₁ I E I ₒ r ₒ r ₁ Shows the negative relationship between rate of interest and level of Investment

8. Derivation of IS Curve The resultant changes in Real GDP due to changes in investment corresponding to interest rate changes. We know that AE=C+I+G+X-M r₀ F AE₀ Agg . Exp. 45 Y O Y₀ r I E F I₀ I (At r₀, I₀) AE₁ (At r₁, I₁) E Y₁

9. Level of Investment Rate of interest o Investment Function F I₁ I E I ₒ r ₒ r ₁ r ₒ r ₁ Yₒ Y₁ Yₒ Y₁ Yₒ Y₁ o o o E E E F F F Agg . Exp. S&I Rate of Interest Goods Market Equilibrium AE₀ AE₁ Iₒ I₁ Saving-Investment equality IS-Curve

10. What is LM Curve? 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).

11. Demand for Money Transaction & Precautionary Demand for Money ( M t&p ) Speculative Demand for Money (M s ) Rate of Interest O Y O Y₀ M₀ M₀ Y₁ M₁ r₀ r₁ M t&p M TP Rate of Interest O r₀ r₁ r₂ r₂ M S M₁ M₀

12. Supply of Money Total demand for Money Y ₀ Supply of Money Rate of Interest O M D = M tp +M s or M D =K(y)+L(r) M ₀ M D (Y ) Demand for Money Rate of Interest M M ₁ r 1

13. Money Market Equilibrium Rate of Interest Demand for Money when income is Y ₂ Supply and Demand for Money Demand for Money when income is Y ₁ Demand for Money when income is Y ₀ M D (Y ₂) E ₂ E ₁ M/P r ₁ r ₂ r ₀ M S E ₀ M D (Y ₀) M D (Y ₁)

14. Derivation of LM Curve  Rate of Interest Supply and Demand for Money M D (Y ₂) E ₂ E ₁ M/P r ₁ r ₂ r ₀ M S E ₀ M D (Y ₀) M D (Y ₁) Income(Y) Rate of Interest r ₀ r ₁ r ₂ LM Curve E ₀ E ₁ E ₂