IS-LM model

Study Materials

1. IS - LM Model in Economics
Introduction
The IS-LM (Investment Saving – Liquidity Preference Money Supply) curve model emphasizes the
interaction between the goods and money markets represented by two intersecting curves IS & LM curves.
This model was basically used to determine simultaneously both the rate of interest and the level of income.
It is basically a two sector model containing both the goods market (Real Sector) and money market
(Financial Market) & considers a closed economy with or without Govt intervention.
Goods Market Equilibrium: The Derivation of the IS Curve
The goods market is in equilibrium when aggregate demand is equal to income where the aggregate
demand is determined by consumption demand, investment demand (and demand for Govt expenditure if
Govt intervention is considered) in closed economy. The model explains the decisions made by investors
when it comes to the case of investments with the amount of money available and the interest they will
receive. Equilibrium is achieved when the amount invested equals the amount available to invest. The
negative relationship between interest rate and output is known as the IS curve. The term IS the shorthand
expression of the equality of investment and saving which represents the product market equilibrium. On the
other hand, the term LM is the shorthand expression of the equality of money demand (L) and money supply
(M) and represents the money market equilibrium.
IS (Investment Saving) Curve
Meaning - IS curve is the set (locus) of all Y and r combinations that satisfy the output market equilibrium
condition, given that firms are willing to supply any amount that’s demanded that is total demand with given
income Y and the cost of borrowing r must equal total supply: Y
d
(Y, r) = Y. The goods market is in
equilibrium when desired saving and investment are equal or the aggregate demand for goods just equals the
aggregate supply.
Derivation- Because of the inverse relationship between the rate of interest & level of investment, changes
in the rate of interest affect aggregate demand or aggregate expenditure by causing changes in the investment
demand. W Thus IS curve relates different equilibrium levels of national income with various rates of
interest.
For simple derivation of the IS curve we consider a closed economy without any Govt. intervention &
hence the Aggregate Demand (AD) function Y = C + I, where output (Y) is equal to consumption (C) and
Income (I). For the IS curve, the independent variable is the interest rate and the dependent variable is the
level of income. The IS curve is drawn as downward-sloping with the interest rate (i) on the vertical axis and
income (Y) on the horizontal axis. Lower interest rates encourage higher investment. Income is at the
equilibrium level for a given interest rate when the saving that consumers and other economic participants
made out of this income equals investment.

2. In panel (a) of Figure above, the inverse relationship between rate of interest (r) and planned investment (I) is
depicted by the investment demand curve II. It will be seen from panel (a) that at rate of interest Or0 the
planned investment is equal to OI0 & its corresponding aggregate demand curve is C + I0 which, as seen in
panel (b) of the Figure. This AD curve C + I0 equals aggregate output at OY1 level of national income.
Therefore, in the panel (c) at the bottom of the Fig, against rate of interest Or2, level of income equal to OY0
has been plotted. Now, if the rate of interest falls to Or2 the planned investment by businessmen increases
from OI0 to OI1 [panel (a)]. With this increase in planned investment, the aggregate demand curve shifts
upward to the new position C + I1 in panel (b), and the goods market is in equilibrium at OY1 level of
national income. Thus, in panel (c) at the bottom of Fig. the level of national income OY1 is plotted against
the rate of interest, Or1. With further lowering of the rate of interest to Or2 the planned investment increases
to OI2 (panel a). With this further rise in planned investment the aggregate demand curve in panel (b) shifts
upward to the new position C + I2 corresponding to which goods market is in equilibrium at OY2 level of
income. Therefore, in panel (c) the equilibrium income OY2 is shown against the interest rate Or2. By joining
points A, B, D representing various interest-income combinations at which goods market is in equilibrium
we obtain the IS Curve.
Why does IS Curve Slope Downward?
The downward-sloping IS curve represents the negative relation between the interest rate and the equilibrium
output. The decline in the rate of interest brings about an increase in the planned investment expenditure
which in turn causes the aggregate demand curve to shift upward and therefore leads to the increase in the
equilibrium level of national income. Thus, a lower rate of interest is associated with a higher level of
national income and vice-versa. The IS curve, by inversely relating the level of income with the rate of
interest makes it to slope downward.
Steepness of the IS curve depends on
(1) The Elasticity of the Investment Demand Curve: when investment demand is more elastic to the changes
in the rate of interest (i.e. a given fall in the rate of interest will cause a large increase in investment), the IS
curve will be relatively flat (or less steep) due to flat investment demand curve. Similarly, when investment
demand is not very sensitive or elastic to the changes in the rate of interest, the IS curve will be relatively
more steep.
(2) The Size Of The Multiplier: In case of a higher marginal propensity to consume (mpc) and therefore a
higher value of multiplier, the greater will be the rise in equilibrium income produced by a given fall in the
rate of interest and this makes the IS curve flatter. On the other hand, the smaller the value of multiplier due
to lower marginal propensity to consume, the smaller will be the increase in equilibrium level of income.
Thus, in case of smaller size of multiplier the IS curve will be more steep.
Shift in IS Curve
It is the level of autonomous expenditure which determines the position of the IS curve and changes in the
autonomous expenditure cause a shift in it. Autonomous expenditure includes investment expenditure, the
Government spending which does not depend on the level of income and the rate of interest.
A rise in autonomous consumption expenditure shifts aggregate demand upward and shifts the IS
curve to the right. A decline in autonomous consumption expenditure reverses the direction and for a given
interest rate, the aggregate demand function shifts downward, the equilibrium level of aggregate output falls,
and the IS curve shifts to the left.
A rise in planned investment spending shifts the aggregate demand function upward. Additionally,
changes in government spending and taxes are the other two factors that can lead to shifts in the IS curve.
Besides, Government expenditure is also of autonomous type as it does not depend on income and rate of
interest in the economy. Increase in Government expenditure will cause a rightward shift in the IS curve.
The IS curve shifts to the right with a reduction in saving due to one or more factors leading to
increase in consumption like buying a new product even by reducing saving or buying more in anticipation
of shortages or price rise thereby reducing saving.

3. Summary: Any change (decrease in government consumption, increase in taxes, decrease in consumer
confidence) that, for a given interest rate, decreases the demand for goods creates a shift of the IS curve to
the left. Symmetrically, any change (increase in government consumption, decrease in taxes, increase in
consumer confidence) that, for a given interest rate, increases the demand for goods creates a shift of the IS
curve to the right.
The Algebraic Derivation of IS Curve
The IS curve is derived from goods market equilibrium. The IS curve shows the combinations of levels of
income and interest at which goods market is in equilibrium, that is, at which AD = AS or Income.

Here, [1/1-b] is the income multiplier and b is marginal propensity to consume. Given the value of
autonomous expenditure, we can obtain value of Y at different rates of interest to draw an IS curve. It is
worth noting that the value of autonomous (A) determines the intercept of the IS curve, d in the term di in
equation (3) shows the sensitivity of investment to the changes in rate of interest and determines the slope of
IS curve. The slope of the IS curve depends on the size of income multiplier.
The Money Market Equilibrium: LM Curve
According to Keynes, demand for money to hold depends upon transactions motive and speculative motive.
The demand for money depends on the level of income because they have to finance their expenditure, that
is, their transactions of buying goods and services. The demand for money also depends on the rate of
interest which is the cost of holding money. Thus demand for money (M
d
) can be expressed as: Md = L(Y, r)
Now, the intersection of these various money demand curves corresponding to different income levels with
the supply curve of money fixed by the monetary authority would gives us the LM curve.
The LM curve speaks of all combinations of Y and r that equilibrate the money market, given the
economy’s nominal money supply M and price level P. That is, the LM curve is the set of all Y and r
combinations that satisfy the money market equilibrium condition, real money demand must equal the given
real money supply: M
d
(Y, r) =M/P
Mathematically, the LM curve is defined by the equation M/P = L(i,Y), where the supply of money is
represented as the real amount M/P, with P representing the price level, and L being the real demand for
money, which is some function of the interest rate i and the level Y of real income. The initials LM stand for
"Liquidity preference and Money supply equilibrium". As such, the LM function is the set of equilibrium
points between the liquidity preference or Demand for Money function and the money supply function (as
determined by banks and central banks). Each point on the LM curve reflects a particular equilibrium

4. situation in the money market equilibrium diagram, based on a particular level of income where liquidity
preference i.e. demand for money equals to supply of money. It is a positively sloped curve.
LM Curve - Essential Features
1. The LM curve is a schedule that describes the combinations of rate of interest and level of income at
which money market is in equilibrium.
2. The LM curve slopes upward to the right.
3. The LM curve is flatter if the interest elasticity of demand for money is high. On the contrary, the LM
curve is steep if the interest elasticity demand for money is low.
4. The LM curve shifts to the right when the stock of money supply is increased and it shifts to the left if the
stock of money supply is reduced.
5. The LM curve shifts to the left if there is an increase in the money demand function which raises the
quantity of money demanded at the given interest rate and income level. On the other hand, the LM curve
shifts to the right if there is a decrease in the money demand function which lowers the amount of money
demanded at given levels of interest rate and income.
LM Curve Derivation: The LM curve tells what the various rates of interest will be (given the quantity of
money and the family of demand curves for money) at different levels of income. But the money demand
curve or what Keynes calls the liquidity preference curve alone cannot tell us what exactly the rate of interest
will be. In Figure below part (a) and (b) we have derived the LM curve from a family of demand curves for
money.

As income increases, from Y0 to Y1, Y2 money demand curve shifts outward M
d0
to M
d2
and therefore the
rate of interest which equates supply of money, with demand for money rises from r0 to r2 through r1. In
Figure (b) we measure income on the X-axis and plot the income level corresponding to the various interest
rates determined at those income levels through money market equilibrium by the equality of demand for and
the supply of money in Figure (a).
Slope of LM Curve: It will be noticed from Figure (b) that the LM curve slopes upward to the right as
with higher levels of income, demand curve for money (M
d
) is higher and consequently the money- market
equilibrium, that is, the equality of the given money supply with money demand curve occurs at a higher rate
of interest. This implies that rate of interest varies directly with income.
The factors deciding Slope of the LM curve
(a) Responsiveness Of Demand For Money (i.e., liquidity preference) to the changes in income: As the
income increases, say from Y0 to Y1 the demand curve for money shifts from Md0 to Md1 that is, with an
increase in income, demand for money would increase for being held for transactions motive, M
d
or L1 =f(Y).
It is worth noting that in the new equilibrium position, with the given stock of money supply, money held
under the transactions motive will increase whereas the money held for speculative motive will decline. The
greater the extent to which demand for money for transactions motive increases with the increase in income,

5. the greater the decline in the supply of money available for speculative motive and, given the demand for
money for speculative motive, the higher the rise in rate of interest and consequently the steeper the LM
curve, r = f (M2 L2) where r is the rate of interest, M2 is the stock of money available for speculative motive
and L2 is the money demand or liquidity preference for speculative motive.
(b) Elasticity or Responsiveness of Demand for Money (i.e., liquidity preference for speculative motive)
to the changes in rate of interest: The lower the elasticity of liquidity preference for speculative motive with
respect to the changes in the rate of interest, the steeper will be the LM curve. On the other hand, if the
elasticity of liquidity preference (money demand-function) to the changes in the rate of interest is high, the
LM curve will be flatter or less steep.
Shifts in the LM Curve
The LM function shifts (i) with the increase in the money supply given the demand for money, or (ii) due to
the decrease in the demand for money, given the supply of money.
LM curve is drawn by keeping the stock or money supply fixed. When the money supply increases,
given the money demand function, it will lower the rate of interest at the given level of income. This is
because with income fixed, the rate of interest must fall so that demands for money for speculative and
transactions motive rises to become equal to the increased money supply. This will cause the LM curve to
shift outward to the right.
The other factor which causes a shift in the LM curve is the change in liquidity preference (money
demand function) for a given level of income. If the liquidity preference function for a given level of income
shifts upward, this, given the stock of money, will lead to the rise in the rate of interest for a given level of
income. This will bring about a shift in the LM curve to the left. It therefore follows from above that increase
in the money demand function causes the LM curve to shift to the left. Similarly, on the contrary, if the
money demand function for a given level of income declines, it will lower the rate of interest for a given
level of income and will therefore shift the LM curve to the right.
Algebraic Derivation of LM Curve
LM curve shows combinations of interest rates and levels of income at which money market is in
equilibrium, that is, Md = Ms. In demand for money, people care more about the purchasing power of
money, that is for real money balances rather than nominal money balances. Real money balances are given
by M/P where M stands for nominal money demand and p for price level. The demand for real money
balances depends on the level of real income and interest rate. Thus Md = L(Y, i).
Let us assume that money demand function is linear. Then
L(Y, i) = kY – hi k, h > 0 …..(1)
Parameter k represents how much demand for real money balances increases when level of income rises & h
represents how much demand for real money balances decreases when rate of interest rises.
The equilibrium in the money market is established where demand for real money balances equals supply of
real money balances and is given by
M/P = kY – hi….. (2)
Money supply (M) is set by the central bank of a country and we assume it to remain constant for a period.
Besides, we assume the price level (P) to remain constant.
Solving the equation (2) for interest rate we have
i = 1/h (kY – M/P)…. (3)
The above equation (3) describes the equation for LM curve.
Observations for LM curve equation (3) -
First, since in equation above for LM curve, the coefficient (k) of income (Y) is positive, LM curve
will slope upward. That is, higher income requires higher interest rate for money market to be in equilibrium,
given the supply of real money balances.
Second, since the coefficient of real money balances is negative, the expansion in real money
balances will cause a shift in the LM curve to the right, and decrease in the real money balances will shift
LM curve to the left.

6. Third, from the coefficient of income k/h, we can know whether LM curve is steep or flat. If demand
for money is not much sensitive to level of income, then k will be small. Therefore, in case of small k (i.e.
low sensitivity of interest with respect to changes in income), small change in interest rate is required to
offset a small increase in money demand caused by a given increase in income.
Problem: Given the following data about the monetary sector of the economy:
Md = 0.4 Y – 80i
Ms = 1200 crores.
Where Md is demand for money, Y is level of income, Ms is rate of interest and M is the supply of money
1. Derive the equation for LM function
2. Give the economic interpretation of the LM curve.
3. Find the interest rate when income is Rs 4000 crores & if increased by Rs 400 crores.
Solution: For money market to be in equilibrium:
Md = Ms
0.4 Y – 80 i = 1200
80 i = 0.4 Y – 1200
i = (0.4Y/80) – (1200/80)
i = (1/200) Y – 15 ….. (i)
Thus we get the following LM function:
i = (1/200) Y – 15
Alternatively, LM equation or function can also be stated as:
Y = 200i + 3000 … (ii)
If level of national income is Rs. 4000 crores, then using LM equation (i) we have
i = (1/200) x (4000 – 15) = 20 – 15 = 5%
Thus, at income of Rs. 4000 crores, rate of interest will be 5 per cent when money market is in equilibrium.
Now, if level of income is Rs. 4400 crores, equilibrium rate of interest will be
i = (1/200) Y – 15 = (1/200) x (4400 – 15) = 22 – 15 = 7%
Problem: The following data is given for the monetary sector of the economy:
Transaction demand for money, Mt = 0.5Y.
Speculative demand for money, Msp = 105 – 1500 i
Money supply Ms = 150;
Derive LM equation from the above data
Solution:
Total demand function for money can be obtained by adding up the transactions demand for money (M) and
speculative demand for money (Msp). Thus
Md = Mt + Msp and Md = 0.5 Y + 105 – 1500i
In money market equilibrium

7. The LM curve has three stages:
(i) Liquidity trap region where the LM curve is horizontal (also known as the Keynesian region)
(ii) The classical region where the LM curve is vertical, or perfectly inelastic, and
(iii) The intermediate region where the LM curve is positively sloped.

In the liquidity trap region or extreme Keynesian range, monetary policy is totally ineffective in
stimulating income. Despite an increase in money supply, LM curve does not change its position. An
increase in money supply cannot cause the interest rate to fall below the rate given by the liquidity trap.
Equilibrium income then remains unchanged at OY0.
Secondly, in the classical region, where the LM curve is vertical, monetary policy becomes
completely effective. As the LM curve shifts to LM1; rate of interest declines more this time from Or4 to Or3.
This causes income to rise by a larger amount from OY3 to OY4. In view of this, classicists favour monetary
policy.
Finally, in the intermediate range where the LM curve is positive sloping, an increase in money
supply shifts the LM curve from LM to LM1. Consequently, interest rate declines to Or1 and income rises
from OY1 to OY2, Thus, monetary policy is effective.
To be more specific, monetary policy is found to have a degree of effectiveness but not the complete
effectiveness as we see in the classical region. In general, the closer the equilibrium (of IS and LM curves) is
to the classical region, the more effective monetary policy becomes, and the closer the equilibrium is to the
Keynesian range, the less effective monetary policy becomes.
Simultaneous Equilibrium of the Goods Market and Money Market:
The IS and the LM curves relate the two variables:
(a) Income and
(b) The rate of interest.
Income and the rate of interest are therefore determined together at the point of intersection of these two
curves.

E in Figure above is the equilibrium point where IS and LM curves intersect & corresponding rate of interest
thus determined is Or2 and the level of income determined is OY2. At this point income and the rate of
interest stand in relation to each other such that (1) the goods market is in equilibrium, that is, the aggregate

8. demand equals the level of aggregate output, and (2) the demand for money is in equilibrium with the supply
of money (i.e., the desired amount of money is equal to the actual supply of money).
Algebraic Derivation of Joint IS-LM Equilibrium: Mathematically, we can obtain the equilibrium values
by using the equations of IS and LM curves derived above. Thus,

Joint determination of equilibrium values of income and interest rate requires that both the IS and LM
equations hold well. In this way both the goods market and money market equilibrium will be achieved at the
same interest and income levels in the two markets. To find such equilibrium values we substitute the interest
rate from the LM equation (ii) into the IS equation (i). Doing so we have

The equation shows that the equilibrium level of income depends on exogenously given autonomous
variables (A) such as autonomous consumption, autonomous investment, government expenditure on goods
and services, and the real money supply (M/P) and further on the size of multiplier (1/1-b). It will be noticed
from equation (iii) that higher the autonomous expenditure, the higher the level of equilibrium income.
Further, the greater the real money supply, the higher the level of national income.
Effects of Change in Government’s Fiscal and Monetary Policies on IS-LM Model
(A) Effect of Increase/Decrease of Govt. Expenditure on IS-LM framework
(i) Increase in Govt. Expenditure: Increase in Government expenditure which is of autonomous
nature raises aggregate demand for goods and services and thereby causes an outward/rightward shift in IS
curve, as is shown in Figure below, where increase in Government expenditure leads to the shift in IS curve
from IS1 to IS2.

It will be seen from the above figure that, with the LM curve remaining unchanged, the new IS2 curve
intersects LM curve at point B. Thus, in IS-LM model with the increase in Government expenditure (ΔG),
the equilibrium moves from point E to B and with this the rate of interest rises from r1 to r2 and income level
from Y1 to Y2. Thus, IS-LM model shows that expansionary fiscal policy of increase in Government
expenditure raises both the level of income and rate of interest. With the rightward shift in IS curve rate of
interest also rises which causes reduction in private investment.
It is also to be noted that, the horizontal distance between the two IS curves, EK, is equal to the
increase in government expenditure times the government expenditure multiplier, that is, ΔG x [1/1-MPC].

9. (ii) Decrease in Govt. Expenditure: Likewise, it can be illustrated that the reduction in Government
expenditure will cause a leftward shift in the IS curve, and given the LM curve unchanged, will lead to the
fall in both rate of interest and level of income. That’s why often Government often cuts expenditure to
control inflation in the economy.
(B) Effect of Reduction in Taxes on IS-LM framework
An alternative measure of expansionary fiscal policy is the reduction in taxes which through increase
in disposable income of the people raises consumption demand of the people. As a result, cut in taxes causes
a shift in the IS curve to the right as is shown in Figure below, from IS1 to IS2. In the IS-LM model, with the
shift of the IS curve from IS1 to IS2 due to reduction in taxes, the economy moves from equilibrium point E
to D and as is evident from Figure below interest rises from r1 to r2 and corresponding level of income
increases from Y1 to Y2.
On the other hand, if the Government intervenes in the economy to reduce inflationary pressures, it
will raise the rates of personal taxes to reduce disposable income of the people. This rise in taxes will lead to
the reduction of consumption which in turn decreases the aggregate demand. Decrease in aggregate demand
will help in controlling inflation.
(C) Effect of Increase/Decrease of Money-Supply on IS-LM framework
(i) Expansion of Money Supply: IS-LM model can be used to show the effect of expansionary and tight
monetary policies. The expansion in money supply shifts LM curve to the right and decrease in money
supply shifts it to the left.
Suppose the economy is in grip of recession, the Government (through its Central Bank) adopts the
expansionary monetary policy to lift the economy out of recession by increasing the money supply in the
economy. This increase in money supply, keeping liquidity preference or demand for money unchanged, will
lead to the fall in rate of interest. At a lower interest there will be more investment by businessmen which
will cause aggregate demand and income to rise. This implies that with expansion in money supply LM
curve will shift to the right from LM1 to LM2 as shown in following Figure-
As a result, the economy will move from equilibrium point E to D and with this the rate of interest will fall
from r1 to r2 and national income will increase from Y1 to Y2. Thus, IS-LM model shows that expansion in

10. money supply lowers interest rate and which then stimulates more investment demand. Increase in
investment demand through multiplier process leads to a greater increase in aggregate demand and national
income.
(ii) Contraction of Money Supply: If the economy suffers from inflation, the Government will like to
adopt tight or contractionary monetary policy. To control inflation, Govt. through Central Bank can reduce
money supply through open market operations i.e. by selling Government bonds or securities in the open
market and in return gets currency funds from those who buy the bonds. To reduce money supply Central
Bank can also raise Cash Reserve Ratio (CRR) of the banks. The higher CRR implies that the banks have to
keep more cash reserve with the Central Bank and hence less fund for giving credit/loan.
In the above Figure, reduction in money supply will cause a leftward shift of LM curve from LM0 to
LM1 and will lead to the rise in interest rate from r2 to r1 and corresponding fall in the level of income from
Y0 to Y1. The rise in interest rate will reduce investment demand and consumption demand and thereby helps
in controlling inflation.
Problem: Consider an economy with the following features:

Problem: The following data are given for an economy:

12. Problem: For an economy the following functions are given:
or, 150i = 600
or, i = 4% which is equilibrium interest rate.
By putting i = 4 in either of IS or LM equation we have Y = 300
Hence, the Equilibrium interest rate = 4 % & Equilibrium income = Rs 300 crores.
What happens when taxes increase?
Leftward shift of the IS curve. The increase in taxes reduces disposable income. As consumption goes down,
it leads to a decrease in output/income. It shifts the IS curve to the left. The decrease in income reduces the
demand for money. Given that the supply of money is fixed, the interest rate must decrease to push up the

13. demand for money and maintain the equilibrium. But there is no shift of the LM curve since increase in tax
does not affect interest rate.
Summary of effects on IS-LM model due to change in Fiscal & Monetary Policy

Summary of Shifts of IS & LM Curves
1. Effects of Changes in Supply of Money on the Rate of Interest and Income Level
Given the liquidity preference schedule, with the increase in the supply of money, more money will
be available for speculative motive at a given level of income which will cause the interest rate to fall. As a
result, the LM curve will shift to the right. With this rightward shift in the LM curve, in the new equilibrium
position, rate of interest will be lower and the level of income greater than before. This is shown in Figure
below, where at a given supply of money, LM and IS curves intersects at point E. With the increase in the

supply of money, LM curve shifts to the right to the position LM’, and with IS schedule remaining
unchanged, new equilibrium is at point G corresponding to which rate of interest is lower and level of
income greater than at E.
Now, suppose that instead of increasing the supply of money, Central Bank of the country takes steps
to reduce the supply of money. With the reduction in the supply of money, less money will be available for
speculative motive at each level of income and, as a result, the LM curve will shift to the left of E, and the IS
curve remaining un-changed, in the new equilibrium position (as shown by point T in Figure above) the rate
of interest will be higher and the level of income smaller than before.
2. Effects of Changes in the Desire to Save or Propensity to Consume
When people’s desire to save falls, that is, when propensity to consume rises, the aggregate demand
curve will shift upward and, therefore, level of national income will rise at each rate of interest. As a result,
the IS curve will shift outward to the right. In Figure below suppose with a certain given fall in the desire to
save (or increase in the propensity to consume), the IS curve shifts rightward to the dotted position IS’. With
LM curve remaining unchanged, the new equilibrium position will be established at H corresponding to
which rate of interest as well as level of income will be greater than at E.

14. Thus, a fall in the desire to save has led to the increase in both rate of interest and level of income. On
the other hand, if the desire to save rises, that is, if the propensity to consume falls, aggregate demand curve
will shift downward which will cause the level of national income to fall for each rate of interest and as a
result the IS curve will shift to the left.

With this, and LM curve remaining unchanged, the new equilibrium position will be reached to the left of E,
say at point L (as shown in Figure above) corresponding to which both rate of interest and level of national
income will be smaller than at E.
3. Effects of Changes in Autonomous Investment and Government Expenditure
Changes in autonomous investment and Government expenditure will also shift the IS curve. If either
there is increase in autonomous private investment or Government steps up its expenditure, aggregate
demand for goods will increase and this will bring about increase in national income through the multiplier
process. This will shift IS schedule to the right, and given the LM curve, the rate of interest as well as the
level of income will rise.
On the contrary, if somehow private investment expenditure falls or the Government reduces its
expenditure, the IS curve will shift to the left and, given the LM curve, both the rate of interest and the level
of income will fall.
4. Effects of Changes in Demand for Money or Liquidity Preference
If the liquidity preference or demand for money of the people rises, the LM curve will shift to the left.
This is because, greater demand for money, given the supply of money, will raise the rate of interest
corresponding to each level of national income. With the leftward shift in the LM curve, given the IS curve,
the equilibrium rate of interest will rise and the level of national income will fall.
On the contrary, if the demand for money or liquidity preference of the people falls, the LM curve
will shift to the right. This is because, given the supply of money, the rightward shift in the money demand
curve means that corresponding to each level of income there will be lower rate of interest. With rightward
shift in the LM curve, given the IS curve, the equilibrium level of rate of interest will fall and the equilibrium
level of national income will increase.