IS-LM Model For understanding the economy

This is a presentation for understanding the financial state of a country.

1. IS-LM Model The Goods Market & the IS Curve *The goods market is in equilibrium when Output/ Income = Aggregate Demand *At this point, Saving = Investment * Saving depends on the level of income *It is directly related to income * Investment depends on the rate of interest * It is inversely related to interest rate

2. *IS curve reflects the combination of the interest rate & income *So, Investment = Saving I = S *The goods market equilibrium is shown by the IS curve Derivation of IS Curve *Diagram -

3. AD 2 AD 1 E 1 E 2 45 O Y 1 Y 1 Y 2 IS E 1 E 2 i 2 i 1 Y 1 Y 2 O O Real Income Real Income Aggregate Demand Aggregate Demand Interest Rate (A) (B)

4. In this diagram- *The given interest rate is - i 1 *The aggregate demand curve AD 1(part A) intersects the 45 degree line at the point E 1 *It is an equilibrium point of goods market *Equilibrium income is Y 1 *If the rate of interest falls to i 2 , aggregate demand will rise *The aggregate demand curve shifts

5. upwards to AD 2 *The new equilibrium point is E2 *The equilibrium level of income rises to Y2 *If we repeat this exercise for all possible interest rates we can obtain a series of combinations of interest rates & levels of income at which the goods market is in equilibrium *By joining all these points in the B part of Fig., we obtain the IS curve

6. *Thus, IS curve is the locus of pairs of interest rates and levels of income which are compatible with goods market equilibrium *The equilibrium is only on the IS curve *Outside the IS curve, the goods market is not in equilibrium *Because at the right of the IS curve there is excess supply in the goods market *& the left of the IS curve there is excess demand in the goods market

7. The Slope of IS Curve *The IS curve slopes downwards *Because a decrease in interest rate increases investment *Which shifts aggregate demand curve up and rises the equilibrium income level *The steepness of IS curve depends on the sensitivity of investment spending and autonomous consumption expenditure to changes in interest rates *If the investment spending and

8. autonomous consumption expenditure are very sensitive to the interest rate, then the change in interest rate will produce a large change in aggregate demand and it shows large change in income level. In this case IS curve will be flatter *If the investment spending and autonomous consumption expenditure are not very sensitive to change in interest rates then the IS curve will be

9. very steep Shifts in IS Curve *It is depend on – 1.Change in Govt. Spending – Increase in Govt. spending will shift the IS curve to the right While a decrease in Govt. spending shift the IS curve to the left 2.Change in Taxes – An increase in taxes will shift the IS curve to the left

10. While a decrease in taxes shift the IS curve to the right 3.Autonomous Change in Investment – An increase in autonomous investment will shift the IS curve to the right While a decrease in autonomous investment will shift the IS curve to the left *Diagram -

11. IS 1 IS IS 2 O Y Y X Real Income Real Income Interest Rate *The initial IS curve is IS *If there is an increase in autonomous

12. spending IS curve shifts right to IS 1 *& if there is a fall in autonomous spending IS curve shifts left to IS 2

13. Money Market & Derivation of LM Curve *The money market is concerned with demand for and supply of money *The demand for money depends on – Transaction Precautionary Lt & Lp or L 1 = f (Y) Positively related Speculative motives Ls or L 2 = f(r) Negatively related * Supply of money is controlled by the Central Bank

14. *The money market is in equilibrium – Demand for money = Supply of money *The LM curve shows the combinations – Interest rate & Income *Diagram -

15. Y1 O O X Y Y X E1 E2 i 1 i 2 i 1 i 2 LM Y2 Interest Rate Real Income Demand for & Supply of Money M E2 E1 Interest Rate (B) (A) L1 L2

16. In this diagram – *L1 is the original demand curve of money *M is the original supply curve of money *L1 & M interest each other at point E1 *At this equilibrium point (E1), the money market is in equilibrium with the combination of Y1 income and i 1 interest rate *When income rises to Y2, the demand curve shifts to L2 *The new equilibrium point is E2

17. *At this equilibrium point the money market is in equilibrium with the combination of Y2 income and i 2 interest rate *In the (B) part of the diagram, we obtain LM curve, by joining the equilibrium points like E1 and E2 Slope of LM Curve *The LM curve slopes upwards to the right *If the demand for money is relatively

18. insensitive to the interest rate, the LM curve is close to vertical *If the demand for money is very sensitive to interest rate, the LM curve close to horizontal