This document discusses equilibrium in the product (goods) market and money market using IS-LM analysis. It provides explanations of: - Product market equilibrium where supply and demand for goods are equal. This is represented by the IS curve which shows combinations of income and interest rates that equate saving and investment. - Money market equilibrium where demand and supply of money are equal. This is represented by the upward-sloping LM curve which shows combinations of income and interest rates that equate money demand and supply. - General market equilibrium is achieved where the IS and LM curves intersect, simultaneously achieving equilibrium in both the goods market and money market. This point determines the equilibrium levels of income and interest rate.

1. Equilibrium in product and money
market: IS-LM curves
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2. After studying the topic, we will learn about
Product Market Equilibrium
 Derivation of IS Curve
 Money Market Equilibrium
Derivation of LM Curve
General Market Equilibrium: Combining Money
Market and Product Market
 Shifts of the IS and LM Curves
Effect of Fiscal and Monetary Policy on IS and LM
Curve
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3. Product Market Equilibrium
• Market characterized by selling and buying of goods is called
product or goods market.
• Product market is in equilibrium when demand for product and
supply of product are equal.
• Product market is in equilibrium when saving and investment are
equal.
• S=I
• In the goods/product market equilibrium, we have:
• (a) The saving function
• (b) The investment function
• (c) An equilibrium condition.
.
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4. IS-CURVE
• IS-CURVE : The IS curve shows equilibrium
combinations of income and interest rate
where along IS curve product or good market
is in equilibrium.
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5. Derivation of IS-Curve
• (a) The saving function
S = f (Y), where S is saving and Y is income.
(b) The investment function
I =f (r), I is investment and r is general rate of
interest.
In equilibrium, S=I
For the derivation of IS curve, we have to find
combinations of interest rate, r, and the level of
income, Y, that equate investment with saving.
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6. Derivation of IS-Curve
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7. Explanation
• The derivation of IS curve can be made in
terms of the four-part diagram (Fig. 10.28). In
part (a), we have drawn investment function
that shows the inverse relationship between
investment and the rate of interest. Part (c)
plots the saving function that represents
direct relationship between income and
saving. Part (b) is simply a 45° identity line,
and part (d) plots the IS curve.
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8. Explanation
• Suppose the rate of interest is r0. At this rate
of interest, investment must be I0 and, thus,
the volume of saving must be S0, necessary for
equilibrium. This volume of saving implies an
equilibrium income of Y0 necessary for
equilibrium. This establishes one point on part
(d), say point M. If the rate of interest rises to
r1; investment declines to I1. This results in a
decline in national income to Y1.
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9. Explanation
• With this level of income the volume of saving becomes S1.
This establishes another point on part (d), say point N. The
procedure may be repeated for each level of income
(interest) to obtain corresponding values of interest rate
(income value) that ensure equality between saving and
investment. By joining all these equilibrium points we get
an IS curve drawn in part (d).
• Thus, the IS curve shows various combinations of income
and interest rate that brings the commodity market in
equilibrium. The IS curve is negatively sloped. Its slope
depends on the nature of saving and investment functions.
• The IS curve may shift if there is a change in autonomous
private investment and government expenditure.
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10. • Thus the effect of an increase in r is:
• r ↑→ I↓→ AD ↓→Y↓, and the effect of a
fall in r is:
• r ↓→ I ↑→ AD↑→ Y↑
• The IS curve slopes downwards to the right. Or
it has a negative slope.
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11. Properties of the IS Curve: A
Summary
• i. The IS curve is the equilibrium combinations of income and
interest rate such that the product market or goods market is in
equilibrium.
• ii. The IS curve slopes downward to the right because an increase in
interest rate causes investment expenditure to decline, therefore,
reduces aggregate demand and, hence, equilibrium national
income.
• iii. Its slope depends on the saving and investment functions. The IS
curve will be relatively steep (flat) if investment is less (more)
sensitive to interest rate changes.
• iv. This IS curve will shift by an autonomous change in investment
spending or government spending.
• v. Any point on the IS curve shows that there is neither excess
supply nor excess demand for goods. Any point off the IS curve
shows either excess supply of goods or excess demand for goods.
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12. LM CURVE
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13. Money Market
• Technically, a money market is market
characterized by demand for money and
supply of money.
• It concerns on borrowing and lending of short-
term funds.
• It is a market for short-term loans in the sense
that it provides money for working capital or
circulatory capital.
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14. • The main building blocks of money market
are:
• (i) Central bank,
• (ii) Commercial banks, and
• (iii)Development Banks, …………
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15. Money Market Equilibrium
• Money market is in equilibrium when demand for
and supply of money are equal at given rate of
interest.
Money market equilibrium occurs when
• M = Md
• Demand for Money
• The demand for money is the desired holding of
financial assets in the form of money: that is,
cash or bank deposits.
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16. Demand for Money
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17. • Thus, Keynes’ money demand function is
written as
• Md = f (Y,r) where Y is income level, r is rate of
interest and Md is demand for money.
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18. Supply of Money
• Supply of money (M) is institutionally given. Since it is
exogenously determined by monetary authority of any
country, it is assumed to be constant for certain period
of time. So it is vertical.
• MS ↑ →r ↓ I ↑→ AD ↑→ Y ↑ and P ↑
• Where MS = supply of money
• r = rate of interest
• I = amount of investment
• AD = aggregate demand
• Y = level of national income, that is, aggregate output
• P = price level
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19. Derivation of LM Curve
• The LM curve shows different combinations of
r and Y where along LM curve money market
is in equilibrium.
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20. • The LM curve, "L" denotes demand for money and "M" denotes supply of money,
is a graph of combinations of real income, Y, and the real interest rate, r, such that
the money market is in equilibrium .The graphical derivation of the LM curve is
illustrated below.
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21. • The left-hand side of the graph illustrates money market equilibrium for a
given level of Y. For example, when Y = Y0 the equilibrium real interest rate
is 5%. The right-hand-side of the graph gives the LM curve. The LM curve
is plotted with the real interest rate on the vertical axis and real income
(GDP) on the horizontal axis. Each point on the LM curve represents a
money market equilibrium for a particular real interest rate and income
pair (r, Y). For example, the money market equilibrium at (r=5%, Y=Y0) is
given by the black (middle) dot on the LM curve.
• At a higher level of income, Y1 > Y0, the money demand curve shifts up and
right and a new equilibrium occurs at r = 7%. This equilibrium is
represented by the blue (upper) dot on the LM curve. Similarly, at a lower
level of income Y2 < Y0 the money demand curve shifts down and left and
a new equilibrium occurs at r = 3%. This equilibrium is given the by the red
(lower) dot on the LM curve.
•
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22. • The above analysis shows that the LM curve is an upward
sloping curve in the graph with r on the vertical axis and Y
on the horizontal axis.
• Every point on the LM curve represents an intersection
between the real money supply (M/P) and real money
demand (Ld).
• The LM curve will shift whenever the variables we hold
fixed, other than Y, in the money-supply/money-demand
diagram change.
• These variable are M/P and e. In particular, if M/P increases
holding expected inflation fixed then r falls in the money
market and so the LM curve shifts down and right.
• Similarly, if expected inflation increases real money
demand falls, lowering the interest rate, and the LM curve
shifts down and to the right.
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23. • Properties of the LM Curve: A Summary:
• i. The LM curve consists of equilibrium combinations of
income and interest rate for the money market.
• ii. The LM curve slopes upward to the right.
• iv. The LM curve shifts due to changes in money supply
and money demand.
• v. All points on the LM curve show money market
equilibrium such that there is neither excess demand
for money (EDM) nor excess supply of money (ESM).
Any point off the LM curve exhibits either EDM or ESM.
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24. Combining Goods Market and Money
Market: General Equilibrium:
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25. Description
• Above figure shows the general equilibrium in terms of IS
and LM curves. Here, when both the curves are plotted on
the same axes, the equilibrium level of income, Ye, and the
equilibrium interest rate, re, are determined simultaneously.
• This is known as the synthesis of monetary analysis and
income analysis or macroeconomic general equilibrium.
Point E is the (only) point of general equilibrium for both the
markets. Point E is a stable equilibrium point.
• If we take any other points in the LM curve except point E,
money market is in equilibrium leaving good market in
disequilibrium. Similarly, if we take any other points in the IS
curve except point E, good market is in equilibrium leaving
money market in disequilibrium. So, point E is the point for
general equilibrium.
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