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
oWhy IS-LM Analysis
oWhat is IS-LM Analysis
oIS Curve and its Derivation
oLM Curve and its Derivation
oSimultaneous 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:
Rate 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
F
I₁
I
E
Iₒ
rₒ
r₁
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
F
I₁
I
E
Iₒ
rₒ
r₁
rₒ
r₁
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

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(Mt&p)
Speculative Demand for Money (Ms)
Rate
of
Interest
O
Y
O
Y₀
M₀ M₀
Y₁
M₁
r₀
r₁
Mt&p MTP
Rate
of
Interest
O
r₀
r₁
r₂
r₂
MS
M₁
M₀

12. Supply of
Money
Total demand for
Money Y₀
Supply of Money
Rate
of
Interest
O
MD =Mtp +Ms or
MD =K(y)+L(r)
M₀
MD (Y0)
Demand for Money
Rate
of
Interest
M
M₁
r1

13. •
Money Market
Equilibrium
Rate
of
Interest
Demand for
Money when
income is Y₂
Supply and Demand for Money
Demand for Money
when income is Y₁
Demand for
Money when
income is Y₀
MD (Y₂)
E₂
E₁
M/P
r₁
r₂
r₀
MS
E₀ MD (Y₀)
MD (Y₁)

14. •
Derivation of LM
Curve
Rate
of
Interest
Supply and Demand for Money
MD (Y₂)
E₂
E₁
M/P
r₁
r₂
r₀
MS
E₀ MD (Y₀)
MD (Y₁)
Income(Y)
Rate of Interest
r₀
r₁
r₂
LM Curve
E₀
E₁
E₂