IS-LM Analysis

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IS-LM Analysis

  1. 1. IS-LM ANALYSIS AND AGGREGATE DEMAND DR. LAXMI NARAYAN ASSISTANT PROFESSOR OF ECONOMICS GOVT. COLLEGE FOR WOMEN, BHODIA KHERA
  2. 2. Lecture Outline Why IS-LM Analysis? What IS-LM Analysis? Equilibrium in Goods Market – IS curve. Equilibrium in Money Market – LM curve. Simultaneous Equilibrium Deriving Aggregate Demand
  3. 3. Why IS-LM Analysis? Classical Economist: Rate of interest is a real phenomenon determined by saving and investment Keynes: rate of interest is purely a monetary phenomenon. Both arguments were challenged because of indeterminacy as: Rate of interest affects the level of GDP by its effect on Investment. Level of GDP affects the rate of interest via demand for money. A rise in level of GDP as a result of investment is cut short when rate of interest rise as a result of increase in GDP
  4. 4. 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 HicksHensen Synthesis. Simultaneous determination of rate of interest and the real GDP and alternate derivation of AD curve is at the core of IS-LM analysis.
  5. 5. 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.
  6. 6. IS Curve and Product Market Equilibrium? 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. That is, every point on the IS curve is an income/real interest rate pair (Y, r) such that the demand for goods is equal to the supply of goods.
  7. 7. Derivation of IS Curve 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.
  8. 8. Derivation of IS Curve The derivation is based on the following propositions. An increase in rate of Interest leads to a decrease in the level of Investment. An decrease in the level of investment leads to a decrease in the level of income. Therefore, an increase in the rate of interest leads to a decrease in the rate of interest.
  9. 9. Agg. Exp. G Rate of Interest S&I 0 I0 I1 I2 0 S r2 r1 r0 0 F E Y2 Y1 Y0 G F E Y2 Y1 Y0 Y=AE Good Market AE0 (I0, r0) Equilibrium AE1 (I1, r1) AE2 (I2, r2) Y=AE=C(Y-T)+I(r)+G Income S I0 atr0 I1atr1 I2atr2 Income E F G Y2 Y1 Y0 Income I = Ia-br, b>0
  10. 10. SLOPE OF IS CURVE The slope of the IS curve depends on: The sensitivity of investment (AE) to interest rate changes Rate of Interest The value of multiplier When ‘I’ is more sensitive to ‘r’ and when multiplier value is high(high MPC) IS1 IS2 0 Real GDP(Y) When ‘I’ is less sensitive to ‘r’ and when multiplier impact is low(low MPC)
  11. 11. Factors that Shift the IS Curve A change in autonomous factors that is unrelated to the interest rate Changes in autonomous consumer expenditure Changes in planned investment spending unrelated to the interest rate Changes in government spending Changes in taxes Changes in net exports unrelated to the interest rate
  12. 12. Shifting of IS Curve Y=AE Aggregate. Exp.. F E1 Rate of Interest IS0 1 Y1 IS1 r0 0 F1 E 0 r1 AE0 (r0) A0E0 (r0) AE1 (r1) A1E0 (r1) Y1 1 Y0 Y0 E E1 F F1 1 Y1 Y2 1 Y0 Y0 Income Decrease in Govt. Exp. Decrease in Investment Increase in Taxes Increase in Consumer Exp. Decrease in Net Exports Income
  13. 13. LM Curve and Money Market Equilibrium? 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).
  14. 14. DEMAND FOR MONEY Transaction Demand for Money(Mt) Y K Mt = K(y) : 1>K>0 K = Proportion of income kept Y1 Y0 is cash for transaction purpose Mt O M0 M1 r Speculative Demand for Money(Ms) Ms = L(r) : L`<0 r1 r2 Liquidity Trap r0 O M1 M2 Ms
  15. 15. Total Demand for money Rate of Interest Supply of Money O MS Rate of Interest YD r1 O M Supply of Money MD = Mt + Ms or MD = K(y) + L(r) MD (YD) M0 M1 Demand for Money
  16. 16. MONEY MARKET EQUILIBRIUM Rate of Interest MS r2 r1 E2 E1 r0 E O M P = L (r ,Y ) Demand for money when income is Y2 MD (Y2) MD (Y1) MD (Y0) M/P Supply and Demand for Money Demand for money when income is Y1 Demand for money when income is Y0
  17. 17. Derivation of LM Curve The derivation is based on the following propositions. An increase in the level of income leads to an increase in the demand for money. An increase in the demand for money leads to an increase in the rate of interest. Therefore, an increase in the level of income leads to an increase in the rate of interest.
  18. 18. DERIVATION OF LM CURVE Rate of Interest MD (Y2) MS Rate of Interest LM Curve MD (Y1) r2 E2 r2 E2 E1 r1 E1 r1 r0 r0 E E MD (Y0) O M O Supply and Demand for Money Y0 Y1 Y2 Income(Y)
  19. 19. SLOPE OF LM CURVE The slope of the LM curve depends on: The sensitivity of money demand (MD)to interest rate changes The sensitivity of money demand (MD)to changes in GDP When ‘MD’ is more sensitive to ‘Y’ and less sensitive to ‘r’ Rate of Interest LM1 LM2 0 Real GDP(Y) When ‘MD’ is less sensitive to ‘Y’ and more sensitive to ‘r
  20. 20. SHIFTING OF LM CURVE Rate of Interest MS MD r0 Rate of Interest LM0 (Y0) E0 r1 O MS r0 E1 M0 M1 r1 O Supply and Demand for Money E0 E1 Y0 Income(Y) LM1
  21. 21. Simultaneous Equilibrium in Product and Money Market r LM: Money Market Equilibrium. M P = L (r ,Y ) r0 E Y0 Y = C ( − T ) + I (r ) + G Y IS: Goods Market Equilibrium. Y The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.
  22. 22. Disequilibrium in Product Market r C rB rA D B At A - Product Market is in equilibrium. Suppose r increases from rA to rB. A Excess Demand for goods YC YA IS At point B, Y=YA, but rB > rA Y At B we will have Excess Supply of goods in the goods market. ↑r → ↓I → ↓ AD→ ↓ YA>ADB (Excess Supply of goods). → So at a Higher Interest Rate (such as rB), the only way to return back to equilibrium is to have lower Y (such as YC).
  23. 23. Disequilibrium in Money Market r LM0(P0M0) Initially at A: MD = MS). rC rA D A C B Income(Y) O YA Suppose Y Increases from YA to YB and we move to B. At B, r = rA but Y increases to YB. Increase in Y increase in Md Md> MS (Excess Demand for money). YB For the Money Market to return back to equilibrium we need to have an increase in r so as to decrease Md back to the given MS level. And at this higher Y level (YB) r has to ↑ to C (rC) to ↓ Md to its old level so that Md=MS again.
  24. 24. Disequilibrium in IS-LM We can conclude: If disequilibrium is at the right of IS curve indicating Excess Supply in Goods market, only way to restore equilibrium is to decrease Y. same way for point on the left, increase Y. If disequilibrium is at the right of LM curve indicating Excess Demand for Money in money market, only way to restore equilibrium is to increase rate of interest(r). Same way for points on the left of the LM, decrease ‘r’
  25. 25. Disequilibrium in IS-LM r Any point other than point E is point of disequilibrium. Point A&B: I=S but L≠ M Point M&N: L=M but I≠ S LM r0 B T N M L E V Point K: L>M & S<I KA Y0 IS Y Point V: L>M & S>I Point L: L<M & S<I Point K: L<M & S<I
  26. 26. How Equilibrium is re-established in IS-LM When Disequilibrium is in only One Market r r0 At point ‘A’ economy is in equilibrium LM in product market and disequilibrium in money market. A r2 E At A, excess supply of money reduces r0 to r1 Lower interest rates at r1 , increases IS investment which increases income to Y1 r1 Y0 Y2 Y1 Y Higher Income increase demand for money and interest rates till economy reaches at point E
  27. 27. How Equilibrium is re-established in IS-LM When Disequilibrium is in only One Market r At point ‘D’ economy is in equilibrium in money market (L=M) and disequilibrium in Product Market. LM As D lies right of IS curve, means supply r0 r1 D E in good markets, that is S>I or AE<AS Low demand in good market reduces income from Yo IS This reduces money demand. Lower demand for money reduces interest rates. Y Y2 Y0 This process continues till equilibrium is resorted at point ‘E’ where both markets are in equilibrium
  28. 28. r Shift in the IS and LM curve and Change in Equilibrium IS0 r1 r0 r2 IS1 LM IS2 E1 E r LM2 E2 Y2 Y0 Y1 Y r2 r0 r1 LM E2 E E1 IS Y2 Y0 Y1 Y
  29. 29. r LM 2 at P2 Derivation of AD Curve IS LM at P0 r2 E2 r0 E r1 r E1 Y0 Y2 Y1 C P2 P0 P1 A B Y At new equilibrium income Y1 and price P1, we have the point B. Now if price increase to P2 LM curve shifts left and new equilibrium corresponding to E2 will be C AD curve Y2 Y0 Y1 Y
  30. 30. r LM2 Derivation of AD Curve if LM IS curve shift due to factors r2 other than price level that is, price level remain constant For example AD can be increased by increasing money supply: ↑M ⇒ LM shifts right ⇒ ↓r ⇒ ↑I ⇒ ↑Y at each value of P LM E2 r0 E r1 r P E1 Y2 Y0 Y1 B C A Y P AD1 AD AD 2 Y2 Y0 Y1 Y
  31. 31. r LM2 IS Monetary Policy and AD Curve LM r2 E2 r0 E r1 r P E1 Y2 Y0 Y1 B C A Y Expansionary Monetary Policy: Shift LM curve right to LM1. Increase income to Y1 Shift AD curve to AD1 Contractionary Monetary Policy: Shift LM curve Left to LM2. Decreases income to Y2 Shift AD curve to AD2. P AD1 AD AD 2 Y2 Y0 Y1 Y
  32. 32. r IS1 IS0 r1 E1 IS2 r0 E r2 r P Fiscal Policy and AD Curve LM E2 Y2 Y0 B C Y Y1 A Expansionary Fiscal Policy: Shift IS curve right to IS1. Increase income to Y1 Shift AD curve to AD1 P AD1 AD AD 2 Y2 Y0 Y1 Y Contractionary Fiscal Policy: Shift IS curve Left to IS2. Decreases income to Y2 Shift AD curve to AD2.
  33. 33. Weaknesses of IS-LM Model Only a Comparative Static Model. Ignores impact of International Trade. Considers price level as exogenous variable. Ignores time lags. Does not include labour market equilibrium in the analysis. Ignores impact of future expectations .
  34. 34. REFERENCES Jain, T.R and Majhi, B.D., “Macroeconomics” V.K. Publications. Rana, K.C. and Verma, K.N., “Macro Economic Analysis” Vishaal Publications. Rana, A.S., “Advance Macro Economics-Theory and Policy,” Kalyani Publishers. Shapiro, E, “Macro Economic Analysis” Galgotia Publications.
  35. 35. FAQs Explain the determination of GDP and rate of interest with the help of IS-LM curve Analysis. Trace the derivation of IS and LM curves. Derive the aggregate demand curve through IS-LM curve Model. Explain the effect of Monetary and Fiscal policy through IS-LM Model.

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