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# LM model assignment help

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### LM model assignment help

1. 1. IS – LM MODEL
2. 2. INVESTMENTS •INVESTMENT IS NO LONGER AUTONOMOUS. IT IS NOW DEPENDENT ON INTEREST RATE. •HIGHER THE INTEREST RATE, LOWER WILL BETHE INVESTMENT. •I = Ῑ - b i b TELLS THE INTEREST RATE RESPONSIVENESS OF
3. 3. AGGREGATE DEMAND •AD= Ᾱ - bi –c( 1- t)Y Equilibrium in the goods market now requires AD = Y Y= Ᾱ - bi = αG (Ᾱ- bi) where αG= 1-c( 1-t) 1-c( 1-t)
4. 4. IS curve It is the combination of all those points at which the goods market is in equilibrium. EQUATION OF IS CURVE i = Ᾱ - Y b αG b Reason why it is downward sloping: It tells as the interest rate falls, investment will increase and thus output.
5. 5. Slope of the IS curve •It depends on αG , b •Higher the αG, flatter the IS curve, higher the change in output with a given change in interest rate. reason: higher αG means higher MPC , higher MPC implies higher output. •Higher b, flatter the IS curve, higher the change in output with a given change in interest rate. reason: Higher b means that investment is highly sensitive to the interest rate, so small
6. 6. Disequilibrium points in IS curve •E3 and E4 are disequilibrium points. •At E3, interest rate is lower than the rate i1 i.e. needed to attain equilibrium. At this point the investment will be higher. Thus, AD is higher than output. •At E4, output is higher than the AD. Thus, excess supply of good
7. 7. Wealth constraint •Wealth is stored either in form of money or in form of assets such as bonds. •Money provide convenience for transactions. But it doesn’t provide ay interest rate. Thus interest rate is the opportunity cost of holding money. •Bonds provide interest rate but can’t be used for transaction purposes. •Real wealth= real demand of money balances + real demand of bonds.
8. 8. Real demand of money balances. L= k Y – hi Here k tells the income responsiveness to demand of real balances. h tells the interest rate responsiveness to demand of real balances. High income, allows individual to hold large amount of money. Thus, demand of real balances is positively related to income. Higher the interest rate, higher is the opportunity cost of holding money. Thus , demand of real
9. 9. Real demand of money balances
10. 10. LM curve •It is the combination of all those points at which money market is in equilibrium. •With a given money supply, we can derive the LM curve from the demand of real balances curve. •Reason why it is upward sloping: as the interest rate increase, demand of bonds increase and thus demand of money falls. With the same level of money supply, inorder to achieve equilibrium income should increase.
11. 11. Derivation of LM curve
12. 12. LM curve L = money supply. kY – hi = m͞ / ͞p kY – m͞ / ͞p = hi i = kY - m͞ / ͞p h h
13. 13. Slope of LM curve •It depends on k and h •Higher k, steeper the LM curve, smaller will the increase in the income due to given change in interest rate. Or large change in interest rate with a given change in income. reason: if the income increase then the demand of money will rise by large amount. Thus, we require a huge increase in interest rate to bring the market into equilibrium. •lower h, steeper the LM curve, smaller will the increase in the income due to given change in interest rate.
14. 14. Points off the LM curve •E1 is ESM •Reason: at higher interest rates, demand of bonds is high and thus there is excess supply of money. •E3 is EDM •Reason: at same interest rate i1 income rise to Y2 . Thus, E1 E2 E3E4 Y1 Y2 i2 i1
15. 15. How the equilibrium output and interest rate are determined •They are determined by the intersection of two curves IS and LM. •So that at equilibrium both the goods market and the asset market is in equilibrium. •IS: Y= αG( Ᾱ- bi) LM :i = kY - m͞ / ͞p h h •Substituting the value of I from LM into Is will give
16. 16. What causes changes in equilibrium points •Shifts in IS or LM curves , will bring changes in equilibrium points. •Shift in LM due to changes in money supply •Shift in IS due to change in autonomous spending.
17. 17. Suppose there is increase in autonomous spending •This will shift IS curve rightwards. •Change in Y is less than the αG •Reason: y L with the same money supply i I Y • thus, both asset market and goods market clears
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