The IS-LM model explain the relationship between product market and money market.

1. IS-LMCurve
DR. JAMILAHMAD
DEPARTMENTOF ECONOMICSA,M,U, ALIGARH

2.  Classical Economist:
 Rate of interest is a real phenomenon determined by saving and investment.
 Keynes:
 Rate of interest is purely a monetary phenomenon determine by Md and Ms.
 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.
 Y = C+I
 Y = C + S
 I = S

3. IS Curve and Goods Market Equilibrium?
 The term IS refers to the equality between Investment(I) & saving(S) the corresponding
equilibrium in the Goods Market.
 IS curve is the locus of different combinations of Interest Rate(r) and Level (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.
 Rate of interst decreses– investment increase—AD—Increase---- Level income increse
 AD = C+I

4. Derivation of IS Curve
 Keynes assumption that the rate of interest has little effect on Saving.
 The saving curve shows that saving increases as income increases. Saving is an
increasing function of income.
 S = f(Y)
 On the other hand , Investment depends on the rate of interest and the level of income.
 As the rate of interest falls, the investment starts to increase and vice versa. The level of
investment rises with the level of income.
 I = f(r)

5. Cont….
 When the rate of interest falls the level of investment increases and vice versa. Thus,
changes in the rate of interest affect aggregate demand or aggregate expenditure by
causing changes in the investment demand. When the rate of interest falls, it lowers
the cost of investment projects and thereby raises the profitability of investment.
 The businessmen will therefore undertake greater investment at a lower rate of
interest. The increase in investment demand will bring about increase in aggregate
demand which in turn will raise the equilibrium level of income.
 A fall in the rate of interest, the planned investment will increase which will cause an
upward shift in aggregate demand function (C + I²) resulting in goods market
equilibrium at a higher level of national income.
 The lower the rate of interest, the higher will be the equilibrium level of national
income. Thus, the IS curve is the locus of those combinations of rate of interest and
the level of national income at which goods market is in equilibrium.r level of
national income.

7. Why does IS curve slopes downward
 The decline in the rate of interest brings about an increase in the planned investment
expenditure. The increase in investment spending causes the aggregate demand curve to
shift upward and therefore leads to the increase in the equilibrium level of national
income. Thus, a lower rate of interest is associated with a higher level of national income
and vice-versa. This makes the IS curve, which relates the level of income with the rate of
interest, to slope downward.
 Steepness of the IS curve depends on (1) the elasticity of the investment demand curve,
and (2) the size of the multiplier. The elasticity of investment demand signifies the degree
of responsiveness of investment spending to the changes in the rate of interest.
 The negative slope of the IS curve reflects the increase in income and investment as the
rate of interest falls. The slope of the IS curve depends on 2 factors :
 1. The sensitivity (elasticity) of investment and saving to changes in the interest rate,
 2. Size of the multiplier.

8. Properties of IS Curve
 1. Downward Sloping,
 Increase/Decrease in autonomous expenditure will shift the IS curve Rightward/Leftward.
 The steepness or flatness of the IS curve describes the elasticity or responsiveness of C and
I to the nominal interest rate.
 -- Steep IS curve: inelastic.
 -- Flat IS curve: elastic.

9. Shifts in IS Curve due to taxes
 An increase in taxes shifts the IS curve to the left.
 Changes in autonomous consumer expenditure.
 Changes in planned investment spending
unrelated tothe interest rate.
Changes in government spending

10. LM curve
 The LM curve represents the combinations of the interest rate and income such that money
supply and money demand are equal.
 The demand for money comes from households, firms, and governments that use money as
a means of exchange and a store of value.
 The law of demand holds: as the interest rate increases, the quantity of money demanded
decreases because the interest rate represents an opportunity cost of holding money. When
interest rates are higher, in other words, money is less effective as a store of value.
 To trace out the LM curve, we look at
what happens to the interest rate when
the level of output in the economy
changes and the supply of money is hel
fixed.

11. The LM Curve
 In this Figure - "A Change in Income" shows the money market equilibrium at two
different levels of real GDP. At the higher level of income, money demand is shifted to
the right; the interest rate increases to ensure that money demand equals money supply.
 Thus the LM curve is upward sloping: higher real GDP is associated with higher
interest rates. At each point along the LM curve, money supply equals money demand.

12. The LM Curve
 LM curve slopes upward to the right. This is because with higher levels of income,
demand curve for money (Md) is higher and consequently the money- market
equilibrium, that is, the equality of the given money supply with money demand curve
occurs at a higher rate of interest. This implies that rate of interest varies directly with
income.

13. Features of LM Curve:
 From our analysis of the LM curve, we arrive at its following essential features:
1. The LM curve is a schedule that describes the combinations of rate of interest and
level of income at which money market is in equilibrium.
2. The LM curve slopes upward to the right.
3. The LM curve is flatter if the interest elasticity of demand for money is high. On the
contrary, the LM curve is steep if the interest elasticity demand for money is low.
4. The LM curve shifts to the right when the stock of money supply is increased and it
shifts to the left if the stock of money supply is reduced.
5. The LM curve shifts to the left if there is an increase in the money demand function
which raises the quantity of money demanded at the given interest rate and income
level. On the other hand, the LM curve shifts to the right if there is a decrease in the
money demand function which lowers the amount of money demanded at given
levels of interest rate and income.

14. Shift in LM Curve:
 LM curve can shift upward or downward if there are exogenous changes in the money
supply (Ms) and money demand (Md). Change in money demand can occur due to
change in K i.e., the proportion of income kept as cash for transactions purposes.
Change in Md can also occur if there is increase or decrease in the speculative demand
for money.
 Shift due to Increase in Money Supply:
 LM function will shift downward and rightward as a result of increase in money
supply. Because, the increased money supply will flow in the speculative motive
which will reduce the rate of interest without any immediate change in income level.
A pair with same income and lower r will result into shifting the LM curve as shown
in Fig-

15. Shift in LM Curve:
 Variations in the real money supply shift the LM curve, as shown in Figure 31.34 "A
Shift in the LM Curve". If the money supply decreases, then the LM curve shifts in.
This leads to a higher real interest rate and lower output as the LM curve shifts along
the fixed IS curve.
 with income fixed, the rate of interest must fall so that demand for money for
speculative and transactions motive
rises to become equal to the greater money
supply. This will cause the LM curve to
shift outward to the right.

16. Equilibrium
 combines the LM curve from Figure-"The LM Curve" and the IS curve from Figure-
"The IS Curve". The crossing of these two curves is the combination of the interest rate
and real GDP, denoted (r*,Y*), such that both the money market and the goods market
are in equilibrium.
 AD=AS and Md=Ms

17. Thank you