IS-LM ANALYSIS

AND

AGGREGATE

DEMAND

DR. LAXMI NARAYAN

ASSISTANT PROFESSOR OF ECONOMICS

GOVT. COLLEGE FOR WOMEN, BHODIA KHERA

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

Why IS-LM Analysis?

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

Classical Economist: Rate of

interest is a real phenomenon

determined by saving and

investment

Keynes: rate of interest is

purely a monetary

phenomenon.

Why IS-LM Analysis?

Simultaneous determination of rate of interest and the

real GDP and alternate derivation of AD curve is at the

core of 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.

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 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.

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

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.

E

F

G

EF

G

0

0I2atr2 I2

I1 I1atr1

I0 I0 atr0

S

S

E

FG

0r0

r1

r2

Y0Y2 Y1

Y0Y2 Y1

Y0Y2 Y1Income

Agg. Exp.

S & I

Rate of Interest

AE0 (I0, r0)Y=AE

AE1 (I1, r1)AE2 (I2, r2)

Income

Income

I = Ia-br, b>0

Y=AE=C(Y-T)+I(r)+G

Good Market Equilibrium

SLOPE OF IS CURVE

The slope of the IS curve depends on:

� The sensitivity of investment (AE) to interest rate changes

�The value of multiplier

0

Rate of Interest

Real GDP(Y)

IS1

IS2

When ‘I’ is more

sensitive to ‘r’ and when

multiplier value is

high(high MPC)

When ‘I’ is less sensitive

to ‘r’ and when multiplier

impact is low(low MPC)

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

E

F

0

E

F

0

r0

r1

Y0Y2

Y0Y1

Income

Aggregate. Exp..

Rate of Interest

AE0 (r0)

Y=AE

AE1 (r1)

Income

A1E0 (r1)

F1

E1

E1

A0E0 (r0)

Y1

0

Y1

0

Y1

1

Y1

1

F1

Shifting of IS Curve

�Decrease in Govt. Exp.

�Decrease in Investment

�Increase in Taxes

�Increase in Consumer Exp.

�Decrease in Net Exports

IS0

IS1

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).

DEMAND FOR MONEY

Transaction Demand for Money(Mt)

Mt = K(y) : 1>K>0K = Proportion of income kept is cash for transaction purpose

Speculative Demand for Money(Ms)M0

K

M1

Y0

Y1

Mt

Y

M1

Liquidity Trap

M2

r2

r1

Ms

r

r0

Ms = L(r) : L`<0

O

O

Supply of Money

M

Rate of Interest

Supply of Money

MS

Total Demand for money

MD = Mt + Ms

orMD = K(y) + L(r)

M0 M1

Demand for Money

Rate of Interest

r1MD (YD)

YD

O

O

Supply and Demand for Money

Rate of Interest

r0

MD (Y0)

MS

M/PDemand for money

when income is Y0

MD (Y1)

Demand for money

when income is Y1MD (Y2)

Demand for money

when income is Y2

MONEY MARKET EQUILIBRIUM

r1

r2

E

E1

E2

O

( , )M P L r Y=

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.

Supply and Demand for Money

Rate of Interest

r0

MD (Y0)

MS

M

MD (Y1)

MD (Y2)

DERIVATION OF LM CURVE

r1

r2

E

E1

E2

O

Income(Y)

Rate of Interest

r0

r1

r2

E1

E2

O Y0

E

Y1 Y2

LM Curve

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

0

Rate of Interest

Real GDP(Y)

LM1

LM2

When ‘MD’ is more

sensitive to ‘Y’ and less

sensitive to ‘r’

When ‘MD’ is less

sensitive to ‘Y’ and

more sensitive to ‘r

Supply and Demand for Money

Rate of Interest

MD (Y0)

MS

M0

SHIFTING OF LM CURVE

r0 E0

O

Income(Y)

Rate of Interest

r0 E0

O Y0

LM0

MS

M1

E1

r1 r1E1

LM1

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.

Simultaneous Equilibrium in Product and Money Market

IS:

Y

rLM:

r0

Y0

E

Goods Market Equilibrium.

Money Market Equilibrium.

( , )M P L r Y=

( ) ( )Y C Y T I r G= − + +

Excess Demandfor goods

r

Y

D A

C

YC YA

rA

rB

B � At A - Product Market is in

equilibrium.

At B we will have Excess Supply of goods in the goods market. ↑↑↑↑r →→→→ ↓↓↓↓I →→→→ ↓↓↓↓ AD→→→→ ↓↓↓↓ YA>ADB (Excess Supply of goods).

Disequilibrium in Product Market

� At point B, Y=YA, but rB > rA

� Suppose r increases from

rA to rB.

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).

IS

Income(Y)

rCC

O YB

LM0(P0M0)

rA BA

YA

D

� Initially at A: MD = MS).

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.

rDisequilibrium in Money Market

� 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).

Disequilibrium in IS-LM

� 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’

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.

Disequilibrium in IS-LM

IS

Y

rLM

r0

Y0

E

� Any point other than point E

is point of disequilibrium.

A

BM

NK

V

L

T

� Point A&B: I=S but L≠ M

� Point K: L<M & S<I

� Point M&N: L=M but I≠ S

� Point K: L>M & S<I

� Point V: L>M & S>I

� Point L: L<M & S<I

How Equilibrium is re-established in IS-LM

IS

Y

rLM

r0

Y0

E

A

When Disequilibrium is in only One Market

At point ‘A’ economy is in equilibrium

in product market and disequilibrium

in money market.

r2

r1

Y2 Y1

At A, excess supply of money reduces r0 to r1

Lower interest rates at r1 , increases

investment which increases income to Y1

Higher Income increase demand for money and interest

rates till economy reaches at point E

How Equilibrium is re-established in IS-LM

IS

Y

rLM

r0

E

D

When Disequilibrium is in only One Market

At point ‘D’ economy is in equilibrium in money

market (L=M) and disequilibrium in Product Market.

r1

Y2 Y0

As D lies right of IS curve, means supply

in good markets, that is S>I or AE<AS

Low demand in good market

reduces income from Yo

This reduces money demand. Lower

demand for money reduces interest rates.

This process continues till equilibrium is resorted at point ‘E’

where both markets are in equilibrium

Shift in the IS and LM curve and Change in Equilibrium

IS0

Y

rLM

r0

Y0

E

IS

Y

rLM

Y0

IS1

IS2E1

Y1

E2

r1

r2

Y2r0 E

E1

Y1

E2

r1

r2

Y2

LM2

Derivation of AD CurveIS

Y

r

Y0

r0 E

E1

Y1

E2

r1

r2

Y2

Y

r

Y0

P0

Y1

P1

P2

Y2

LM at P0

LM 2 at P2

A

B

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

C

AD curve

IS

Y

r

Y0

r0 E

E1

Y1

E2

r1

r2

Y2

Y

r

Y0

P

Y1Y2

LM

LM2

AC

BP

ADAD1

AD2

Derivation of AD Curve if LM

curve shift due to factors

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

IS

Y

r

Y0

r0 E

E1

Y1

E2

r1

r2

Y2

Y

r

Y0

P

Y1Y2

LM

LM2

AC

BP

ADAD1

AD2

Monetary Policy

and AD Curve

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.

Y

r

Y0

P

Y1Y2

AC

BP

ADAD1

AD2

Fiscal Policy and

AD Curve

Expansionary Fiscal Policy:

� Shift IS curve right to IS1.

� Increase income to Y1� Shift AD curve to AD1

Contractionary Fiscal Policy:

� Shift IS curve Left to IS2.

� Decreases income to Y2� Shift AD curve to AD2.

IS0

Y

rLM

r0

Y0

E

IS1

IS2E1

Y1

E2

r1

r2

Y2

� 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 .

Weaknesses of IS-LM Model

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.

REFERENCES

�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.

FAQs