Lecture 8 - IS-LM Analysis | Macroeconomics- Learning and Analysis PDF Download

 Page 1


IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
The Goods Market and the Money Market: The 
Simultaneous Equilibrium 
Lesson: IS-LM Analysis 
Lesson Developer: Amit Girdharwal 
College/ Department: Dyal Singh College, University of 
Delhi 
  
  
Page 2


IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
The Goods Market and the Money Market: The 
Simultaneous Equilibrium 
Lesson: IS-LM Analysis 
Lesson Developer: Amit Girdharwal 
College/ Department: Dyal Singh College, University of 
Delhi 
  
  
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
Contents 
1. Learning Outcomes 
2. Introduction 
3. Goods Market Equilibrium: Derivation of the IS curve 
4. The Investment demand schedule 
5. Slope of the IS curve 
6. Steepness of the IS curve 
7. Shifts in the IS curve 
8. Money Market Equilibrium: Derivation of LM Curve 
9. Slope of the LM curve 
10. Shifts in the LM curve 
11. Simultaneous Equilibrium in the Goods Market and the Money Market: The 
intersection of the IS and the LM curves 
12. Excess Demand and Excess Supply in the Goods Market and the Money 
Market Simultaneously 
13. Impacts of Monetary and Fiscal Policies 
14. The Transmission Mechanism 
15. IS-LM and the Aggregate Demand Curve 
16. Conclusion 
17. Summary 
18. Multiple choice questions 
19. QUESTIONS FOR REVIEW 
20. Bibliography 
 
1. Learning Outcomes 
 After reading this chapter, you should be able to; 
? Explain the two way relationship between the goods market and the money 
market. 
? Derive the IS-LM curves. 
? Discuss the simultaneous equilibrium in the goods market and the money market. 
? Understand the impacts of the monetary and fiscal policies on the equilibrium 
level of real output and their implications. 
? To derive the AD curve with the help of IS-LM curves. 
 
2. Introduction 
According to J.M.Keynes, the national income is determined by the three factors in the 
closed economy model, namely, consumption demand, investment demand and the 
government expenditure (Y= C + I +G). Any change in these factors amounts to change 
in the equilibrium level of income. In Keynes psychological law of consumption function 
(C = a +bY), we studied that as income increases, consumption also increases but 
Page 3


IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
The Goods Market and the Money Market: The 
Simultaneous Equilibrium 
Lesson: IS-LM Analysis 
Lesson Developer: Amit Girdharwal 
College/ Department: Dyal Singh College, University of 
Delhi 
  
  
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
Contents 
1. Learning Outcomes 
2. Introduction 
3. Goods Market Equilibrium: Derivation of the IS curve 
4. The Investment demand schedule 
5. Slope of the IS curve 
6. Steepness of the IS curve 
7. Shifts in the IS curve 
8. Money Market Equilibrium: Derivation of LM Curve 
9. Slope of the LM curve 
10. Shifts in the LM curve 
11. Simultaneous Equilibrium in the Goods Market and the Money Market: The 
intersection of the IS and the LM curves 
12. Excess Demand and Excess Supply in the Goods Market and the Money 
Market Simultaneously 
13. Impacts of Monetary and Fiscal Policies 
14. The Transmission Mechanism 
15. IS-LM and the Aggregate Demand Curve 
16. Conclusion 
17. Summary 
18. Multiple choice questions 
19. QUESTIONS FOR REVIEW 
20. Bibliography 
 
1. Learning Outcomes 
 After reading this chapter, you should be able to; 
? Explain the two way relationship between the goods market and the money 
market. 
? Derive the IS-LM curves. 
? Discuss the simultaneous equilibrium in the goods market and the money market. 
? Understand the impacts of the monetary and fiscal policies on the equilibrium 
level of real output and their implications. 
? To derive the AD curve with the help of IS-LM curves. 
 
2. Introduction 
According to J.M.Keynes, the national income is determined by the three factors in the 
closed economy model, namely, consumption demand, investment demand and the 
government expenditure (Y= C + I +G). Any change in these factors amounts to change 
in the equilibrium level of income. In Keynes psychological law of consumption function 
(C = a +bY), we studied that as income increases, consumption also increases but 
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
increase in consumption is less than proportionate. In the multiplier process, we learnt 
that the value of multiplier depends upon the marginal propensity to consume (mpc). 
Higher the value of mpc, higher the value of multiplier (k = 1 – 1/mpc). Thus, change in 
the consumption level leads to change in the real output. The second component, 
investment, is determined by the rate of interest, combined with the marginal efficiency 
of capital. The rate of interest and the planned investment are inversely related. Higher 
the interest rate, lower the planned investment and vice versa. As the rate of interest 
affects the level of investment, and investment is a component of national income, thus, 
change in the interest rate also has its impact on Gross Domestic Product (GDP). The 
rate of interest is determined by the demand for money (M
d
) and the supply of money 
(M
s
) in the money market. So, there is a two-way relationship between the goods 
market (C + I + G) and the money market (M
d
 =M
s
). This two-way relationship between 
the goods market and the money market seems to be absent in Keynesian model of 
income determination. 
  Later J.R.Hicks, Hansen ,Abba.P.Lerner and other economists analysed the Keynesian 
theory in much depth and found the joint relationship between the goods market and 
money market. They put forward a more comprehensive and integrated model of 
Keynesian framework wherein the variables such as demand for and supply of money, 
national income, rate of interest and the level of investment are inter-related and 
interdependent. This extended version of Keynesian model is explained with the help of 
two curves called the IS (IS stands for ‘Investment’ and ‘Saving’) and LM (LM stands for 
Liquidity i.e. demand for money, and supply of money) curves and, therefore, known as 
IS-LM curve model. The impacts, effectiveness and the implications of the monetary and 
fiscal policies on the real GDP can be easily understood with the help of IS-LM curves. 
The IS-LM model has now become one of the most important and basic tools of 
macroeconomics to predict the futuristic behaviour and appropriateness of various 
policies and variables. 
Now we will discuss the IS-LM model in detail. First we will derive the IS-LM curves and 
later we will examine the impacts of monetary and fiscal policies on the level of GDP and 
the rate of interest and their implications. 
3. Goods Market Equilibrium: Derivation of the IS curve 
The IS-LM model explains the interaction of the goods market and the money market 
and their simultaneous equilibrium. The goods market is in equilibrium when aggregate 
demand (consumption demand, investment demand and the government expenditure 
equals aggregate expenditure or national income(Y =AD = AE = C + I + G) such that 
planned investment is equal to the planned savings (I
p
 = S
p
).  The Investment is a 
component of aggregate demand and negatively related with the rate of interest. When 
investment increases (because of low interest rate), there is a change in aggregate 
demand. Higher aggregate demand leads to higher level of national income. Thus, the 
rate of interest and the level of income are inversely related. The IS curve shows 
equilibrium level of income associated with each given rate of interest such that planned 
saving and planned investment are equal.   
In the diagram 1, panel A, the investment demand curve is explained. The Investment 
demand curve is negatively sloped. The Aggregate demand schedule and national 
income is depicted in panel B. In panel C, the IS curve is derived. 
Page 4


IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
The Goods Market and the Money Market: The 
Simultaneous Equilibrium 
Lesson: IS-LM Analysis 
Lesson Developer: Amit Girdharwal 
College/ Department: Dyal Singh College, University of 
Delhi 
  
  
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
Contents 
1. Learning Outcomes 
2. Introduction 
3. Goods Market Equilibrium: Derivation of the IS curve 
4. The Investment demand schedule 
5. Slope of the IS curve 
6. Steepness of the IS curve 
7. Shifts in the IS curve 
8. Money Market Equilibrium: Derivation of LM Curve 
9. Slope of the LM curve 
10. Shifts in the LM curve 
11. Simultaneous Equilibrium in the Goods Market and the Money Market: The 
intersection of the IS and the LM curves 
12. Excess Demand and Excess Supply in the Goods Market and the Money 
Market Simultaneously 
13. Impacts of Monetary and Fiscal Policies 
14. The Transmission Mechanism 
15. IS-LM and the Aggregate Demand Curve 
16. Conclusion 
17. Summary 
18. Multiple choice questions 
19. QUESTIONS FOR REVIEW 
20. Bibliography 
 
1. Learning Outcomes 
 After reading this chapter, you should be able to; 
? Explain the two way relationship between the goods market and the money 
market. 
? Derive the IS-LM curves. 
? Discuss the simultaneous equilibrium in the goods market and the money market. 
? Understand the impacts of the monetary and fiscal policies on the equilibrium 
level of real output and their implications. 
? To derive the AD curve with the help of IS-LM curves. 
 
2. Introduction 
According to J.M.Keynes, the national income is determined by the three factors in the 
closed economy model, namely, consumption demand, investment demand and the 
government expenditure (Y= C + I +G). Any change in these factors amounts to change 
in the equilibrium level of income. In Keynes psychological law of consumption function 
(C = a +bY), we studied that as income increases, consumption also increases but 
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
increase in consumption is less than proportionate. In the multiplier process, we learnt 
that the value of multiplier depends upon the marginal propensity to consume (mpc). 
Higher the value of mpc, higher the value of multiplier (k = 1 – 1/mpc). Thus, change in 
the consumption level leads to change in the real output. The second component, 
investment, is determined by the rate of interest, combined with the marginal efficiency 
of capital. The rate of interest and the planned investment are inversely related. Higher 
the interest rate, lower the planned investment and vice versa. As the rate of interest 
affects the level of investment, and investment is a component of national income, thus, 
change in the interest rate also has its impact on Gross Domestic Product (GDP). The 
rate of interest is determined by the demand for money (M
d
) and the supply of money 
(M
s
) in the money market. So, there is a two-way relationship between the goods 
market (C + I + G) and the money market (M
d
 =M
s
). This two-way relationship between 
the goods market and the money market seems to be absent in Keynesian model of 
income determination. 
  Later J.R.Hicks, Hansen ,Abba.P.Lerner and other economists analysed the Keynesian 
theory in much depth and found the joint relationship between the goods market and 
money market. They put forward a more comprehensive and integrated model of 
Keynesian framework wherein the variables such as demand for and supply of money, 
national income, rate of interest and the level of investment are inter-related and 
interdependent. This extended version of Keynesian model is explained with the help of 
two curves called the IS (IS stands for ‘Investment’ and ‘Saving’) and LM (LM stands for 
Liquidity i.e. demand for money, and supply of money) curves and, therefore, known as 
IS-LM curve model. The impacts, effectiveness and the implications of the monetary and 
fiscal policies on the real GDP can be easily understood with the help of IS-LM curves. 
The IS-LM model has now become one of the most important and basic tools of 
macroeconomics to predict the futuristic behaviour and appropriateness of various 
policies and variables. 
Now we will discuss the IS-LM model in detail. First we will derive the IS-LM curves and 
later we will examine the impacts of monetary and fiscal policies on the level of GDP and 
the rate of interest and their implications. 
3. Goods Market Equilibrium: Derivation of the IS curve 
The IS-LM model explains the interaction of the goods market and the money market 
and their simultaneous equilibrium. The goods market is in equilibrium when aggregate 
demand (consumption demand, investment demand and the government expenditure 
equals aggregate expenditure or national income(Y =AD = AE = C + I + G) such that 
planned investment is equal to the planned savings (I
p
 = S
p
).  The Investment is a 
component of aggregate demand and negatively related with the rate of interest. When 
investment increases (because of low interest rate), there is a change in aggregate 
demand. Higher aggregate demand leads to higher level of national income. Thus, the 
rate of interest and the level of income are inversely related. The IS curve shows 
equilibrium level of income associated with each given rate of interest such that planned 
saving and planned investment are equal.   
In the diagram 1, panel A, the investment demand curve is explained. The Investment 
demand curve is negatively sloped. The Aggregate demand schedule and national 
income is depicted in panel B. In panel C, the IS curve is derived. 
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
4. The Investment demand schedule 
 The Investment is spending on additions of capital, such as machines, plants, building 
etc. The investment function is 
                           I =     I
a
 – br                   b > 0   
Where I
a
 is the autonomous investment spending and coefficient ‘b’ denotes the 
sensitivity of investment to the interest rate, r, the autonomous investment is 
independent of level of income and rate of interest. 
-
 
Figure 1: Derivation of the IS Curve 
 
At higher rate r
0
, the planned investment is OI
0 
(panel A). With this planned investment, 
the aggregate demand curve is C+I
0
 and the level of income is OY
0
. In panel C (rate of 
interest and level of income is shown on vertical and horizontal axis respectively) the 
Page 5


IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
 
 
 
 
 
 
 
 
 
 
The Goods Market and the Money Market: The 
Simultaneous Equilibrium 
Lesson: IS-LM Analysis 
Lesson Developer: Amit Girdharwal 
College/ Department: Dyal Singh College, University of 
Delhi 
  
  
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
Contents 
1. Learning Outcomes 
2. Introduction 
3. Goods Market Equilibrium: Derivation of the IS curve 
4. The Investment demand schedule 
5. Slope of the IS curve 
6. Steepness of the IS curve 
7. Shifts in the IS curve 
8. Money Market Equilibrium: Derivation of LM Curve 
9. Slope of the LM curve 
10. Shifts in the LM curve 
11. Simultaneous Equilibrium in the Goods Market and the Money Market: The 
intersection of the IS and the LM curves 
12. Excess Demand and Excess Supply in the Goods Market and the Money 
Market Simultaneously 
13. Impacts of Monetary and Fiscal Policies 
14. The Transmission Mechanism 
15. IS-LM and the Aggregate Demand Curve 
16. Conclusion 
17. Summary 
18. Multiple choice questions 
19. QUESTIONS FOR REVIEW 
20. Bibliography 
 
1. Learning Outcomes 
 After reading this chapter, you should be able to; 
? Explain the two way relationship between the goods market and the money 
market. 
? Derive the IS-LM curves. 
? Discuss the simultaneous equilibrium in the goods market and the money market. 
? Understand the impacts of the monetary and fiscal policies on the equilibrium 
level of real output and their implications. 
? To derive the AD curve with the help of IS-LM curves. 
 
2. Introduction 
According to J.M.Keynes, the national income is determined by the three factors in the 
closed economy model, namely, consumption demand, investment demand and the 
government expenditure (Y= C + I +G). Any change in these factors amounts to change 
in the equilibrium level of income. In Keynes psychological law of consumption function 
(C = a +bY), we studied that as income increases, consumption also increases but 
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
increase in consumption is less than proportionate. In the multiplier process, we learnt 
that the value of multiplier depends upon the marginal propensity to consume (mpc). 
Higher the value of mpc, higher the value of multiplier (k = 1 – 1/mpc). Thus, change in 
the consumption level leads to change in the real output. The second component, 
investment, is determined by the rate of interest, combined with the marginal efficiency 
of capital. The rate of interest and the planned investment are inversely related. Higher 
the interest rate, lower the planned investment and vice versa. As the rate of interest 
affects the level of investment, and investment is a component of national income, thus, 
change in the interest rate also has its impact on Gross Domestic Product (GDP). The 
rate of interest is determined by the demand for money (M
d
) and the supply of money 
(M
s
) in the money market. So, there is a two-way relationship between the goods 
market (C + I + G) and the money market (M
d
 =M
s
). This two-way relationship between 
the goods market and the money market seems to be absent in Keynesian model of 
income determination. 
  Later J.R.Hicks, Hansen ,Abba.P.Lerner and other economists analysed the Keynesian 
theory in much depth and found the joint relationship between the goods market and 
money market. They put forward a more comprehensive and integrated model of 
Keynesian framework wherein the variables such as demand for and supply of money, 
national income, rate of interest and the level of investment are inter-related and 
interdependent. This extended version of Keynesian model is explained with the help of 
two curves called the IS (IS stands for ‘Investment’ and ‘Saving’) and LM (LM stands for 
Liquidity i.e. demand for money, and supply of money) curves and, therefore, known as 
IS-LM curve model. The impacts, effectiveness and the implications of the monetary and 
fiscal policies on the real GDP can be easily understood with the help of IS-LM curves. 
The IS-LM model has now become one of the most important and basic tools of 
macroeconomics to predict the futuristic behaviour and appropriateness of various 
policies and variables. 
Now we will discuss the IS-LM model in detail. First we will derive the IS-LM curves and 
later we will examine the impacts of monetary and fiscal policies on the level of GDP and 
the rate of interest and their implications. 
3. Goods Market Equilibrium: Derivation of the IS curve 
The IS-LM model explains the interaction of the goods market and the money market 
and their simultaneous equilibrium. The goods market is in equilibrium when aggregate 
demand (consumption demand, investment demand and the government expenditure 
equals aggregate expenditure or national income(Y =AD = AE = C + I + G) such that 
planned investment is equal to the planned savings (I
p
 = S
p
).  The Investment is a 
component of aggregate demand and negatively related with the rate of interest. When 
investment increases (because of low interest rate), there is a change in aggregate 
demand. Higher aggregate demand leads to higher level of national income. Thus, the 
rate of interest and the level of income are inversely related. The IS curve shows 
equilibrium level of income associated with each given rate of interest such that planned 
saving and planned investment are equal.   
In the diagram 1, panel A, the investment demand curve is explained. The Investment 
demand curve is negatively sloped. The Aggregate demand schedule and national 
income is depicted in panel B. In panel C, the IS curve is derived. 
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
4. The Investment demand schedule 
 The Investment is spending on additions of capital, such as machines, plants, building 
etc. The investment function is 
                           I =     I
a
 – br                   b > 0   
Where I
a
 is the autonomous investment spending and coefficient ‘b’ denotes the 
sensitivity of investment to the interest rate, r, the autonomous investment is 
independent of level of income and rate of interest. 
-
 
Figure 1: Derivation of the IS Curve 
 
At higher rate r
0
, the planned investment is OI
0 
(panel A). With this planned investment, 
the aggregate demand curve is C+I
0
 and the level of income is OY
0
. In panel C (rate of 
interest and level of income is shown on vertical and horizontal axis respectively) the 
IS-LM Analysis 
Institute of Lifelong Learning, University of Delhi 
 
corresponding point is A
0
, with the rate of interest is or
0 
and the level of income is OY
0
. 
When rate of interest falls to Or
1
, the planned investment increases to OI
I
 (panel A). 
With this increased investment, the aggregate demand curve shifts upward to C+I
1
 and 
the level of income is increased to OY
1
 (panel B). In panel C, the corresponding rate of 
interest is Or
1
, level of income is OY
1
 and the equilibrium point is A
1
. Further lowering 
the rate of interest to Or
2
 in panel A, the aggregate demand curve shifts further to C+I
2
 
(in panel B), and in the panel C the corresponding equilibrium point is at A
2
, with Or
2
 
rate of interest and OY
2
 level of income. By joining the points A
0
 A
1
 A
2 
in panel C, we 
obtain the IS curve, which is negatively sloped and shows the various combinations of 
rate of interest and level of income at which the goods market is in equilibrium. 
The IS curve shows the various combinations of rate of interest and level of income at 
which the goods market is in equilibrium and spending(C+I+G) equals the output(Y). 
5. Slope of the IS curve:   
 The IS curve is downward sloping. It shows the inverse relationship between the rate of 
interest and the level of income such that the goods market is in equilibrium. When the 
interest rate falls, the cost of borrowing funds becomes cheaper, and consequently, level 
of planned investment increases. With the higher level of investment, the national 
income also increases through multiplier process. 
6. Steepness of the IS curve: 
Steepness of the IS curve depends upon the size of the multiplier and the sensitivity of 
the investment demand curve to the rate of interest. Higher the value of multiplier, 
flatter the IS curve. Since the value of the multiplier (k) depends upon the marginal 
propensity to consume (k=1-1/mpc), so higher the value of mpc, higher the value of 
multiplier and flatter the IS curve. Smaller the mpc, lower the value of multiplier and 
steeper the IS curve. 
          Elasticity or the responsiveness of investment demand curve shows the degree of 
receptiveness or responsiveness of investment spending to the rate of interest. If the 
investment demand curve is highly elastic (flatter i.e. high degree of responsiveness), 
then a given fall in the interest rate will fetch more investment and consequently, a 
larger upward shift in aggregate demand curve i.e. larger expansion in the level of 
national income via multiplier effect and flatter the IS curve. 
7. Shifts in the IS curve 
 It is the level of autonomous expenditures which determines the position of the IS 
curve. If there is a change in any of the components of autonomous expenditures such 
as autonomous consumption, autonomous government expenditure or autonomous 
investment, it will shift the IS curve. Keep in mind that autonomous expenditure is free 
from the change in level of income and the rate of interest. Any increment in the 
autonomous expenditure (such as higher level of autonomous consumption or 
investment or government expenditure) shifts the IS curve to the right and decrease in 
the autonomous expenditure shifts the IS curve to the left.