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IS-LM Model for Economics Students

The document discusses the IS-LM model, which was proposed by John Hicks and Alvin Hansen to graphically represent John Maynard Keynes' theory that goods and money markets are interdependent, not independent. The IS-LM model examines the joint equilibrium of the goods market (where investment equals savings) and the money market (where demand for liquidity equals the money supply). The IS curve shows combinations of interest rates and income where the goods market is in equilibrium. The LM curve shows combinations where the money market is in equilibrium. Where the IS and LM curves intersect represents the overall equilibrium in both markets simultaneously and determines the equilibrium interest rate and level of income or output.

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Bakchodi Nhi
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120 views18 pages

IS-LM Model for Economics Students

The document discusses the IS-LM model, which was proposed by John Hicks and Alvin Hansen to graphically represent John Maynard Keynes' theory that goods and money markets are interdependent, not independent. The IS-LM model examines the joint equilibrium of the goods market (where investment equals savings) and the money market (where demand for liquidity equals the money supply). The IS curve shows combinations of interest rates and income where the goods market is in equilibrium. The LM curve shows combinations where the money market is in equilibrium. Where the IS and LM curves intersect represents the overall equilibrium in both markets simultaneously and determines the equilibrium interest rate and level of income or output.

Uploaded by

Bakchodi Nhi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

MACROECONOMICS

Lecture 7: IS-LM Model


IS-LM MODEL

IS-LM Model was proposed by John Hicks and Alvin Hansen


and hence, known as Hicks-Hansen model

J.M. Keynes criticised the classical model of income and


employment by saying that goods and money markets are not
independent rather interdependent

He said simultaneous equilibrium can be worked out to show


this interdependence

Hick and Hansen gave the graphical representation of Keynes’


thoughts with IS-LM Model
IS-LM MODEL

Model examines the combined equilibrium of two markets :

Goods Market- is at equilibrium when investments equal


savings.

Money Market- is at equilibrium when the demand for


liquidity equals money supply.

Examining the joint equilibrium in these two markets helps


in determination of output (Y) and the interest rate (Ri).
GOODS MARKET & IS CURVE

IS curve shows all the combinations of interest rates (Ri)


and outputs or level of income (Y) at which desired saving
is equal to desired investment or at which the goods market
is in equilibrium

It is based on the goods market equilibrium which we


discussed under classical model of income and output
determination
GOODS MARKET & IS CURVE

Assumptions:
Consumption is the function of disposable income
Investment is determined by rate of interest and both are
negatively related
Investment is a combination of private investment and
government investment
Government investment is exogenous in nature and does not
change with income
Saving is calculated by subtracting consumption and taxes
from income
IS CURVE

S
Saving

Govt.
Investment

Y
Ri
Ri

45°
IS

Y
GOVERNMENT INVESTMENT & IS CURVE

IS curve shifts upwards, if government spending increases


IS curve shifts downwards, if government spending falls
SHIFT IN IS CURVE

Saving
Govt.
Investment Fall in public
investment

Ri Income
i i

IS shifts
downwards

45° IS
IS’
i Y
LM CURVE

LM curve shows all the combinations of interest rates and


outputs/income (Y) at which demand for liquidity is equal to
supply of liquidity

LM curve is based on money market equilibrium


LM CURVE

Demand for liquidity depends upon the level of income and


rate of interest

MD  L1 Y  L2 i 
 

Transaction and Precautionary Motive: Demand for


liquidity for these motives depend upon income (L1)

Speculation Motive: Money demanded for speculative


motive is a function of rate of interest (L2)
Demand for Transaction & Precautionary Motives

Income

L1(Y)

Demand for Liquidity


Demand for Speculative Motive

Rate of
Interest At very low level of interest, the money
demanded becomes infinite: people want
to hold back liquidity

Liquidity Trap
L2(R i)

Demand for
Liquidity
LM CURVE

Ri Ri
LM

Income L2(Y)
L1(Y) L1(Y) L1(Y)

45°
Income L2(Y)
MONEY SUPPLY & LM

If money supply increases, LM curve will shift downwards

If money supply falls, LM curve shifts upwards


SHIFT IN LM CURVE
LM shifts
upwards to the
LM’
Ri left Ri
LM

L2(Ri)

Y L2(Y)
L1(Y) L1(Y) L (Y)
1

Fall in money
supply

45° 45°

Y L2(Y)
EQUILIBRIUM IN GOODS & MONEY MARKET
Intersection of IS and LM represents the simultaneous
equilibrium in goods and the money market
Interest rate

LM

Ri

IS

Y Income, Output (Y)


CONCLUSION

 LM is based on the money market equilibrium showing


the equality of demand for liquidity and supply of liquidity

 LM can shift upwards or downwards due to change in


money supply in money market

 Simultaneous equilibrium in goods and money market


can be worked out with IS-LM curves

 Both the markets are in equilibrium when IS curve


intersects LM curve
THANK YOU 

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