Académique Documents
Professionnel Documents
Culture Documents
AND
AGGREGATE
DEMAND
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
Derivation of IS Curve
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
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.
Agg. Exp.
Rate of Interest
S&I
0
I0
I1
I2
0
S
r2
r1
r0
0
F
E
Y2
Y1
Y0
G
F
E
Y2
Y1
Y0
Y=AE
Good Market
AE0 (I0, r0)
Equilibrium
AE1 (I1, r1)
AE2 (I2, r2)
Y=AE=C(Y-T)+I(r)+G
Income
S
I0 atr0
I1atr1
I2atr2
Income
E
F
G
Y2
Y1
Y0
Income
I = Ia-br, b>0
SLOPE OF IS CURVE
The slope of the IS curve depends on:
The sensitivity of investment (AE) to interest rate changes
Rate of Interest
When I is more
sensitive to r and when
multiplier value is
high(high MPC)
IS1
IS2
0
Real GDP(Y)
Shifting of IS Curve
Y=AE
Aggregate. Exp..
E1
Rate of Interest
IS0
1
Y1
IS1
r0
0
F1
r1
AE0 (r0)
A0E0 (r0)
AE1 (r1)
A1E0 (r1)
Y1
1
Y0
Y0
E
E1
F
F1
1
Y1
Y2
1
Y0
Y0
Income
Mt = K(y) : 1>K>0
K = Proportion of income kept
Y1
Y0
M0 M1
r1
r2
Liquidity Trap
r0
O M1 M2
Ms
Rate of Interest
Supply of Money
MS
Rate of Interest
YD
r1
O
M
Supply of Money
MD = Mt + Ms
or
MD = K(y) + L(r)
MD (YD)
M0
M1
Demand for Money
Rate of Interest
MS
r2
r1
E2
E1
r0
E
M P = L (r ,Y )
MD
(Y2)
MD (Y1)
MD (Y0)
M/P
Supply and Demand for Money
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.
DERIVATION OF LM CURVE
Rate of Interest
MD (Y2)
MS
Rate of Interest
LM Curve
MD (Y1)
r2
E2
r2
E2
E1
r1
E1
r1
r0
r0
MD (Y0)
O
Y0 Y1 Y2
Income(Y)
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
When MD is more
sensitive to Y and less
sensitive to r
Rate of Interest
LM1
LM2
0
Real GDP(Y)
When MD is less
sensitive to Y and
more sensitive to r
SHIFTING OF LM CURVE
Rate of Interest
MS
MD
r0
Rate of Interest
LM0
(Y0)
E0
r1
MS
r0
E1
M0
M1
r1
O
E0
E1
Y0
Income(Y)
LM1
Y0
Y = C (Y T ) + I (r ) + G
IS: Goods Market Equilibrium.
rB
rA
At A - Product Market is in
equilibrium.
Suppose r increases from
rA to rB.
Excess Demand
for goods
YC
YA
IS
LM0(P0M0)
Initially at A: MD = MS).
rC
rA
D
A
Income(Y)
O
YA
YB
Disequilibrium in IS-LM
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.
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
Disequilibrium in IS-LM
r
LM
r0
B
T
N
KA
Y0
IS
r2
r1
Y0
Y2
Y1
r0
r1
D
E
Y
Y2 Y0
This process continues till equilibrium is resorted at point E
where both markets are in equilibrium
r1
r0
r2
IS1
LM
IS2
E1
E
LM2
E2
Y2 Y0 Y1
r2
r0
r1
LM
E2
E
E1
IS
Y2 Y0 Y1
LM 2 at P2
Derivation of AD Curve
IS
LM at P0
r2
E2
r0
r1
r
E1
Y0
Y2
Y1
P2
P0
P1
A
B
AD curve
Y2
Y0
Y1
LM2
Derivation of AD Curve if LM
IS
curve shift due to factors
r2
other than price level
LM
E2
r0
r1
r
E1
Y2 Y0
Y1
B
C
P
AD1
AD AD
2
Y2
Y0
Y1
LM2
IS
Monetary Policy
and AD Curve
LM
r2
E2
r0
r1
r
E1
Y2 Y0
Y1
B
C
AD1
AD AD
2
Y2
Y0
Y1
r
IS1
IS0
r1
E1
IS2
r0
r2
r
LM
E2
Y2 Y0
B
C
Y1
P
AD1
AD AD
2
Y2
Y0
Y1
REFERENCES
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.
FAQs
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.