ISLM Analysis

ISLM analysis

Deriving the IS curve

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1 (W1)

I1 (J1)
O
Rate of interest

r1

O
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1 (W1)

I1 (J1)
O
Y1
Rate of interest

r1

O
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1 (W1)

I1 (J1)
O
Y1
Rate of interest

r1

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1 (W1)

I1 (J1)
O
Y1
Rate of interest

r1 a

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1 (W1)
S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1 (W1)
S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1 (W1)
S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2
b

O
Y1
Goods market equilibrium: deriving the IS curve

Injections, Withdrawals
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1 (W1)
S2 (W2)
I2 (J2)
I1 (J1)
O
Y1 Y2
Rate of interest

r1 a

r2
b

IS
(J = W)
O
Y1
 ISLM analysis

Deriving the LM curve

 Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
Rate of interest

Rate of interest
L'

O O Y1
Money National income
 Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
MS
Rate of interest

Rate of interest
L'

O O Y1
Money National income
 Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
MS
Rate of interest

Rate of interest
r1 r1

L'

O O Y1
Money National income
 Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
MS
Rate of interest

Rate of interest
r1 r1
c

L'

O O Y1
Money National income
 Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest

Rate of interest
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest

Rate of interest
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS LM
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income
 ISLM analysis

Equilibrium
 Equilibrium in both the goods and money markets
LM
Rate of interest

IS

O
National income
 Equilibrium in both the goods and money markets
LM
Assume that national income
is currently at a level of Y1
Rate of interest

IS

O Y1
National income
 Equilibrium in both the goods and money markets
LM
This gives a rate of
interest of r1 (point a)
Rate of interest

a
r1

IS

O Y1
National income
 Equilibrium in both the goods and money markets
LM
But at r1, national income
is below the goods market
equilibrium level (Y2)
Rate of interest

a b
r1

IS

O Y1 Y2
National income
 Equilibrium in both the goods and money markets
But as income rises, so there
LM
will be a movement up the
LM curve. The interest rate
will rise, thereby reducing
national income below Y2.
Rate of interest

a b
r1

IS

O Y1 Y2
National income
 Equilibrium in both the goods and money markets
LM
Rate of interest

re

IS

O Ye
National income
 ISLM analysis

ISLM analysis of
changes in goods
and money markets
ISLM analysis of changes in the goods and money markets
LM
Rate of interest

r1

IS

O Y1
National income
ISLM analysis of changes in the goods and money markets
LM
A rise in
injections
Rate of interest

r2
r1

IS2

IS1

O Y1 Y2
National income
ISLM analysis of changes in the goods and money markets
LM1 LM2
A rise in the
money supply
Rate of interest

r1

r3

IS

O Y1 Y3
National income
ISLM analysis of changes in the goods and money markets

A rise in both LM1 LM2

injections and
money supply
Rate of interest

r1

IS2

IS1

O Y1 Y4
National income
 ISLM analysis

Deriving an AD curve
from an ISLM diagram
Deriving the AD curve from an ISLM diagram

Rate of interest (r)

LM1

a
r1
IS

Y1
National income (Y)
Price level (P)

P1 a'

Y1
National income (Y)
Deriving the AD curve from an ISLM diagram
LM2
Rate of interest (r)
LM1

b
r2
a
r1
IS

Y2 Y1
National income (Y)
Price level (P)

P2 b'

P1 a'
AD

Y2 Y1
National income (Y)
 ISLM analysis

ISLM analysis of
fiscal and
monetary policy
 ISLM analysis of fiscal and monetary policy
LM
Rate of interest

r1

IS

O Y1
National income
 ISLM analysis of fiscal and monetary policy
LM
Expansionary
fiscal policy
Rate of interest

r2
r1

IS2

IS1

O Y1 Y2
National income
 ISLM analysis of fiscal and monetary policy
LM1 LM2
Expansionary
monetary policy
Rate of interest

r1

r3

IS

O Y1 Y3
National income
 ISLM analysis of fiscal and monetary policy
Expansionary LM1 LM2
fiscal and
monetary policy
Rate of interest

r1

IS2

IS1

O Y1 Y4
National income