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1. IS – LM MODEL

2. INVESTMENTS
•INVESTMENT IS NO
LONGER AUTONOMOUS. IT
IS NOW DEPENDENT ON
INTEREST RATE.
•HIGHER THE INTEREST
RATE, LOWER WILL BETHE
INVESTMENT.
•I = Ῑ - b i
b TELLS THE INTEREST
RATE RESPONSIVENESS OF

3. AGGREGATE DEMAND
•AD= Ᾱ - bi –c( 1- t)Y
Equilibrium in the goods market now requires
AD = Y
Y= Ᾱ - bi = αG (Ᾱ- bi) where αG= 1-c( 1-t)
1-c( 1-t)

4. IS curve
It is the combination of all those points at which
the goods market is in equilibrium.
EQUATION OF IS CURVE
i = Ᾱ - Y
b αG b
Reason why it is
downward sloping:
It tells as the
interest rate falls,
investment will increase
and thus output.

5. Slope of the IS curve
•It depends on αG , b
•Higher the αG, flatter the IS curve, higher the
change in output with a given change in interest
rate.
reason: higher αG means higher MPC , higher
MPC implies higher output.
•Higher b, flatter the IS curve, higher the change
in output with a given change in interest rate.
reason: Higher b means that investment is
highly sensitive to the interest rate, so small

6. Disequilibrium points in IS curve
•E3 and E4 are disequilibrium points.
•At E3, interest rate is lower than the rate i1 i.e.
needed to attain equilibrium. At this point the
investment will be higher. Thus, AD is higher
than output.
•At E4, output is higher than the AD. Thus,
excess supply of
good

7. Wealth constraint
•Wealth is stored either in form of money or in
form of assets such as bonds.
•Money provide convenience for transactions.
But it doesn’t provide ay interest rate. Thus
interest rate is the opportunity cost of holding
money.
•Bonds provide interest rate but can’t be used
for transaction purposes.
•Real wealth= real demand of money balances +
real demand of bonds.

8. Real demand of money balances.
L= k Y – hi
Here k tells the income responsiveness to demand
of real balances.
h tells the interest rate responsiveness to demand
of real balances.
High income, allows individual to hold large
amount of money. Thus, demand of real balances
is positively related to income.
Higher the interest rate, higher is the opportunity
cost of holding money. Thus , demand of real

9. Real
demand
of
money
balances

10. LM curve
•It is the combination of all those points at
which money market is in equilibrium.
•With a given money supply, we can derive the
LM curve from the demand of real balances
curve.
•Reason why it is upward sloping:
as the interest rate increase, demand of bonds
increase and thus demand of money falls. With
the same level of money supply, inorder to
achieve equilibrium income should increase.

11. Derivation of LM curve

12. LM curve
L = money supply.
kY – hi = m͞ / ͞p
kY – m͞ / ͞p = hi
i = kY - m͞ / ͞p
h h

13. Slope of LM curve
•It depends on k and h
•Higher k, steeper the LM curve, smaller will the
increase in the income due to given change in
interest rate. Or large change in interest rate
with a given change in income.
reason: if the income increase then the
demand of money will rise by large amount.
Thus, we require a huge increase in interest rate
to bring the market into equilibrium.
•lower h, steeper the LM curve, smaller will the
increase in the income due to given change in
interest rate.

14. Points off the LM curve
•E1 is ESM
•Reason: at higher
interest rates, demand
of bonds is high and
thus there is excess
supply of money.
•E3 is EDM
•Reason: at same
interest rate i1 income
rise to Y2 . Thus,
E1
E2
E3E4
Y1 Y2
i2
i1

15. How the equilibrium output and
interest rate are determined
•They are determined by the intersection of two
curves IS and LM.
•So that at equilibrium both the goods market
and the asset market is in equilibrium.
•IS: Y= αG( Ᾱ- bi)
LM :i = kY - m͞ / ͞p
h h
•Substituting the value of I from LM into Is will
give

17. What causes changes in
equilibrium points
•Shifts in IS or LM curves , will bring changes in
equilibrium points.
•Shift in LM due to changes in money supply
•Shift in IS due to change in autonomous
spending.

18. Suppose there is increase in
autonomous spending
•This will shift IS curve rightwards.
•Change in Y is less than the αG
•Reason: y L with the same money
supply i I
Y
• thus, both asset
market and goods
market clears

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