IS-LM ANALYSIS

AND
AGGREGATE
DEMAND

DR. LAXMI NARAYAN

ASSISTANT PROFESSOR OF ECONOMICS
GOVT. COLLEGE FOR WOMEN, BHODIA KHERA
 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
 Why IS-LM Analysis?
Classical Economist: Rate of
interest is a real phenomenon
determined by saving and
investment
Keynes: rate of interest is
purely a monetary
phenomenon.
Both arguments were challenged because of indeterminacy as:

Rate of interest affects the level of GDP by its effect on Investment.

Level of GDP affects the rate of interest via demand for money.
A rise in level of GDP as a result of investment is cut short
when rate of interest rise as a result of increase in GDP
 Why IS-LM Analysis?
Hicks and Hensen integrated
both the real parameters of
savings and investment and
monetary parameters of
supply and demand for money
through IS-LM analysis. This
is popularly Known as Hicks-
Hensen Synthesis.
Simultaneous determination of rate of interest and the
real GDP and alternate derivation of AD curve is at the
core of IS-LM analysis.
 What is IS-LM Analysis?

The term IS refers to the

equality between Investment(I)
& saving(S) the corresponding
equilibrium in the Goods
Market.

The term LM refers to the equality between demand for

money (L)& Supply of money (M) and the corresponding
equilibrium in Money Market.
 IS Curve and Product
Market Equilibrium?
IS curve is the locus of different
combinations of Interest Rate(r)
and Level of GDP (Y) that are
consistent with equality between
saving and Investment or
Aggregate Output and Aggregate
Expenditure.
The IS curve represents all combinations of income (Y) and
the real interest rate (r) such that the market for goods and
services is in equilibrium. That is, every point on the IS
curve is an income/real interest rate pair (Y, r) such that the
demand for goods is equal to the supply of goods.
 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.
 Y=AE Good Market
G AE0 (I0, r0)
AE1 (I1, r1) Equilibrium
F AE2 (I2, r2)
Agg. Exp.

E Y=AE=C(Y-T)+I(r)+G

0 Y2 Y1 Y0 Income
S
G
I0 I0 atr0
I1 F I1atr1
S&I

I = Ia-br, b>0
I2 E I2atr2
0 Y2 Y1 Y0 Income
S
Rate of Interest

E
r2
F
r1 G
r0
0 Y2 Y1 Y0 Income
 SLOPE OF IS CURVE
The slope of the IS curve depends on:
 The sensitivity of investment (AE) to interest rate changes
 The value of multiplier When ‘I’ is more
sensitive to ‘r’ and when
multiplier value is
high(high MPC)
Rate of Interest

IS1
When ‘I’ is less sensitive
IS2 to ‘r’ and when multiplier
impact is low(low MPC)
0
Real GDP(Y)
 Factors that Shift the IS
Curve

A change in autonomous factors

that is unrelated to the interest rate

Changes in autonomous
consumer expenditure

Changes in planned investment spending unrelated to

the interest rate

Changes in government spending

Changes in taxes

Changes in net exports unrelated to the interest rate
 Shifting of IS Curve
Y=AE
F AE0 (r0)
A0E0 (r0)
Aggregate. Exp..

F1 AE1 (r1)
E
A1E0 (r1)
E1
0 Income
1 Y1 1 Y0
Y1 Y0 Decrease in Govt. Exp.
IS0
Decrease in Investment
Rate of Interest

IS1 E Increase in Taxes

r1 E1 Increase in Consumer Exp.
F
r0 F1 Decrease in Net Exports
0 1
Y2 1
Y0 Income
Y1 Y0
 LM Curve and Money
Market Equilibrium?
The LM curve shows all the
combinations of interest rates i
and outputs Y for which the
money market is in equilibrium.
"L" denotes Liquidity and "M"
denotes money,

The LM curve, is a graph of combinations of real income, Y,

and the real interest rate, r, such that the money market is in
equilibrium (i.e. real money supply = real money demand).
 DEMAND FOR MONEY
Y
Transaction Demand for Money(Mt)
K
Y1 Mt = K(y) : 1>K>0
Y0 K = Proportion of income kept
is cash for transaction purpose
Mt
O M0 M1
r Speculative Demand for Money(Ms)

r1 Ms = L(r) : L`<0

r2 Liquidity Trap
r0
O M1 M2 Ms
 Total Demand for money

MD = Mt + Ms
or
YD MD = K(y) + L(r)
Supply of Money

MS Rate of Interest r1
Rate of Interest

MD (YD)

O M0 M1
Demand for Money

O M
Supply of Money
 MONEY MARKET EQUILIBRIUM
MS M P = L (r ,Y )
Rate of Interest

r2 E2 Demand for money

when income is Y2
r1 E1 Demand for money
MD (Y2)
r0 when income is Y1
MD (Y1)
E
MD (Y0)
Demand for money
O M/P when income is Y0
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
MS Rate of Interest
MD (Y2) LM Curve
Rate of Interest

MD (Y1)
E2 r2 E2
r2
E1
r1 E1 r1
r0 E
E r0
MD (Y0)
O M O Y0 Y1 Y2
Supply and Demand for Money 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
LM1 sensitive to ‘r’
Rate of Interest

When ‘MD’ is less

sensitive to ‘Y’ and
LM2
more sensitive to ‘r
0
Real GDP(Y)
 SHIFTING OF LM CURVE
MS MS Rate of Interest
LM0 LM1
MD (Y0)
Rate of Interest

r0 E0 r0 E0

r1 E1
E1 r1

O M0 M1 O Y0
Supply and Demand for Money Income(Y)
 Simultaneous Equilibrium in Product and Money Market
r
LM: Money Market Equilibrium.
M P = L (r ,Y )

r0 E
Y = C (Y − T ) + I (r ) + G
IS: Goods Market Equilibrium.
Y
Y0
The intersection of the IS and LM curves represents simultaneous
equilibrium in the market for goods and services and in the
market for real money balances for given values of government
spending, taxes, the money supply, and the price level.
 Disequilibrium in Product Market
r
C B  At A - Product Market is in
rB
equilibrium.
D A  Suppose r increases from
rA
rA to rB.
Excess Demand
for goods  At point B, Y=YA, but rB > rA
IS
YC YA Y
At B we will have Excess Supply of goods in the goods market.
↑r → ↓I → ↓ AD→ → ↓ YA>ADB (Excess Supply of goods).
So at a Higher Interest Rate (such as rB), the only way to
return back to equilibrium is to have lower Y (such as YC).
 Disequilibrium in Money Market
r LM0(P0M0)
 Initially at A: MD = MS).
 Suppose Y Increases from
rC C YA to YB and we move to B. At
D
B, r = rA but Y increases to YB.
rA B  Increase in Y increase in
A Md  Md> MS (Excess
Demand for money).
Income(Y)
O YA YB
For the Money Market to return back to equilibrium we need to
have an increase in r so as to decrease Md back to the given MS
level. And at this higher Y level (YB) r has to ↑ to C (rC) to ↓ Md to
its old level so that Md=MS again.
 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
Any point other than point E
LM
is point of disequilibrium.
M
Point A&B: I=S but L≠ M
B L
T V

Point M&N: L=M but I≠ S
r0 E
N

Point K: L>M & S<I
KA IS
Point V: L>M & S>I

Point L: L<M & S<I
Y0 Y

Point K: L<M & S<I
How Equilibrium is re-established in IS-LM

When Disequilibrium is in only One Market

r At point ‘A’ economy is in equilibrium

LM in product market and disequilibrium
A in money market.
r0
At A, excess supply of money reduces r0 to r1
r2 E
Lower interest rates at r1 , increases
r1 IS investment which increases income to Y1

Y0 Y2 Y1 Y
Higher Income increase demand for money and interest
rates till economy reaches at point E
 How Equilibrium is re-established in IS-LM
When Disequilibrium is in only One Market
At point ‘D’ economy is in equilibrium in money
market (L=M) and disequilibrium in Product Market.
r
LM As D lies right of IS curve, means supply
D in good markets, that is S>I or AE<AS
r0
Low demand in good market
r1 E reduces income from Yo
IS This reduces money demand. Lower
demand for money reduces interest rates.
Y2 Y0 Y
This process continues till equilibrium is resorted at point ‘E’
where both markets are in equilibrium
 Shift in the IS and LM curve and Change
in Equilibrium
r
IS1 LM
IS0

IS2
r1 E1
r0 E r
r2 LM2 LM
E2
E2
Y2 Y0 Y1 Y r2
r0 E
r1 E1
IS

Y2 Y0 Y1 Y
 r LM 2 at P2 Derivation of AD Curve
IS
LM at P0
r2 E2
r0 E
r1 E1

r Y2 Y0 Y1 Y
At new equilibrium income Y1 and price
C P1, we have the point B.
P2
P0 A Now if price increase to P2 LM curve
P1
B shifts left and new equilibrium
corresponding to E2 will be C
AD curve
Y2 Y0 Y1 Y
 r
Derivation of AD Curve if LM LM2
IS
curve shift due to factors LM
other than price level r2 E2
that is, price level remain r0 E
constant r1 E1
For example AD can be
increased by increasing
r Y2 Y0 Y1 Y
money supply:
↑M ⇒ LM shifts right
⇒ ↓r B
P P
C A
⇒ ↑I
AD1
⇒ ↑Y at each AD AD
2
value of P Y2 Y0 Y1 Y
 r
LM2
IS Monetary Policy
LM and AD Curve
r2 E2
r0 E Expansionary Monetary Policy:
r1 E1  Shift LM curve right to LM1.
 Increase income to Y1
 Shift AD curve to AD1
r Y2 Y0 Y1 Y
Contractionary Monetary Policy:
 Shift LM curve Left to LM2.
P B  Decreases income to Y2
P
C A  Shift AD curve to AD2.
AD1
AD AD
2
Y2 Y0 Y1 Y
 r
IS1 LM Fiscal Policy and
IS0
AD Curve
r1 E1
IS2
r0 E Expansionary Fiscal Policy:
r2  Shift IS curve right to IS1.
E2
 Increase income to Y1
 Shift AD curve to AD1
r Y2 Y0 Y1 Y
Contractionary Fiscal Policy:
 Shift IS curve Left to IS2.
P B  Decreases income to Y2
P
C A  Shift AD curve to AD2.
AD1
AD AD
2

Y2 Y0 Y1 Y
 Weaknesses of IS-LM Model

 Only a Comparative Static

Model.
 Ignores impact of
International Trade.
 Considers price level as
exogenous variable.
 Ignores time lags.
 Does not include labour market equilibrium in the
analysis.
 Ignores impact of future expectations .
 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.