Adjustment Towards Equilibrium

In Fig. 9.21 we show four points off the IS and LM curves (A, B, C and D). At this stage it may
be noted that to the right of the IS curve there is excess supply of goods (ESG) and to the left of
the IS curve there is ESG. Since it is a fixed-price model, excess demand for goods (EDG) will
lead to output expansion and ESG will lead to output contraction.

To the left of the LM curve, there is excess supply of money (ESM) which will cause r to fall and
to the right of the LM curve there is excess demand for money (EDM) which will cause r to rise.
We see that if there is any deviation from point E, and the economy moves to, say, point F, it will
come back to point E, in a cyclical manner though, as is indicated by the arrows in quadrant IV.

The stability property may be explained further:

First, let us consider points A and B above the LM curves. There is ESM because, the
corresponding r is too high for money market equilibrium. As a result r has to fall and there is a
tendency for the macro-economy to move toward the LM curve. Conversely, at points below the
LM curve, such as C and D, there is EDM which will cause r to rise, as is pointed out by the two
upward pointing arrows.

Now we consider two points B and D, lying above the IS curve, where there is ESG, i.e., output
exceeding aggregate demand or saving plus taxes exceeding investment plus government
expenditure (S + T > I + G). As a result Y will fall.
At point A there is ESM which will cause r to fall, as is shown by the downward pointing arrow.
The converse is also true. At points such as B and C, which also lie below and to the left of the IS
curve, there is EDG.

This means that actual output is less than the level that clears the goods market. So output (income)
has to rise to meet the excess demand as is indicated by the rightward pointing arrows. At interest
rate indicated by either B or C, the corresponding output level that will equate I + G with S + T,
as given by the point along the IS curve, is below the actual output level. Since there is ESG, Y
will rise.

At point B there is EDG which will cause Y to rise. Moreover the ESM will cause r to fall. At
point C there is EDG which will cause r to rise, as is pointed out by the upward pointing arrow.

However, a point like F on the LM curve shows money-cum-bond market equilibrium, but since
it is not on the IS curve, it shows commodity market disequilibrium. This point may be compared
with point A or D which is off both the curves and shows disequilibrium in both the markets. Since
point F is off the IS curve and lies above and to the right of the IS curve, there is ESG. This will
cause output to fall, aggregate price level remaining the same.

Similarly, any point on the IS curve other than E such as E’ shows commodity (goods) market
equilibrium, but money market disequilibrium since it is off the LM curve. Since this point lies
above and to the left of the LM curve there is ESM — which will cause the rate of interest to fall.
Only at point E are both the markets in equilibrium at the same time.

The equilibrium condition of the IS-LM model is satisfied only at this point where there is neither
excess demand nor excess supply in any one of the two markets – the goods market and the money
market. So there is neither upward nor downward pressure on the level of income or on the rate of
interest. The nature of disequilibrium and the types of adjustment in the two markets are
summarized in Table 9.1.
ii. Stability of the IS-LM Model in Light of Different Speeds of Adjustments of Output and
Interest:
We know that the IS-LM model is inherently stable. Any disequilibrium — either in the money
market or in the commodity market or in both the markets — will lead to restoration or equilibrium,
perhaps in a cyclical manner. Both Y and r adjust to restore equilibrium in both the markets.

However, at times it is both useful and instructive to restrict the dynamics of the IS- LM model by
the reasonable assumption that the money market adjusts very fast and the commodity market (i.e.,
the market for goods and services) adjusts slowly.

Since the money market can adjust merely through the buying and selling of bonds, it is fair enough
to assume that the interest rate adjusts rapidly and the money market is always in equilibrium. This
simply means that the economy is always on the LM curve: any departure from the equilibrium in
the money market is immediately eliminated by an appropriate change in the interest rate.

In disequilibrium, the economy, therefore, moves along the LM curve as shown in Fig. 9.22. The
goods market adjusts relatively slowly because firms require some time to adjust their output
levels.
For points below the IS curve, the economy moves along the LM curve with rising income and
interest rates and for points above the IS curve, the economy moves down along the LM curve
with falling output and interest rates until both the markets reach point E. The adjustment process
is stable in the sense that the economy moves to the equilibrium point E as usual.

Suppose the economy is to the left of the IS curve say at point E’. There is excess demand in the
commodity market. This will cause Y to rise. As a result there will be an excess demand for money.
As Y increases L(Y, r) increases above M (money supply). This implies that L > M.

Then r will rise immediately so that L(Y, r) falls to keep the money market in
equilibrium. Since the money market clears instantaneously, r will increase in response to excess
demand for money so that M is equated L(Y, r). The economy will move along the LM curve from
E’ to E, raising both Y and r.

The logic of the adjustment process is simple. To the right of the IS curve, there is an excess supply
of goods and firms are, therefore, having undesired inventories. This will force them to cut
production. Consequently the economy moves down the LM curve. As the economy moves toward
the equilibrium level of income, with a falling interest rate, desired investment spending rises as
the interest rate falls.