The model explains the decisions made by investors when it comes to investments with the amount of money available and the interest they will receive. Equilibrium is achieved when the amount invested equals the amount available to invest. The IS-LM model describes the aggregate demand of the economy using the relationship between output and interest rates. This lowers the level of output and results in equating the quantity demanded with the quantity produced.
The Goods Market and Money Market: The Keynes in his analysis of national income explains that national income is determined at the level where aggregate demand i. In this simple analysis of equilibrium in the goods market Keynes considers investment to be determined by the rate of interest along with the marginal efficiency of capital and is shown to be independent of the level of national income.
The rate of interest, according to Keynes, is determined by money market equilibrium by the demand for and supply of money. In this way changes in money market equilibrium influence the determination of national income and output in the goods market.
However, there is apparently one flaw in the Keynesian analysis which has been pointed out by some economists and has been a subject of a good deal of controversy.
It has been asserted that in the Keynesian model whereas the changes in rate of interest in the money market affect investment and therefore the level of income and output in the goods market, there is seemingly no inverse influence of changes in goods market i. It has been shown by J.
Hicks and others that with greater insights into the Keynesian theory one finds that the changes in income caused by changes in investment or propensity to consume in the goods market also influence the determination of interest in the money market.
Now, this IS-LM curve model has become a standard tool of macroeconomics and the effects of monetary and fiscal policies are discussed using this IS and LM curves model.
The Derivation of the is Curve: The IS-LM curve model emphasises the interaction between the goods and money markets. The goods market is in equilibrium when aggregate demand is equal to income.
The aggregate demand is determined by consumption demand and investment demand. With this introduction of interest as a determinant of investment, the latter now becomes an endogenous variable in the model.
When the rate of interest falls the level of investment increases and vice versa. Thus, changes in the rate of interest affect aggregate demand or aggregate expenditure by causing changes in the investment demand. The increase in investment demand will bring about increase in aggregate demand which in turn will raise the equilibrium level of income.
Thus IS curve relates different equilibrium levels of national income with various rates of interest. The lower the rate of interest, the higher will be the equilibrium level of national income. Thus, the IS curve is the locus of those combinations of rate of interest and the level of national income at which goods market is in equilibrium.
How the IS curve is derived is illustrated in Fig. In panel a of Fig.
It will be seen from panel a that at rate of interest Or0 the planned investment is equal to OI0. Therefore, in the panel c at the bottom of the Fig. Now, if the rate of interest falls to Or2 the planned investment by businessmen increases from OI0 to OI1 [see panel a ].
Thus, in panel c at the bottom of Fig. With further lowering of the rate of interest to Or2, the planned investment increases to OI2 see panel a. Therefore, in panel c the equilibrium income OY2 is shown against the interest rate Or2.
By joining points A, B, D representing various interest-income combinations at which goods market is in equilibrium we obtain the IS Curve. It will be observed from Fig. What accounts for the downward-sloping nature of the IS curve. As seen above, the decline in the rate of interest brings about an increase in the planned investment expenditure.In the IS-LM model, the impact of an increase in government purchases in the goods market has ramifications in the money market, because the increase in income causes a(n) _____ in money _____.
AD-AS Model Aggregate Supply is the total amount of goods and services in the economy available at all possible price levels. Aggregate Demand is the amount of goods and services in the economy that will be purchased at all possible price levels.
Fiscal and Monetary Policies and IS-LM Curve Model! Effect of Fiscal Policy: Let us first explain how IS-LM model shows the effect of expansionary fiscal policy of increase in Government expenditure on level of national income.
As reflected by the IS-LM model an expansionary fiscal policy, therefore, increases the interest rate and the level of output in the IS-LM model for a closed economy. Next we consider the impact of a contractionary fiscal policy. The IS-LM model predicts that an increase in money supply will decrease interest rate (as seen in the IS -LM diagram).
The quantity theory predicts that an increase in money supply will increase price level or inflation, which, via the Fisher effect, will increase the nominal interest rate. What is the 'IS-LM Model' The IS-LM model, which stands for "investment-savings, liquidity-money," is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market.