the is- lm curve
TRANSCRIPT
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The IS- LM Model
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Goods market equilibrium IS curve
Goods market equilibrium :
Y = C+I (AD) or
Investment=Savings at different rates ofinterests or
Planned spending= Planned output
Therefore, it is called I equal S (Investmentequal Savings)or I-S function.
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For the derivation of IS curve, rate of interest
is an important determinant of investment
making the latter an endogenous variable. There exists an inverse relationship between
the interest rate and investment. When firms
borrow to purchase investment goods, they
have to pay an interest rate. When interest
rate increases, the cost of borrowings
increases. This decreases the profitability of
the firms and thus,planned investment
decreases.
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Increase in investment demand(I) increases
aggregate demand(AD) and thus raises the
equilibrium level of income. In the derivation of the IS curve, we seek to
find out the equilibrium level of Y as
determined by the equilibrium in goodsmarket by a level of investment determined by
a given rate of interest.
IS curve relates the equilibrium levels ofnational income with rates of interest.
(explained in the following graphs)
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In fig (a), the fall in interest rate increases the investment level
and shifts the AD curve upwards resulting in equilibrium at a
higher level of national income.(fig.b)
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Thus IS curve is a locus of
those combinations of
rate of interest and the
level of national incomeat which good market is
in equilibrium. (fig.c)
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Slope of IS curve :
Decline in interest rates causes increase in
investment expenditureThis causes an increase in the aggregate demand
moving the AD curve upwards.
This leads to an increase in the equilibrium levelof national income.
Thus a lower rate of interest is associated with a
higher level of national income and vice versa.This makes the IS curve slope downwards.
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Steepness of IS curve
Depends upon
1. Elasticity of the investment demand curve i.e.
responsiveness of investment to the rate of
interest.
2. The size of the multiplier.- Multiplier depends
on mpc. Higher mpc means steeper AD curve
(c=a+by). It also means highier multiplier i.e.
greater increase in equilibrium level of
national income and a steeper IS curve.
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Shift in IS curve
The level of autonomous expenditure
determines the position of the IS curve and
changes in autonomous expenditure cause
shift in it.
Autonomous expenditure means the
expenditure be it investment expenditure,
government expenditure or consumption exp.Which does not depend on level of income or
rate of interest.
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Graphical explanation
Rateofint
We illustrate the shift in the IS curve by making changes in government exp (G)
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Since the increase in the
income to OY2 has not
been brought about bythe changes in the
interest rate but
autonomous of it, I doesnot imply movement
along the previous IS
curve but will cause an
upward shift in it (IS)
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Money Market Equilibrium- The
LM Curve
As per keynes, demand for money to hold
depends upon transactions motive and
speculative motive.
Money held for transactions motive is a
function of income.
Greater the level of income, greater the
money held for transaction motive and
therefore higher the level of money demand
curve.
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Graph- LM curve
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Slope of LM curveDepends on two factors : 1) The responsiveness
of demand for money(liquidity preference) to
the changes in income.
With the increase in income, demand curve for
money moves up disturbing the equilibrium .
For the equilibrium to be restored, rate on
interest moves up.
Hence the speculative demand for money goes
down. Given the speculative demand, higher
the rise in the rate on interest, steeper the LM
curve.
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2)Responsiveness of demand for money to the
changes in the rate of interest :Lower the elasticity of liquidity preference with
respect to the changes in interest rate, the
steeper will be the LM curve and vice versa.
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Shift in the LM curve due to
change in money supply
Rateofint
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Shift in LM curve due to change in
money demand function
The other factor causing shift of the LM curve
is the change in liquidity preference function
at a given level of income.
This will lead to the rise in the rate of interest
and a shift in the LM curve to the left.
If, with the given situations, the rate of
interest has to be maintained, the income
should be reduced and the money demand
function must shift back to its original level.
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Intersection of IS- LM curves
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At the point of intersection of the IS and Lm
curves, the rate of interest and the income are
related in such a way that :
1) The goods market is in equilibrium i.e Agg
demand= aggregate output.
2) The money market is also in equilibrium i.e.
demand for money is in equilibrium with the
supply of money.
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The IS- Lm curve analysis has succeeded in
synthesizing the monetary and fiscal policies. With the IS-LM curve analysis, we are better
able to explain the effect of changes in certain
important economic variables such as desireto save, the supply of money, investment,
demand for money on the rate of interest and
level of income.
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Effect of changes in the supply of money on
the rate of interest and income level:
When supply of money increases, rate of
interest falls and Y increases.
When supply of money decreases, the rate of
interest increases and Y decreases.
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Changes in the desire to Save or propensity toconsume:
The increase in mpc moves the AD curve up
increasing the national income. This movesthe IS curve to the right and moves up the rate
of interest at the equilibrium level.
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Changes in autonomous investment and
government expenditure:Increases the investment expenditure increasing
the agrregate demand. IS curve moves to the
right and increases the rate of interest andnational income.
.
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Changes in demand for money or liquidity
preference:
Affects the LM curve. Increase in money
demand moves the LM curve to the left. Thus
the equilibrium rate of interest will rise andnational income will fall.
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