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 HicksHensen 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.

Agg. Exp.

Rate of Interest

S&I

0
I0
I1
I2
0
S
r2
r1
r0
0

F
E
Y2

Y1

Y0
G

F
E
Y2

Y1

Y0

Y=AE
Good Market
AE0 (I0, r0)
Equilibrium
AE1 (I1, r1)
AE2 (I2, r2)
Y=AE=C(Y-T)+I(r)+G
Income
S
I0 atr0
I1atr1
I2atr2
Income

E
F
G
Y2

Y1

Y0

Income

I = Ia-br, b>0

SLOPE OF IS CURVE
The slope of the IS curve depends on:
 The sensitivity of investment (AE) to interest rate changes

Rate of Interest

 The value of multiplier

When I is more
sensitive to r and when
multiplier value is
high(high MPC)
IS1

IS2
0

Real GDP(Y)

When I is less sensitive

to r and when multiplier
impact is low(low MPC)

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
Aggregate. Exp..

E1

Rate of Interest

IS0

1
Y1

IS1
r0
0

F1

r1

AE0 (r0)
A0E0 (r0)
AE1 (r1)
A1E0 (r1)

Y1

1
Y0

Y0

E
E1

F
F1

1
Y1

Y2

1
Y0

Y0

Income

Decrease in Govt. Exp.

Decrease in Investment
Increase in Taxes
Increase in Consumer Exp.
Decrease in Net Exports
Income

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

Transaction Demand for Money(Mt)

Mt = K(y) : 1>K>0
K = Proportion of income kept

Y1
Y0

is cash for transaction purpose

Mt
O

M0 M1

Speculative Demand for Money(Ms)

Ms = L(r) : L`<0

r1
r2

Liquidity Trap

r0
O M1 M2

Ms

Total Demand for money

Rate of Interest

Supply of Money

MS

Rate of Interest

YD

r1
O

M
Supply of Money

MD = Mt + Ms
or
MD = K(y) + L(r)

MD (YD)
M0
M1
Demand for Money

MONEY MARKET EQUILIBRIUM

Rate of Interest

MS

r2
r1

E2
E1

r0
E

M P = L (r ,Y )

Demand for money

when income is Y2

MD

(Y2)
MD (Y1)
MD (Y0)

M/P
Supply and Demand for Money

Demand for money

when income is Y1
Demand for money
when income is Y0

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

Rate of Interest

MD (Y2)

MS

Rate of Interest
LM Curve

MD (Y1)
r2

E2

r2

E2

E1

r1

E1

r1

r0

r0

MD (Y0)
O

Supply and Demand for Money

Y0 Y1 Y2
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
sensitive to r

Rate of Interest

LM1

LM2
0

Real GDP(Y)

When MD is less
sensitive to Y and
more sensitive to r

SHIFTING OF LM CURVE

Rate of Interest

MS
MD

r0

Rate of Interest
LM0

(Y0)

E0

r1

MS

r0
E1

M0

M1

r1
O

Supply and Demand for Money

E0
E1

Y0
Income(Y)

LM1

Simultaneous Equilibrium in Product and Money Market

r
LM: Money Market Equilibrium.
M P = L (r ,Y )
r0

Y0

Y = C (Y T ) + I (r ) + G
IS: Goods Market Equilibrium.

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

rB
rA

 At A - Product Market is in
equilibrium.
 Suppose r increases from
rA to rB.

Excess Demand
for goods

YC

YA

IS

 At point B, Y=YA, but rB > rA

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

LM0(P0M0)
 Initially at A: MD = MS).

rC
rA

D
A

 Suppose Y Increases from

YA to YB and we move to B. At
B, r = rA but Y increases to YB.
 Increase in Y increase in
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
LM

r0

B
T
N

Any point other than point E

is point of disequilibrium.

Point A&B: I=S but L M

Point M&N: L=M but I S

Point K: L>M & S<I

KA
Y0

IS

Point V: L>M & S>I

Point L: L<M & S<I

Point K: L<M & S<I

How Equilibrium is re-established in IS-LM

When Disequilibrium is in only One Market
r
r0

At point A economy is in equilibrium

LM in product market and disequilibrium
in money market.

r2

At A, excess supply of money reduces r0 to r1

Lower interest rates at r1 , increases
IS investment which increases income to Y1

r1
Y0

Y2

Y1

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
r

At point D economy is in equilibrium in money

market (L=M) and disequilibrium in Product Market.
LM As D lies right of IS curve, means supply

r0
r1

D
E

in good markets, that is S>I or AE<AS

Low demand in good market
reduces income from Yo
IS This reduces money demand. Lower
demand for money reduces interest rates.

Y
Y2 Y0
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
IS0

r1
r0
r2

IS1

LM

IS2

E1
E

LM2

E2

Y2 Y0 Y1

r2
r0
r1

LM

E2
E
E1
IS

Y2 Y0 Y1

LM 2 at P2

Derivation of AD Curve

IS

LM at P0

r2

E2

r0

r1
r

E1

Y0

Y2

Y1

P2
P0
P1

A
B

At new equilibrium income Y1 and price

P1, we have the point B.
Now if price increase to P2 LM curve
shifts left and new equilibrium
corresponding to E2 will be C

AD curve

Y2

Y0

Y1

LM2

Derivation of AD Curve if LM
IS
curve shift due to factors
r2
other than price level

that is, price level remain

constant
For example AD can be
increased by increasing
money supply:
M LM shifts right
r
I
Y at each
value of P

LM
E2

r0

r1
r

E1

Y2 Y0

Y1

B
C

P
AD1
AD AD
2

Y2

Y0

Y1

LM2

IS

Monetary Policy
and AD Curve

LM

r2

E2

r0

r1
r

E1

Y2 Y0

Y1

B
C

Expansionary Monetary Policy:

 Shift LM curve right to LM1.
 Increase income to Y1
 Shift AD curve to AD1
Contractionary Monetary Policy:
 Shift LM curve Left to LM2.
 Decreases income to Y2
 Shift AD curve to AD2.

AD1
AD AD
2

Y2

Y0

Y1

r
IS1

IS0

r1

E1

IS2

r0

r2
r

Fiscal Policy and

AD Curve

LM

E2

Y2 Y0

B
C

Y1

Expansionary Fiscal Policy:

 Shift IS curve right to IS1.
 Increase income to Y1
 Shift AD curve to AD1

P
AD1
AD AD
2

Y2

Y0

Y1

Contractionary Fiscal Policy:

 Shift IS curve Left to IS2.
 Decreases income to Y2
 Shift AD curve to AD2.

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.