ISLM Analysis

ISLM analysis

Deriving the IS curve

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 (W1)

I1 (J1) O

Rate of interest

r1

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 (W1)

I1 (J1) O Y1

Rate of interest

r1

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 (W1)

I1 (J1) O Y1

Rate of interest

r1

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals Assume that an interest rate of r1 gives investment of I1 and saving of S1 S1 (W1)

I1 (J1) O Y1

Rate of interest

r1

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals

Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2
S1 (W1) S2 (W2)

I2 (J2) I1 (J1)
O Y1 Y2

Rate of interest

r1 r2

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals

Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2
S1 (W1) S2 (W2)

I2 (J2) I1 (J1)
O Y1 Y2

Rate of interest

r1 r2

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals

Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2
S1 (W1) S2 (W2)

I2 (J2) I1 (J1)
O Y1 Y2

Rate of interest

r1 r2

a b

Goods market equilibrium: deriving the IS curve

Injections, Withdrawals

Now assume that the interest rate falls to r2, giving investment of I2 and saving of S2
S1 (W1) S2 (W2)

I2 (J2) I1 (J1)
O Y1 Y2

Rate of interest

r1 r2

a b
IS (J = W) Y

ISLM analysis

Deriving the LM curve

Money market equilibrium: deriving the LM curve

Assume that at a level of national income, Y1, the demand for money is L'

Rate of interest

L'

O
Money

Rate of interest

Y1 National income

Money market equilibrium: deriving the LM curve

Assume that at a level of national income, Y1, the demand for money is L' MS

Rate of interest

L'

O
Money

Rate of interest

Y1 National income

Money market equilibrium: deriving the LM curve

Assume that at a level of national income, Y1, the demand for money is L' MS

Rate of interest

r1 L'

Rate of interest

r1

O
Money

Y1 National income

Money market equilibrium: deriving the LM curve

Assume that at a level of national income, Y1, the demand for money is L' MS

Rate of interest

Rate of interest

r1 L'

r1

O
Money

Y1 National income

Money market equilibrium: deriving the LM curve

Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS

Rate of interest

Rate of interest

r1

L" L'

r1

O
Money

Y2 Y1 National income

Money market equilibrium: deriving the LM curve

Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS

Rate of interest

r2 r1 L" L'

Rate of interest

r2 r1

O
Money

Y2 Y1 National income

Money market equilibrium: deriving the LM curve

Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS

Rate of interest

Rate of interest

r2 r1 L" L'

r2 r1

d c

O
Money

Y2 Y1 National income

Money market equilibrium: deriving the LM curve

Now assume that at the higher level of national income, Y2, the demand for money rises to L" MS

LM

Rate of interest

Rate of interest

r2 r1 L" L'

r2 r1

d c

O
Money

Y2 Y1 National income

ISLM analysis

Equilibrium

Equilibrium in both the goods and money markets

LM

Rate of interest

IS
O

National income

Equilibrium in both the goods and money markets

LM
Assume that national income is currently at a level of Y1

Rate of interest

IS
O Y1

National income

Equilibrium in both the goods and money markets

LM
This gives a rate of interest of r1 (point a)

Rate of interest

r1

IS
O Y1

National income

Equilibrium in both the goods and money markets

LM
But at r1, national income is below the goods market equilibrium level (Y2)

Rate of interest

a
r1

IS
O Y1 Y2

National income

Equilibrium in both the goods and money markets

But as income rises, so there will be a movement up the LM curve. The interest rate will rise, thereby reducing national income below Y2.

LM

Rate of interest

a
r1

IS
O Y1 Y2

National income

Equilibrium in both the goods and money markets

LM

Rate of interest

re

IS
O Ye

National income

ISLM analysis

ISLM analysis of changes in goods and money markets

ISLM analysis of changes in the goods and money markets

LM

Rate of interest

r1

IS
O Y1

National income

ISLM analysis of changes in the goods and money markets

LM

A rise in injections
Rate of interest

r2

r1

IS2

IS1
O Y1 Y2

National income

ISLM analysis of changes in the goods and money markets

LM1 A rise in the money supply
Rate of interest

LM2

r1
r3

IS
O Y1

Y3

National income

ISLM analysis of changes in the goods and money markets

A rise in both injections and money supply
Rate of interest

LM1

LM2

r1

IS2

IS1
O Y1 Y4

National income

ISLM analysis

Deriving an AD curve from an ISLM diagram

Deriving the AD curve from an ISLM diagram

Rate of interest (r)

LM1

r1

a IS
National income (Y)

Y1

Price level (P)

P1

a'

National income (Y)

Y1

Deriving the AD curve from an ISLM diagram

Rate of interest (r)

LM2 b a

LM1

r2 r1

IS
National income (Y) Price level (P)

Y2

Y1

P2 P1

b' a' AD
National income (Y)

Y2

Y1

ISLM analysis

ISLM analysis of fiscal and monetary policy

ISLM analysis of fiscal and monetary policy

LM

Rate of interest

r1

IS
O Y1

National income

ISLM analysis of fiscal and monetary policy

LM

Expansionary fiscal policy

Rate of interest

r2

r1

IS2

IS1
O Y1 Y2

National income

ISLM analysis of fiscal and monetary policy

LM1 Expansionary monetary policy
Rate of interest

LM2

r1
r3

IS
O Y1

Y3

National income

ISLM analysis of fiscal and monetary policy

Expansionary fiscal and monetary policy
Rate of interest

LM1

LM2

r1

IS2

IS1
O Y1 Y4

National income

ISLM analysis

Keynesian analysis of fiscal and monetary policy

Keynesian analysis of fiscal and monetary policy

Rate of interest

LM Expansionary fiscal policy

IS2 IS1
O Y1 Y2

National income

Keynesian analysis of fiscal and monetary policy

Expansionary monetary policy

Rate of interest

LM1 LM2

IS
O Y1Y2

National income

ISLM analysis

Monetarist analysis of fiscal and monetary policy

Monetarist analysis of fiscal and monetary policy

LM

Rate of interest

Expansionary fiscal policy

IS2 IS1

Y1Y2

National income

Monetarist analysis of fiscal and monetary policy

LM1 LM2

Expansionary monetary policy

Rate of interest

IS

Y1

Y2

National income