IS-LM MODEL

Inclusion of the money sector and showing the

simultaneous working of the product and money
markets.

IS curve: a curve showing the eqlb situation in the

goods market
It is the locus of combinations of national income
and rate of interest for which the goods market is in
eqlb.

Eqlb is achieved when demand for goods is equal to

supply of goods

Demand for goods = C + I + G ………(1)

Supply of goods = C + S + T ………..(2)

Equating 1 & 2 C+I+G = C+S+T

Or, I+G = S+T

Assumptions:

1. Savings is dependent on national income

or S = S(Y) and dS / dY > 0

2. Investment is dependent on rate of interest

or, I = I(r) and dI / dr < 0

3. Govt. expenses and taxes are autonomous.

4. When savings and investments are equal then we
have eqlb in the goods market.

5. The combination of national income and rate of

interest for which S = I brings about eqlb in
goods market.

Properties of IS curve :

o It is downward sloping.

o Its slope depends on the interest sensitivity of

investment and marginal propensity to save

o At all the points savings is equal to investments

Shifts of IS curve :

The IS curve will shift rightwards if there is an increase

in Govt. expenditure or decrease in taxes.

The slope of the curve will change if either mps

changes or interest sensitivity of investment changes.

Eqn. of IS curve:
Y = C(Y) + I(r) + G

LM Curve: shows eqlb in money market.

The combination of national income and rate of

interest, which brings eqlb in the money market, is
shown by the LM curve.

Eqlb in money market is obtained when demand for

money is equal to supply of money.
Supply of money is determined by the Central Bank
of a country, so it is autonomous. Ms =
M(constant)

Demand for money depends on three motives

Transaction motive : T.D. = K = k(Y) and dK/dY >

0

Precautionary motive

Speculative motive : S.D. = L = l(r) and dl/dr <

0

Md = k(Y) + l(r)

Thus the combination of Y and r for which Md will

equal Ms gives the LM curve.

Assumptions :
The transaction and precautionary demand depend on
the level of income.

Speculative demand is inversely proportional to the

rate of interest.

The prices of bonds remain constant.

The bond prices are inversely proportional to the rate

of interest.

For every combination of Income and rate of interest

we get a level of money demand. The level of money
demand which is equal to money supply gives money
market eqlb.
Properties of LM curve :

o It is upward rising.

o At every point, money demand is equal to money

supply.

o Slope of LM curve depends on the responsiveness

of transaction demand to changes in income and
that of speculative demand to rate of interest.

Shifts of LM curve :

The LM curve will shift right if money supply

increases and
shift left if money supply decreases.

There will be change in the slope of LM curve if the

value of ‘k’ or ‘l’ changes.

Eqn. of LM curve :
Ms = k(Y) + l(r)

GENERAL EQLB. OF PRODUT AND MONEY

MARKETS

The general eqlb of the economy is when the

product and money markets are in eqlb jointly.

It is obtained as a combination of income and rate

of interest which will bring eqlb simultaneously in
the product and money markets.
We have,
Y = C(Y) + I(r) + G ……(1)

Ms = k(Y) + l(r) …….(2)

The values of Y and r which will solve these eqns.

brings about general eqlb.