Economics

IS – LM Model

50% OFF on NABARD courses

Code: NABARD50
 Macro - Economic General Equilibrium
The IS and the LM curves relate the two
variables:
(a) Income (Output)
(b) The rate of interest

Now we will discuss the joint equilibrium of both

markets (Goods market and Money Market) in order
to see how Income (output) and interest rates are
determined simultaneously.

For simultaneous equilibrium, interest rates and

income levels have to be such that both the goods
market and the money market are in equilibrium.

Income and the rate of interest are therefore

determined together at the point of intersection
of these two curves.
Thus, the IS-LM curve model is based on:
(1) The Investment-demand function
(2) The Consumption function
(3) The Money demand function
(4) The Quantity (Supply) of money

The IS-LM curve model explained above has succeeded in integrating the theory of money
with the theory of income determination.
Changes in Autonomous Investment and Government Expenditure

Δ𝑌 = Δ−
𝐼 ∗𝑘
Changes in Autonomous Investment and Government Expenditure

Δ𝑌 = Δ−
𝐼 ∗𝑘
 Changes in Autonomous Investment and Government Expenditure
Changes in autonomous investment and Government expenditure will shift the IS
curve. If either there is increase in autonomous private investment or Government steps up
its expenditure → Aggregate demand for goods will increase → This will bring about increase
in national income through the multiplier process.
This will shift IS schedule to the right, and given the LM curve, the rate of interest as
well as the level of income will rise.
 Changes in Autonomous Investment and Government Expenditure
Changes in autonomous investment and Government expenditure will shift the IS
curve. If either there is increase in autonomous private investment or Government steps up
its expenditure → Aggregate demand for goods will increase → This will bring about increase
in national income through the multiplier process.
This will shift IS schedule to the right, and given the LM curve, the rate of interest as
well as the level of income will rise.
 Changes in Autonomous Investment and Government Expenditure
On the contrary, if somehow private investment expenditure falls or the Government reduces
its expenditure.
The IS curve will shift to the left and, given the upward sloping LM curve, both the rate of
interest and the level of income will fall.
 Changes in the Desire to Save or Propensity to Consume

Let us consider what happens to the rate of interest

when desire to save or in other words, propensity to
consume changes?

Income can either be consumed or saved

Desire to save falls → Propensity to consume rises

▪ The aggregate demand curve will rotate upward

▪ Therefore, level of national income will rise at each rate of
interest
▪ As a result, the IS curve will shift outward to the right.

Thus, a fall in the desire to save has led to the increase

in both rate of interest and level of income.
Thus, a fall in the desire to save has led to the
increase in both rate of interest and level of
income.
If the desire to save rises → The propensity to
consume falls

• Aggregate demand curve will shift downward

which will cause the level of national income to
fall for each rate of interest.

• As a result the IS curve will shift to the left.

• With this, and LM curve remaining unchanged,

the new equilibrium position will be reached to
the left of E, corresponding to which both rate
of interest and level of national income will
be smaller than at E.
 Shift in LM Curve
Shift in LM Curve
▪ Increase in the money demand function due
to external reasons, without any change in
level of Income → LM curve shift to the left
▪ Decline in money demand function due to
external reasons, without any change in level
of Income → LM curve shift to the right

▪ Increase in the money supply causes → LM

curve to shift to the right
▪ Decline in the money supply causes → LM
curve to shift to the left
With rightward shift in the LM curve,
given the IS curve, the equilibrium level of
rate of interest will fall and the
equilibrium level of national income will
increase.
With rightward shift in the LM curve,
given the IS curve, the equilibrium level of
rate of interest will fall and the
equilibrium level of national income will
increase.
With the leftward shift in the LM curve, given
the IS curve, the equilibrium rate of interest
will rise and the level of national income will
fall.
 Effect of Changes in Supply of Money on the Rate of Interest and
Income Level
What will happen if the supply of money is increased
by the action of the Central Bank?

Given the liquidity preference schedule, with the

increase in the supply of money → More money will be
available for speculative and transactions motive at a
given level of income → It cause the interest rate to fall.
As a result, the LM curve will shift to the right.
Now, the new equilibrium will be at point G.

Conclusion –
When Money supply increases – Rate of Interest falls
What have we learned?
▪ We see that changes in propensity to consume (or desire to save), autonomous
investment or Government expenditure, the supply of money and the demand for
money will cause shifts in either IS or LM curve.
▪ Thereby bring about changes in the rate of interest as well as in national income.

▪ The integration of goods market and money market in the IS-LM curve model
clearly shows that Government can influence the economic activity or the level of
national income through monetary and fiscal measures.

▪ Through adopting an appropriate monetary policy (i.e., changing the supply of money)
the monetary authority can shift the LM curve and through pursuing an appropriate
fiscal policy (expenditure and taxation policy) the Government can shift the IS curve.

Thus both monetary and fiscal policies can play a useful role in
regulating the level of economic activity in the country.
 IS-LM Curve Model: Explaining Role of Government’s Fiscal Policies

Effect of Fiscal Policy

Fiscal policy is the use of government revenue collection and expenditure to influence
a country's economy.

What is the impact of government expenditure on National Income?

▪ The increase in income will be greater than the increase in government spending.

The impact of a change in income following a change in government spending is called

government expenditure multiplier, symbolized by KG.

The government expenditure multiplier is, thus, the ratio of change in income
(∆Y) to a change in government spending (∆G).
How IS-LM model shows the effect of increase in Government expenditure
on level of income ▪ Increase in Government expenditure which is of
autonomous nature raises aggregate demand for
goods and services and thereby causes an outward
shift in IS curve.

▪ So, increase in Government expenditure leads to

the shift in IS curve from IS1to IS2.
▪ Now, with the LM curve remaining unchanged, the
new IS2 curve intersects LM curve at point B.

▪ Thus, in IS-LM model with the increase in

Government expenditure (AG), the equilibrium
moves from point E to B and with this the rate of
interest rises from r1 to r2 and income level from Y1
Thus, IS-LM model shows that 𝟏
to Y2. 𝚫𝒀 = 𝟏−𝑴𝑷𝑪 × 𝚫𝑮
expansionary fiscal policy of increase in
Government expenditure raises both
the level of income and rate of interest.
How IS-LM model shows the effect of reduction of taxes on
level of income ▪ An alternative measure of expansionary fiscal
policy is the reduction in taxes which through
increase in disposable income of the people raises
consumption demand of the people.

▪ Cut in taxes causes a shift in the IS curve to the

right, from IS1 to IS2.
▪ With the shift of the IS curve from IS1 to
IS2 following the reduction in taxes, the economy
moves from equilibrium point E to D.
▪ Rate of interest rises from r1 to r2 and level of
income increases from Y1 to Y2.

But now the value of Δ𝑌 will be given by the value of

tax multiplier.
−𝑴𝑷𝑪
𝚫𝒀 = × 𝚫𝑻
𝟏 − 𝑴𝑷𝑪
 Revise Impact of Monetary Policy

What is Monetary Policy?

▪ Monetary policy is the macroeconomic policy laid down by the central bank.
▪ It involves management of money supply and interest rate and is the demand side
economic policy used by the government of a country to achieve macroeconomic
objectives like inflation, consumption, growth and liquidity.

▪ Monetary Policy can be Contractionary or Expansionary.

Decrease in money Increase in money

supply cause LM curve supply cause LM curve
to shift to the left. to shift to the right.
Suppose the economy is in grip of recession, the Government
(through its Central Bank) adopts the expansionary monetary
policy to lift the economy out of recession.
Thus, it takes measures to increase the money supply in the
economy.

The increase in money supply, state of liquidity prefer-

ence or demand for money remaining unchanged, will
lead to the fall in rate of interest.

At a lower interest there will be more investment by

businessmen. More investment will cause income to rise.
This implies that with expansion in money supply LM curve
will shift to the right.
As a result, the economy will move from equilibrium point E
to D and with this the rate of interest will fall from r1 to r2
and national income will increase from Y1 to Y2.
Thus, IS-LM model shows the expansion in money supply
lowers interest rate and raises income.
 LM Curve

LM curve is horizontal when there is infinite interest

responsiveness of Demand for money which occurs when
the economy is in the liquidity trap.
It is a situation in which the general public is prepared to
hold on to whatever amount of money is supplied, at a
given rate of interest. They do so because of the fear of
adverse events like deflation, war.

LM curve is vertical when there is zero interest

responsiveness of Demand for money. That is demand for
money does not depend upon rate of interest.
 Effectiveness of Government Policies

LM curve is horizontal when there is infinite interest

responsiveness of Demand for money which occurs when
the economy is in the liquidity trap.
 Effectiveness of Government Policies

LM curve is horizontal when there is infinite interest

responsiveness of Demand for money which occurs when
the economy is in the liquidity trap. It is a situation in
which the general public is prepared to hold on to
whatever amount of money is supplied, at a given rate of
interest. They do so because of the fear of adverse events
like deflation, war.
Effectiveness of Government Policies

For any given level of MS here, there is only one level of the
interest rate at which the money market is in equilibrium.
Hence, the LM curve is horizontal.
Fiscal policy is very effective: output increases by the full
amount that the IS curve shifts.
Monetary policy is now completely ineffective: an increase in
the money supply does not shift the LM curve at all.

The general public is prepared to hold on to whatever amount of

money is supplied, at a given rate of interest.
 Effectiveness of Fiscal Policy

The LM curve represents the combinations of income and the

interest rate at which the money market is in equilibrium. If
money demand does not depend on the interest rate, then we
can write the LM equation as Ms = Md (Y). There is only one
level of income at which the money market is in equilibrium.
Thus, the LM curve is vertical.
Fiscal policy now has no effect on output; it can affect only the
interest rate. Monetary policy is effective: a shift in the LM curve
increases output by the full amount of the shift.

LM curve is vertical when there is zero interest

responsiveness of Demand for money.
Happy Learning!