IS-LM FRAMEWORK

IS-LM Framework

Basic Idea

  • Objective: Bring together the Goods Market and Money Market to achieve equilibrium.

  • Goods Market: Involves buying and selling of goods and services.

  • Money Market: Involves the interaction of Demand for Money (Md) and Supply of Money (Ms); the size of money stock is crucial.

Goods and Money Market Interaction

  • Income Level Determinants:

    • The Goods Market determines the overall level of Income (Y).

    • Planned Investment (I) influences the level of Income, which is determined by the interest rate (i).

    • The Money Market determines the interest rate where Md = Ms.

    • Changes in the Goods Market affect Income, thereby impacting Md, and subsequently the interest rate (i).

  • Role of Central Banks:

    • Supply of Money (Ms) is determined by Central Banks or Government.

    • Demand for Money (Md) correlates with the level of Income generated in the Goods Market.

Goods and Money Market Links

Goods Market

  • Income (Y) can be expressed as:

    • Y = Consumption (C) + Investment (I)

  • Alternate relationship:

    • Y = C + Savings (S), hence S = I

    • Thus, Income level (Y) comes from aggregate demand fueled by C, I, and S.

Money Market

  • Relationship overview:

    • Demand for Money (Md) = Supply of Money (Ms)

    • Interest rate (i) is determined accordingly

    • Md varies with the overall income level.

Conditions for Goods Market Equilibrium

  • Equilibrium Condition:

    • Aggregate Demand (AD) = Income (Y)

    • Planned Investment (I) must equal Planned Savings (S).

    • Thus Y = C + I and S = I imply equilibrium between S & I is influenced by C, S, and I functions.

Goods Market Equilibrium

C – I Approach

  • Consumption and investment relationships:

    • C = C(Y) (+ve correlation)

    • I = I(i) (–ve correlation)

  • Equilibrium Condition:

    • Y = C(Y) + I(i)

S – I Approach

  • Savings and Investment relationships:

    • S = S(Y) (+ve correlation)

    • I = I(i) (–ve correlation)

  • Equilibrium Condition:

    • S(Y) = I(i)

Goods Market Equilibrium Graph

  • Graph Interpretations (various investment and interest levels affect savings and income against different axes).

Explanation of the IS Graph

  • Characteristics:

    • Graph A identifies the investment schedule showing investment as a negative function of interest rates.

    • Graph B shows savings equal to investment represented by a 45° line.

    • Graph C depicts the direct relationship between savings and income.

    • Graph D represents the IS curve illustrating goods market equilibrium.

Example – IS Curve Graph

  • Investment Scenarios:

    • Example: If interest rate is 6%, investment is Rs. 40; savings must match this.

    • Adjusting rates: Lower rates (4%) increase investments, shifting the balance in the Income (Y) level.

    • Tracing these combinations results in the formation of the IS curve.

Important Points – IS Curve

  • Each interest rate has a unique level of income where S = I.

  • Higher interest rates correlate with lower income levels at which S = I.

  • Understanding these relationships is crucial for policy implications on income and investments.

Conditions for Money Market Equilibrium

  • Determinants and measurements of Md include functions of both transactions and speculative demands, leading to the equilibrium condition where Ms = Md.

Money Market Equilibrium

  • Highlighting total demand and supply as fundamental to understanding equilibrium dynamics in the market.

Money Market Equilibrium Graph

  • Involves speculative and transaction-related money demands leading to overall money market equilibrium analysis.

Explanation of the LM Graph

  • Speculative Demand Assessment:

    • Illustrates the inversed relationship of interest rates affecting speculative demand, impacting transactions across income levels.

Example – LM Curve Graph

  • Interest Rate Variations:

    • Illustrates different combinations of income and interest rates leading to various equilibria in the money market.

Equilibrium in Goods and Money Market

  • Graphical Representation:

    • IS curve declines while the LM curve rises; point of intersection yields simultaneous determination of equilibrium interest rates and income levels.

Explanation of the Graph

  • Demonstrates how transitions between stability and disequilibrium occur, influencing both markets through rates of interest and income levels.

Shift in LM Curves

  • Effect of Money Supply Changes:

    • Expansions (or contractions) in money supply shift the LM curve, impacting the equilibrium interest and income levels—essentially illustrating the practical implications of Central Bank policies.

Shift in IS Curves

  • Consumption Preferences Influence:

    • Changes in savings desire shift IS curves, demonstrating how propensity impacts national income across different interest rates.

Fiscal Policy – Impact on IS-LM Model

  • Expansionary fiscal policies shift the IS curve outward, affecting overall income (Y) and interest rates (i).

Monetary Policy – Impact on IS-LM Model

  • Expansionary monetary policies lead to shifts in the LM curve, reflecting changes in income based on prevailing monetary supply strategies.