Preface

Economics and mathematics are highly interrelated subjects. Models of economic theories are developed using
integration, differentiation, and probability. In the context of macroeconomics, it is often important to formulate
strategies to combat phenomena like inflation or frame fiscal and monetary policies to stabilize the economy
as well as boost economic growth. The use of mathematics is crucial to the development of these strategies and
policies. The University of Calcutta has combined these two subjects into one paper that is offered in the third
year of the B Com (Hons.) curriculum with the express intention of providing a comprehensive overview of these
subjects, which will help the students grasp and apply the concepts learnt in their overall study of commerce.

About the Book

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This book is designed to provide a comprehensive coverage with an easy-to-understand treatment of macroeconomic

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theory and advanced business mathematics, covering the syllabus for undergraduate honours students of commerce

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in the University of Calcutta.
Macroeconomics examines and analyses the performance of the economy as a whole. The major macroeconomic

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issues related to national income, inflation, employment, interest rate, and price level are dealt with in a very
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articulate manner in terms of verbal logic, graphical illustration, and mathematical proofs. While it contains the
necessary topics completely covering the syllabus of the University of Calcutta, it also captures well the syllabi
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prescribed by other leading universities in India.

The second part of the book, Advanced Business Mathematics covers calculus, algebra, and probability
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theory. Keeping in mind that this book is for undergraduate commerce students, the theoretical portions have
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been discussed in a simple manner for better understanding.

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Key Features
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• The contents and sequence of topics in the book have been prepared by following the syllabus given by the
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University of Calcutta.
• The extent of each chapter has been decided keeping in mind the number of lectures assigned in the syllabus
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so that it would be easy for the teachers to frame their lesson plans.
• Practical examples are inserted to make the theoretical concepts easily understandable for the students.
• Numerical problems are provided for easy understanding of the different aspects of macroeconomic theory.
• In the advanced mathematics portion, a large number of problems are solved including those from different
years’ C.U. question papers.
• Solutions to the university questions as well as model questions are provided, which will help the students
prepare for their examinations.

Organization of the Book

The first part containing macroeconomic theory is divided into six chapters by following the sequence of the
syllabus prescribed by the University of Calcutta.
Chapter 1 provides a basic idea of the different aspects of macroeconomics. This chapter outlines some
fundamental concepts and the scope of macroeconomics.

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 viii  Preface

Chapter 2 begins with the national income accounts. The concept and meaning of national income, its
measurement, components, and different methods of computing have been discussed in a very simple way.
Examples with problems and solutions are given for conceptual clarity.
Chapter 3 deals with the determination of national income under the assumption of a fixed price of final
goods and a constant rate of interest in the economy. This chapter presents the basic ideas developed in Keynes’s
theory to explain how effective demand determines national income.
Chapter 4 covers the Keynesian theory of aggregate demand when investment depends on the interest rate. The
Keynesian theory of aggregate demand is constructed on the assumption that two facts are true simultaneously.
First, the quantity of savings supplied equals the quantity of investment demanded; in other words, the product
market is in equilibrium. Second, the quantity of money demanded is equal to the quantity of money supplied.
In the Keynesian theory, we study the determination of equilibrium in these two markets simultaneously.
In Chapter 5, we discuss the concept and functions of money. We also talk about the demand for money,
quantity theory of money, supply of money, credit creation process of commercial banks, and the different

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components of money supply. In this connection, we also discuss the concept of money multiplier and the process

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of controlling the supply of money by the central bank of a country.
Chapter 6 deals with inflation. As inflation affects the everyday lives of the citizens of a country and the

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overall situation of an economy, it is essential to discuss the concept, causes, and impacts of inflation. It is also
necessary to differentiate between demand-pull and cost-push inflation. In this connection, it is essential to know

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the costs of inflation and the relation between inflation and unemployment. Finally, we should be conversant
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with the measures to control inflation.
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The second part of this book deals with advanced business mathematics. This part is divided into nine chapters.
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Chapter 1 introduces the basic concepts of number system, function and its classification, properties of
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functions, some special functions, and application of function in business and economics.
Chapter 2 explains the concept of limit of a variable and function, limit of some standard functions, and
the concept of continuity and discontinuity with the graphical representation.
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In Chapter 3, we discuss the differentiability of a function. There are three sections. In the first section,
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first order differentiability of a function is discussed. Here, differentiation of different types of functions—
differentiation of composite functions, parametric functions, implicit function, logarithmic functions etc.—
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are discussed. In the second section, the concept of second order derivative of a function is introduced. The
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third section expounds on the concept of more than one variable, that is, function of several variables, partial
derivative of a function, and Euler’s theorem on homogeneous function and derivative of a function using
total differential.
After introduction of elementary differential calculus in Chapter 4, the application of calculus is discussed.
The significance of derivatives, their meaning in different aspects such as rate measures and economics
is discussed. In addition, increasing and decreasing functions and maxima and minima of a function are
elucidated here.
Integration is an important concept in calculus. In Chapter 6, a part of indefinite integration is introduced.
In Chapters 6, 7, and 8, important notions in algebra—matrix and determinant—are introduced. Some basic
definitions related to matrix and determinant, their algebras and finally the system of linear equations solved
using matrices and determinants are described.
Lastly, in Chapter 9, we introduce probability theory. Here, the classical definition of probability is introduced.
Important theorems such as total probability theorem, joint probability theorem, and conditional probability
theorem are stated.

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 Preface  ix

Online Resources
The following resources are available to faculty and students using this text:
• Solutions to Chapter-end Exercises
• Solutions to Model Question Papers

Acknowledgements
We thank the people who encouraged us to work on this manuscript. We are deeply indebted to our colleagues
at the Department of Economics of the University of Calcutta, at Hooghly Women’s College, and Goenka
College of Commerce and Business Administration, Kolkata. Their contributions have been of immense value
to us during the preparation of this text. Comments at the early stages, provided by several colleagues while going
through large portions of the manuscript, helped greatly improve the quality of this book.
We express our gratitude to the Head of the Department of Economics of the University of Calcutta and

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the Principals of Hooghly Women’s College and Goenka College of Commerce and Business Administration

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for inspiring us at different stages of this project.

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Comments provided by the referees are gratefully acknowledged. We thank the editorial team at Oxford
University Press for their patience and support.

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Readers are welcome to share their feedback and suggestions with us at [email protected], asengupta15@
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yahoo.com, and [email protected].
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Panchanan Das
Anindita Sengupta
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Swapan Samanta
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 Brief Contents
Features of the Book  iv
Companion Page  vi
Preface vii
Detailed Contents  xii
Road Map  xviii

PART I  MACROECONOMICS  1
1. Macroeconomics—Scope and Basic Concepts 3
2. National Income Accounting 18

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3. Theory of Equilibrium Income Determination 40

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4. Commodity and Money Market Equilibrium 72

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5. Money and Economy 97
6. Inflation and the Economy 124
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Solved Question Paper (only Group A)—2012  150
Solved Question Paper (only Group A)—2013  154
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Solved Question Paper (only Group A)—2015  158

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Model Question Paper-1  162

Model Question Paper-2  163
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Model Question Paper-3  164

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PART II  ADVANCED BUSINESS MATHEMATICS 165

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1. Functions 167
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2. Limit and Continuity 182

3. Differentiation 203
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4. Applications of Derivatives 249

5. Integration 265
6. Matrix—I 284
7. Determinants 305
8. Matrix—II 331
9. Probability Theory 342

Solved Question Paper—2015  366

Solved Question Paper—2016  374
Model Question Paper-1  384
Model Question Paper-2  386
Index 389
About the Authors  395

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 Detailed Contents
Features of the Book  iv
Companion Page  vi
Preface vii
Brief Contents  xi
Road Map  xviii

PART I  MACROECONOMICS  1
1. Macroeconomics—Scope and Basic Concepts 1.7 Aggregate Demand and
3 Aggregate Supply Approach in

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1.1 Introduction: Different Schools of Macroeconomics11

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Thought3 1.7.1 Aggregate Demand  11
1.1.1 Classical Macroeconomics   3 1.7.2 Aggregate Supply  12

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1.1.2 Keynesian Macroeconomics  4 1.7.3 Short-run Equilibrium  14
1.1.3 Classical Keynesian Synthesis  4 1.7.4 Long-run Equilibrium  15
1.1.4 Monetarism   4
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2. National Income Accounting 18
1.1.5 New Classical
2.1 Introduction 18
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Macroeconomics   5
2.2 Circular Flow of Income 19
1.1.6 Rational Expectations Theory  5
2.3 Concepts and Measurement of
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1.1.7 Real Business-cycle Theory  5

Gross National Product 21
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1.1.8 New Keynesian Economics   6

2.3.1 Gross National Product and
1.1.9 Neoliberalism   6
Gross Domestic Product  24
1.1.10 Resurgence of Keynesian
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2.3.2 Net National Product and Net

Economics   6
Domestic Product  25
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1.2 Scope of Macroeconomics 6

2.3.3 National Income  25
1.3 Objectives of Studying
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2.3.4 Personal Income and Disposable

Macroeconomics7
Personal Income  26
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1.4 Fundamental Macroeconomic

2.3.5 Per Capita Income  27
Variables  7
2.4 Nominal and Real National
1.5 Stock Concept and Flow Concept
Income27
in Macroeconomics 9
2.5 Fundamental Identity in National
1.6 Basic Macroeconomic Relations 10
Income Accounting 29
1.6.1 Relation between Aggregate
2.6 Approaches to Measurement of
Output and Inflation   10
National Income 30
1.6.2 Relation between Aggregate
2.6.1 Production Approach  30
Output and Interest Rate  10
2.6.2 Income Approach  33
1.6.3 Relation between Aggregate
2.6.3 Expenditure Approach  34
Output and Unemployment  10

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 Detailed Contents  xiii

2.7 Problems in Gross National Product 3.8.3 Tax Cut Multiplier  66

Accounting36 3.8.4 Principle of Effective
2.8 Gross National Product as Measure Demand 68
of Welfare36
4. Commodity and Money Market
3. Theory of Equilibrium Income Equilibrium72
Determination40 4.1 Introduction 72
3.1 Introduction 40 4.2 Product Market Equilibrium 73
3.2 Concept of Equilibrium National 4.2.1 Derivation of IS Curve  74
Income41 4.2.2 Slope of IS Curve  76
3.3 Keynes’s Theory of Income 4.2.3 Shifts of the IS Curve  77
Determination43 4.2.4 Points off the IS Curve  78
3.4 Consumption Function 44 4.3 Money Market Equilibrium 79
3.4.1 Average and Marginal 4.3.1 Transactions Demand for

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Propensities to Consume  46 Money 79

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3.4.2 Saving Function from 4.3.2 Precautionary Demand for

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Consumption Function  47 Money 80
3.4.3 Determinants of Propensity to 4.3.3 Speculative Demand for
Save 49
y Money 80
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3.4.4 Important Features of Keynes’s 4.3.4 Supply of Money  83
Consumption Function  51 4.3.5 Money Market Equilibrium:
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3.4.5 Importance of Consumption LM Curve 83

Function 51 4.3.6 Slope of LM Curve  84
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3.5 Investment Function 52 4.3.7 Points off LM Curve  85

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3.5.1 Autonomous Investment  52 4.3.8 Shifts of LM Curve   85

3.5.2 Investment Depends on 4.4 IS−LM Model 86
Income 53 4.4.1 Derivation of Aggregate
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3.5.3 Investment Depends on Interest Demand Curve  87

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Rate 53 4.4.2 Mathematical Formulation of

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3.6 Simple Keynesian Model of Income IS−LM Model  88

Determination57 4.5 Fiscal and Monetary Policies 89
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3.6.1 Components of Aggregate 4.5.1 Fiscal Policy Multiplier  89

Demand in a Simple Model  57 4.5.2 Effectiveness of Fiscal Policy  91
3.6.2 Determination of Equilibrium 4.5.3 Monetary Policy Multiplier  93
National Income  57 4.5.4 Effectiveness of Monetary
3.7 Multiplier 60 Policy 94
3.7.1 Investment Multiplier  60
5. Money and Economy 97
3.7.2 Assumptions of Multiplier
5.1 Introduction 97
Theory 63
5.2 Functions of Money 98
3.8 Keynesian Model with Government
5.3 Quantity Theory of Money 99
Sector63
5.3.1 Fisher’s Version  100
3.8.1 Government Expenditure
5.3.2 Cambridge Version  103
Multiplier 65
5.4 Keynesian Liquidity Preference
3.8.2 Tax Behaves as Stabilizer   66
Theory106

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 xiv  Detailed Contents

5.5 Friedman’s Modern Quantity 6.3.2 Demand-pull Inflation and

Theory of Money and Monetarism 110 Wage–Price Spiral  129
5.6 Supply of Money 112 6.3.3 Keynesian View of Demand-pull
5.6.1 High-powered Money and Inflation vs. Monetarist View of
Measurement of Money Demand-pull Inflation  130
Supply 113 6.3.4 Cost-push Theory of
5.7 Money Multiplier 114 Inflation 131
5.8 Credit Creation by Commercial 6.3.5 Interaction between Demand-pull
Banks116 and Cost-push Inflation  133
5.8.1 Limitations of Credit Creation 6.4 Costs of Inflation 134
Process 118 6.5 Inflation and Unemployment 136
5.9 Control of Money Supply 118 6.5.1 Rational Expectations Theory
5.9.1 Monetary Policies Adopted by and Non-existence of Trade-off

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Reserve Bank of India to Control between Rates of Inflation and

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Money Supply  120 Unemployment 142
6.6 Monetary and Fiscal Policies to

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6. Inflation and the Economy 124
Control Inflation 143
6.1 Introduction 124
6.6.1 Monetary Policy to Control
6.2 Concept of Inflation and
y Inflation 144
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Inflationary Gap 125
6.6.2 Fiscal Policy to Control
6.2.1 Inflationary Gap  127
Inflation 145
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6.3 Demand-pull and Cost-push

6.6.3 Other Measures to Control
Theories of Inflation 127
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Inflation 146
6.3.1 Demand-pull Theory of
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Inflation 128
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Solved Question Paper (only Group A)—2012  150

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Solved Question Paper (only Group A)—2013  154

Solved Question Paper (only Group A)—2015  158
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Model Question Paper-1  162

Model Question Paper-2  163
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Model Question Paper-3  164

PART II  ADVANCED BUSINESS MATHEMATICS 165

1. Functions 167 1.2.2 Discrete Variable  168
1.1 Introduction 167 1.3 Function, Domain, and Range 169
1.1.1 Natural Numbers  167 1.3.1 Alternative Definition of
1.1.2 Integers  167 Function 169
1.1.3 Rational Number  167 1.4 Classification of Functions 170
1.1.4 Irrational Numbers  168 1.4.1 Algebraic Function   170
1.1.5 Real Numbers  168 1.4.2 Non-Algebraic or Transcendental
1.1.6 Complex Numbers  168 Function 171
1.2 Constant and Variable 168 1.4.3 Explicit and Implicit
1.2.1 Continuous Variable  168 Functions 171

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 Detailed Contents  xv

1.5 Parametric Representation of 2.2.3 Test for Discontinuity of

Function171 Function 195
1.6 Composite Function or Function 2.2.4 Graphical Representation of
of Function 171 Continuous and Discontinuous
1.7 Properties of Functions 171 Functions 196
1.7.1 Even Function and Odd 2.2.5 Theorems on Continuous
Function 171 Functions 197
1.7.2 Bounded Function  172 2.2.6 Continuity of Some Standard
1.7.3 Monotonic Function  172 Functions 197
1.8 Some Special Functions 172
3. Differentiation 203
1.8.1 Constant Function  172
3.1 First-order Derivative 203
1.8.2 Identity Function  172
3.1.1 Introduction  203
1.8.3 Modulus Function or Absolute
3.1.2 Increment  203

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Value Function  172
3.1.3 Derivative of a Function  204

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1.8.4 Greatest Integer Function  173
3.1.4 Differentiation of Functions
1.9 Single-valued and Multiple-valued

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Using First Principle  205
Functions173
3.1.5 Derivative of Some Standard
1.10 Functions in Business and
Economics173
y Functions 207
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3.1.6 Fundamental Theorems on
1.10.1 Demand Function  173
Differentiation 207
1.10.2 Supply Function  173
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3.1.7 Differentiation of Function

1.10.3 Production Function  173
of a Function or Composite
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1.10.4 Profit Function  173

Function 208
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1.10.5 Revenue Function  174

3.1.8 Differentiation of Implicit
2. Limit and Continuity 182 Functions 210
2.1 Limit of Function 182 3.1.9 Differentiation of Inverse
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2.1.1 Limit of Independent Functions 210

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Variable 182 3.1.10 Differentiation of Parametric

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2.1.2 Infinite Limit  183 Functions 211

2.1.3 Definition  183 3.1.11 Differentiation of Logarithmic
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2.1.4 Left-hand and Right-hand Limit Functions 211

of a Function  183 3.1.12 Differentiation of One Function
2.1.5 Alternative Definition  183 with Respect to Another  212
2.1.6 Fundamental Theorems on 3.2 Second- and Higher-order
Limits 184 Derivatives231
2.1.7 Some Standard Limit 3.3 Function of More Than One
Formulas 184 variable: Partial Derivatives
2.1.8 Evaluation of Limit of a and Total Differential 237
Function 185 3.3.1 Partial Derivative  238
2.2 Continuity of a Function 195 3.3.2 Homogeneous Function  240
2.2.1 Definition  195 3.3.3 Euler’s Theorem on Homogeneous
2.2.2 Alternative Definition  195 Function 241
3.3.4 Total Differentials  242

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 xvi  Detailed Contents

4. Applications of Derivatives 249 6.2.3 Null Matrix or Zero

4.1 Introduction 249 Matrix 285
4.2 Geometrical Significance of 6.2.4 Rectangular Matrix  285
Derivative249 6.2.5 Square Matrix  285
4.3 Significance of Derivative as Rate 6.2.6 Diagonal Matrix  286
Measure250 6.2.7 Scalar Matrix  286
4.4 Some Specific Functions Frequently 6.2.8 Identity Matrix or Unit
Used in Economics 250 Matrix 286
4.4.1 Cost Function  250 6.2.9 Upper Triangular and Lower
4.4.2 Revenue Function  251 Triangular Matrix  286
4.4.3 Profit Function  251 6.2.10 Transpose of a Matrix  286
4.4.4 Demand Function  251 6.2.11 Symmetry and Skew-Symmetric
4.4.5 Supply Function  251 Matrix 287

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4.5 Increasing and Decreasing 6.2.12 Singular and Non-singular

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Functions251 Matrix 287
4.6 Maxima and Minima of Functions 252 6.2.13 Equality of Matrices  287

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4.7 First Derivative Test for Maximum 6.3 Operations on Matrices 288
and Minimum Values 252 6.3.1 Scalar Multiplication  288
4.8 Maximum and Minimum by
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Second Derivative Method 253 Subtraction 288
4.9 Point of Inflexion 253 6.3.3 Matrix Multiplication  289
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6.4 Properties of Transpose of a Matrix 291

5. Integration 265
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6.5 Some More Definitions 293

5.1 Introduction 265
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6.5.1 Idempotent Matrix  293

5.2 Definition 266
6.5.2 Orthogonal Matrix  293
5.3 General Rule of Integration 266
6.5.3 Inverse of a Matrix  293
5.4 Standard Formulae of Integration 266
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5.5 Integration by Substitution 270 7. Determinants 305

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5.5.1 Type I  270 7.1 Introduction 305

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5.5.2 Type II  270 7.2 Definition 305

5.5.3 Type III  271 7.3 Minors and Cofactors 306
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5.5.4 Type IV  271 7.3.1 Calculation of Determinant

5.5.5 Type V  272 Using Cofactor  307
5.5.6 Type VI  272 7.4 Properties of Determinant 307
5.6 Standard Integrals 276 7.5 Product of Determinants 309
5.7 Rules for Solving Following 7.6 Adjugate or Adjoint of a
Integral277 Determinant310
7.7 Reciprocal or Inverse of
6. Matrix—I 284
Determinant311
6.1 Introduction  284
7.8 Symmetric and Skew-symmetric
6.1.1 Definition  284
Determinant311
6.2 Some Basic Definitions 285
7.9 Solution of System of Linear
6.2.1 Row Matrix  285
Equations Using Cramer’s Rule 312
6.2.2 Column Matrix  285

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 Detailed Contents  xvii

8. Matrix—II 331 9.2.7 Compound Event  343

8.1 Adjoint or Adjugate of a Square 9.2.8 Mutually Exclusive Events  343
Matrix331 9.2.9 Mutually Exhaustive
8.2 Reciprocal of a Matrix 331 Events 343
8.3 Inverse of a Matrix 332 9.2.10 Equally Likely Events  343
8.3.1 Properties of inverse of a 9.3 Classical Definition of Probability 344
matrix 332 9.3.1 Odds  344
8.4 Solving System of Linear Equations 9.3.2 Limitation of Classical
Using Matrix Inversion Method 333 Definition 344
8.4.1 Two equations with two 9.4 Important Notations
variables 333 Frequently Used 345
8.4.2 Three equations with three 9.5 Theorems on Total Probability 346
variables 333 9.6 Compound Probability or Joint

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Probability and Conditional
9. Probability Theory 342

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Probability347
9.1 Introduction 342
9.6.1 Compound Probability

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9.2 Terminology 342
Theorem 348
9.2.1 Random Experiment  342
9.6.2 Extension of Compound
9.2.2 Random Variable  342
y Probability Theorem  348
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9.2.3 Trial  342
9.6.3 Dependent and Independent
9.2.4 Sample Space  342
Events 348
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9.2.5 Event  343

9.7 Important Deductions 348
9.2.6 Simple Event  343
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Solved Question Paper—2015  366

Solved Question Paper—2016  374
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Model Question Paper-1  384

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Model Question Paper-2  386

Index 389
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About the Authors  395

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 CHAPTER

4
Commodity and Money Market
Equilibrium
This chapter is about the Keynesian theory of aggregate demand when investment depends on the interest rate.
We will show that aggregate demand depends not only on the money supply, as in the classical theory, but also

s
on fiscal policy and on the expectations of households and firms. The Keynesian theory of aggregate demand

es
is constructed on the assumption that two facts are true simultaneously. First, the quantity of savings supplied
equals the quantity of investment demanded; in other words, the product market is in equilibrium. Second, the

Pr
quantity of money demanded is equal to the quantity of money supplied. In other words, the existing stock of
money in circulation is willingly held. In the Keynesian theory, we have to study the determination of equilibrium
in these two markets simultaneously.
y
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In Chapter 3, we discussed national income determination and investment multiplier by assuming that
private investment is autonomous. This is the subject matter of product market analysis, where equilibrium
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national income is determined by equating aggregate demand to aggregate supply of output. We also add the
investment function, where private investment depends on both income and interest rates. In this chapter,
iv

we extend our analysis by taking the interest rate as an important determinant of investment; a reduction
in the interest rate raises investment demand. Now, we have to find out what determines the interest rate.
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This search extends our analysis further to include the markets where interest rate is determined. This is the
money market or market for financial assets where interest rate is determined. The interest rate, however,
is not determined from the money market in an isolated manner. This forces us to study the interaction of
d

the product and money markets. National income and interest rates are jointly determined by equilibrium
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in the product and money markets. The analysis in this chapter qualifies some conclusions we came to in
Chapter 3.
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4.1 Introduction
Keynes contended that monetary policy was powerless to boost the economy out of a depression because it depended
on reducing interest rates, and in a depression, interest rates were already close to zero. Increased government
spending, on the other hand, would not only boost demand directly, but also set off a chain reaction of increased
demand from workers and suppliers whose incomes had been increased by the government’s expenditure. Similarly,
a tax cut would put more disposable income in the wallets of consumers, and that too would boost demand. The
appropriate fiscal policy during periods of high unemployment was to run a budget deficit. These ideas flew in the
face of the conventional wisdom that budget deficits were always bad. Historical research, however, pioneered
by Milton Friedman has convinced many economists that the Depression was mainly the result of incompetent
monetary policy in both Britain and the United States rather than the inability of monetary policy to influence the
economy. Many economists had expected a resumption of the Great Depression when World War II ended, but
instead the US economy experienced an era of spectacular growth. To the surprise of almost everyone, the most

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 Commodity and Money Market Equilibrium 73

aggravating problem of the post-war economy has

been inflation, while recessions have been relatively Product market
brief and mild.
Fiscal policy
In Keynes’s model, equilibrium national income
is originated from the product market and interest
rate is determined in the money market. Later on, Income Interest rate
John Hicks devised the IS-LM model (IS stands for
investment-savings and LM for liquidity-money). He
explained that income and interest rates are jointly
determined by the interaction of the product market Money market
and money market. A part of the aggregate demand
Monetary policy
(consumption) in the product market depends on
income, while another part (investment) depends Fig. 4.1 Logical structure of the chapter

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on interest rate. In the money market also, a part of

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money demand depends on income and another part depends on interest rate. Thus, income and interest rate are
determined jointly by the product market and money market equilibrium. This is the essence of Hicks’s IS-LM

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model. The IS-LM model emphasizes the interaction between the product and money markets. In Chapter 3,
we discussed national income determination by arguing that income affects spending, which in turn determines

y
output and income. In this chapter, we consider the effects of interest rates on investment and aggregate spending,
sit
and ultimately on income. Thus, we need the dependence of the money market on income. Higher income raises
money demand, and thus interest rates. Higher interest rates lower spending, and thus income. Spending, interest
er

rates, and income are determined jointly by equilibrium in the product and money markets. Fiscal policy works
iv

by changing government expenditure or tax rates or both through the product market, but monetary policy
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works by changing money supply through the money market.

Figure 4.1 shows the logical structure of the chapter.
The chapter starts, after a few introductory remarks, with a discussion of the link between interest rates
d

and aggregate demand by analysing the investment function once again in Section 4.2. We extend our analysis
or

from Chapter 3 to include the interest rate as a determinant of aggregate demand and derive the key relationship
between income and interest rates in the form of the IS curve, which explains equilibrium in the product
xf

market. In Section 4.3, we turn to the money market. We show that the demand for money depends on interest
O

rates and income. There are combinations of interest rates and income levels for which the money market is
in equilibrium in the form of the LM curve. In Section 4.4, we deal with the two-sector Keynesian model of
national income determination by combining the IS and LM schedules to study the joint determination of
interest rates and income. Section 4.5 lays out the multiplier process and the effectiveness of monetary and
fiscal policies in this framework.

4.2 Product Market Equilibrium

This section explains how the interest rate is related to income in the Keynesian theory of the product market.
In the classical theory, income is determined on the assumption that there is no unemployment. Given this
assumption, the determination of the real interest rate is relatively straightforward since, once they had determined
full employment output, the classical economists were able to represent savings by an upward sloping supply
schedule. The equilibrium real interest rate could then be found as the rate at which the quantity of savings
supplied was equal to the quantity of investment demanded.

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 74 Economics II

In the Keynesian model, it is no longer true that there is a unique level of income. The fact that income
may fluctuate over the business cycle will affect the interest rate because households will be willing to save
more if they are rich than if they are poor. If income is high and unemployment is low, there will be a relatively
high supply of savings. Firms will not need to offer a high rate of interest to attract lenders and so a high value
of income will be associated with a low equilibrium interest rate. If instead income is low and unemployment
is high, investors will compete with each other to borrow a small pool of savings and they will bid up the rate
of interest. A low value of income will be associated with a high equilibrium interest rate. In the Keynesian
model, we summarize this idea by deriving a schedule, the IS curve, that plots the nominal interest rate on the
vertical axis and the level of income on the horizontal axis. At every point on the IS curve, the product market
is in equilibrium.

4.2.1 Derivation of IS Curve

The product market is in equilibrium when the aggregate demand for output equals aggregate supply of it. In a

s
closed economy, aggregate demand has three components: consumption expenditure, investment expenditure, and

es
government expenditure. Consumption expenditure depends on disposable income (national income less taxes),
investment expenditure depends on the interest rate, and government expenditure is autonomous. Aggregate

Pr
supply in the product market is gross national product (GNP) at factor cost or national income. Thus, the
equilibrium condition in the product market is given by

y
sit
Y = C (Y − t(Y )) + I ( r ) + G , 0 < C ′ < 1, 0 < t ′ < 1, I ′ < 0 (4.1)
er

dC dT
Here, C ′ = = mpc. The tax function is T = t(Y ) , and t ′ = is the marginal tax rate.
dY dY
iv

dI
Un

I′ = measures interest elasticity of investment. The alternative form of equilibrium is

dr
I (r ) + G = S (Y − t(Y )) + t(Y ) (4.2)
d

dS
or

Here, S ′ = = mps
dY
xf

The alternative form of the equilibrium condition states that investment (I) equals savings (S) under the
O

assumption that government budget is balanced. Thus, the product market equilibrium schedule is popularly
known as the IS curve, the schedule along which investment equals savings. The product market equilibrium,
either in equation 4.1 or 4.2, consists of several combinations of income (Y) and interest rate (r) that keep equality
between aggregate demand and aggregate supply, or between savings and investment.
The geometric representation of product market equilibrium is the IS curve. The IS curve is a locus of several
combinations of income and interest rate that maintain the product market in equilibrium in a sense that aggregate
demand equals aggregate supply, or investment equals savings. The product market equilibrium schedule, the IS
curve, is an extension of national income determination with a 45°-line diagram as shown in Chapter 3. Now
investment is no longer fully exogenous but is also determined by the interest rate.
By following the trick we have applied in Chapter 3 the derivation of the IS curve is shown in Fig. 4.2.
Panel B of Fig. 4.2 shows the investment function, which relates investment to the interest rate. Panel A of
Figure 4.2 locates equilibrium points corresponding to different interest rates, and the IS curve is drawn in
Panel C. The negatively sloped investment curve implies that investment demand rises when the interest rate
falls and vice versa. In Chapter 3, we discussed why investment is inversely related to the interest rate. The level

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 Commodity and Money Market Equilibrium 75

C, I, G r r
E2 C + I2 + G I

C + I1 + G E1
r1 r1
E1 C

r2 r2 E2
I2 + G
I′ IS
I1 + G
45°
Y1 Y2 Y I1 I2 I Y1 Y2 Y
Panel A Panel B Panel C

Fig. 4.2 Derivation of IS curve: aggregate demand approach

s
es
of investment is I1 when the interest rate is r1. This level of investment produces aggregate demand for output
C + I1 + G shown in Panel A. Given this level of aggregate demand, the product market is in equilibrium at

Pr
point E1, where equilibrium national income is determined at Y1 as shown in Panel A of Fig. 4.2. Thus, when
the interest rate is at r1, income will be at Y1, satisfying equilibrium in the product market. Measuring income

y
along the horizontal axis and the interest rate along the vertical axis, this (Y1, r1) combination which maintains
sit
equilibrium in the product market is plotted at point E1 in Panel C of Fig. 4.2. When the interest rate falls to
r2, investment rises to I2 and the equilibrium point shifts to E2, where aggregate demand (C + I2 + G) equals
er

income (Y2). Therefore, income level Y2 corresponds to the interest rate r2, satisfying equilibrium in the product
iv

market. This (Y2, r2) combination point is placed at E2 in Panel C. By joining all points such as E1, and E2, we
can draw the IS curve.
Un

A given reduction in the interest rate, from r1 to r2, raises the intercept of the aggregate demand curves by
the same vertical distance, as shown in Panel A of Fig. 4.2. However, the implied change in income is larger than
d

the change in investment demand because of the multiplier effect. The larger the mpc, the larger the change in
or

income produced by a given change in the interest rate.

Let us assume a linear consumption function and a linear investment function as we used in Chapter 3:
xf

C(Y) = a + bYd = a + b(Y − T) = a + b(1 − t)Y, T = tY

I(r) = a1 − b1r
O

The equation of the IS curve becomes

Y = a + b (1− t )Y + a1 − b1r + G
or, (4.3)
{1− b (1− t )}Y = a + a1 − b1r + G
From equation 4.3, it is clear that an increase in the interest rate reduces aggregate demand.
Alternatively, by using savings−investment equality, the equation of the IS curve is

S +T = I +G
or,
− a + {1− t − b(1− t )}Y + tY = a1 − b1r + G (4.4)
or,
[1− b(1− t )]Y = a + a1 − b1r + G

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 76 Economics II

r The derivation of the IS curve for the linear

investment schedule is illustrated in Fig. 4.3 in
E1
I+G terms of a four-quadrant figure. In quadrant 2, we
r1
have shown the linear investment schedule and
E2 government expenditure by measuring them along
r2
the horizontal axis from right to left with reference
IS
I2 + G I1 + G G to the origin O. The interest rate is measured
I, G O Y1 Y2 Y along the vertical axis. The investment schedule
E1 45° is negatively sloped and government expenditure
S1 + T is not dependent on the interest rate, shown by
E2 a vertical line. The savings plus tax schedule is
S2 + T S+T
shown in quadrant 4 by an upside-down straight
line. The linear savings schedule is obtained from

s
the linear consumption schedule. In quadrant 3,

es
S, T
a 45º diagonal line is used to find out equilibrium
Fig. 4.3 Derivation of IS curve: investment−savings in the product market. The IS curve is derived in

Pr
approach quadrant 1.
At an interest rate r1, investment plus

y
government expenditure is I1 + G. Point E1 in quadrant 3 determines equilibrium in the product market
sit
by equating I1 + G to S1 + T at income level Y1. Therefore, the combination of Y1 income and r1 interest
rate keeps the product market in equilibrium, which is shown by point E1 in the first quadrant. Points
er

E1 shown in the first and third quadrants represent the same equilibrium. A fall in the interest rate to r2
iv

raises investment to I2, increasing the level of spending at each income level. The new equilibrium point
Un

E2 requires higher savings at S2 corresponding to higher income level Y2. In the first quadrant, point E2
records the new equilibrium in the product market corresponding to (Y2, r2) combination of income and
interest rate. We can apply the same procedure to all conceivable levels of the interest rate and thereby
d

generate all the points that make up the IS curve. Thus, by joining all combination points such as E1 and
or

E2, we can draw the IS curve.

xf

4.2.2 Slope of IS Curve

O

The IS curve is negatively sloped reflecting the increase in aggregate demand associated with a reduction in the
interest rate. Therefore, the lower the rate of interest, the higher the income by maintaining the product market
in equilibrium. We can calculate the slope of the IS curve from either equation 4.3 or 4.4:

dr 1 − b (1 − t )
= (4.5)
dY −b1

dr
As 0 < b < 1, 0 < t < 1, and b1 > 0, the slope of the IS curve, <0
dY
The steepness of the curve depends on how sensitive investment spending is to changes in the interest
rate. Suppose that investment spending is very sensitive to the interest rate, so that b1 in equation 4.5 is large,
that is, a given change in the interest rate produces a large change in investment demand and also aggregate
demand that produces ultimately a large change in equilibrium income. If investment is very sensitive to the
interest rate, the IS curve is very flat. Conversely, if b1 is small and investment spending is not very sensitive

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 Commodity and Money Market Equilibrium 77

to the interest rate, the IS curve is relatively steep. If investment is perfectly interest elastic or the investment
schedule is horizontal, the IS curve will be horizontal to the income axis. On the other hand, if investment is
perfectly interest inelastic, that is, the investment schedule is vertical, the IS curve will be vertical.

4.2.3 Shifts of the IS Curve

The IS curve will shift when the autonomous parts of aggregate demand or other parameters of the IS curve equation
is changed. Let us see what happens if government expenditure goes up. Assume that government goods and
services cannot be easily substituted for private consumption goods so that the private savings schedule is unaffected
by an increase in government purchases. The effect of an increase in government purchases, when we make this
assumption, is illustrated in Fig. 4.4. When government expenditure increases, the I + G line shifts outwards
to I + G1. Given the interest rate at r1,
investment plus government expenditure r
is more. To keep the product  market

s
in equilibrium, savings plus tax will I + G1 I + G E1 E11

es
also be more, which corresponds to r1
higher income Y11. Therefore, the new

Pr
E2 E21
combination of income and interest r2 IS1
rate (Y11, r1) produces equilibrium in
y
IS
I2 + G I1 + G G
sit
the product market at the increased
I, G O Y1 Y2 Y11 Y21 Y
level of government expenditure. An
45°
er
increase in aggregate demand due to S1 + T
higher government spending shifts the
iv

aggregate demand curve up, raising the

Un

equilibrium level of output at interest S2 + T S+T

rate r1. At each level of the interest rate,

equilibrium income is now higher. S, T
d

Accordingly, the IS schedule in the

or

first quadrant shifts rightwards from IS

Fig. 4.4 Shifts of the IS curve due to an increase in government
to IS1. We have shown below that the
xf

expenditure
horizontal shift of the IS schedule is equal
O

to the multiplier times the increase in

government spending. Thus, an increase in government purchases or transfer payments will shift the IS curve
out to the right, with the extent of the shift depending on the size of the multiplier. Similarly, we can show
that a reduction in transfer payments or in government purchases shifts the IS curve to the left.
The position of the IS curve changes with the change in tax rate. We can analyse the effect of a change in net
taxes on the IS curve. We assume that taxes are levied as a lump sum on households and firms, and that net taxes
affect savings only through their effect on disposable income. The IS curve shifts to the left when net taxes go
up. For the case of a change in net taxes, we need to consider two effects of an increase in taxes on the product
market. First, if net taxes increase, the S + T schedule, shown in the southeast quadrant, will shift directly to
the left. Second, there is an indirect effect that follows from the fact that if net taxes increase, households will
have less disposable income and their supply of savings will fall. Since the direct effect is more than the indirect
effect, the S + T schedule will shift to the left, shifting the IS curve also to the left. The leftward shift of the IS
curve when taxes increase is smaller than the rightward shift when government purchases increase because, in the
case of taxes, the savings curve shifts to partially offset the change in the demand for funds by the government.

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 78 Economics II

We have shown the shifts of the IS schedule owing to an increase in mpc, or a decrease in mps, in Fig. 4.5.
A fall in mps shifts the S + T schedule rightwards. This is because when mps declines, other things remain
the same, people will save less at the
r
given level of income. In other words,
E1 a fall in mps or a rise in mpc means
I+G
r1 a rise in aggregate demand through
E2
more consumption, which produces
r2 more income. Therefore, a given rate
IS1
of interest corresponds to higher
I2 + G I1 + G IS
G income to keep the product market
I, G O Y1 Y2 Y in equilibrium. Thus, a fall in mps shifts
45°
S1 + T
the IS schedule rightwards. However,
in this case, the slope of the IS schedule

s
also changes, implying that the change
S2 + T

es
S+T
in mps or mps does not produce a
parallel shift.

Pr
S, T
4.2.4 Points off the IS Curve

y
Fig. 4.5 Shifts of the IS curve due to an increase in mpc
It is clear that any combination point
sit
of income and interest rate on the
IS curve satisfies the equilibrium condition in a sense that planned
er
r
output is exactly equal to planned demand, and, hence, no unintended
iv

inventory changes appear on the curve. Now, let us understand the

Un

implication of a combination point off the IS curve. This is illustrated

E1 E4 in Fig. 4.6. Positions off the IS curve imply disequilibrium in the
r1 product market. In Fig.4.6, points E1 and E2 are on the IS schedule,
d

but point E3 lies below the curve, while point E4 is above the curve.
or

E2
At point E3, we have the same level of income, Y1 as at E1, but the
E3
r2 interest rate is lower. Therefore, the demand for investment is higher
xf

IS
than at E3, and the demand for goods is higher than at E1. This means
O

O Y1 Y2 Y
that aggregate demand exceeds the level of output, and so there is
an excess demand for goods generating a fall in inventory. On the
Fig. 4.6 Disequilibrium in the product other hand, at point E4, the interest rate is higher than at E2. Thus,
market investment demand and aggregate demand are lower than at E2. There
is an excess supply of goods at point E4, raising the inventory level.
Therefore, points above the IS schedule correspond to an excess supply of goods, and points below relate to
an excess demand for goods.
Problem 4.1 Find an equation of the IS curve in a closed economy where the consumption, investment, and
government expenditure are
C = 350 + 0.3Y; I = 120 − 40r; G = 120
What value of the real interest rate clears the goods market when Y = 600? Calculate the slope of the IS curve.

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 Commodity and Money Market Equilibrium 79

Solution The IS curve represents equilibrium in the product market. Therefore, the equation of the IS curve is
Y=C+I+G
or, Y = 350 + 0.3Y + 120 − 40r + 120
or, 0.7Y + 40r = 590
When Y = 600, 40r = 590 − 420 = 170 or, r = 4.25
dr
Slope of the IS curve, = −0.0175
dY

4.3 Money Market Equilibrium

The nominal money demand is the individual’s demand for cash in hand. The real money demand, on the other
hand, is the demand for money in terms of the number of units of goods that money will buy. The real money

s
demand is equal to the nominal money demand divided by the price level. If the nominal money demand is `500

es
and the price level is `5, then the real money demand is 100. The real money demand is called the demand for real
balances. People create demand for real balances because money has some important functions. We will discuss in

Pr
detail different functions of money in Chapter 5. In the context of demand for money, we are now mentioning two
important functions of money: money functions as a medium of exchange, and money functions as a store of value.
y
sit
Money is the means by which we purchase goods and services. Money facilitates the exchange, because everyone
is willing to accept money as a medium of exchange for whatever it is that one might want to buy or sell. It is also
er
very easily divisible to the scale of what is being exchanged. Money is a store of value because it is a liquid asset. The
liquidity of an asset refers to how quickly the asset can be turned into cash, and since money is already cash, it is
iv

the most liquid asset possible. This is probably the reason that so many people hold onto cash as a store of value.
Un

Given our explanations of the functions of money, it will not be surprising that there are three different types
of demand for money. In Keynes’s theory, money is demanded due to three main motives: transactions motive,
precautionary motive, and speculative motive. The transactions motive gives rise to the transactions demand
d

for money, which refers to the demand for cash by the people for making current transactions of all kinds. The
or

precautionary motive induces the public to hold money to provide for contingencies requiring sudden expenditure
xf

and for unforeseen opportunities of advantageous purchases. This demand arises because of uncertainties. The
speculative motive giving rise to the speculative demand for money is the most important contribution Keynes
O

made to the theory of the demand for money. The transactions and precautionary motives are related to the
medium of exchange function of money. The asset demand for money is connected with the speculative motive.

4.3.1 Transactions Demand for Money

The transactions demand for money is using money as a medium of exchange. People want to hold money for
transactions purposes to bridge the gap between the earning point and the spending point. If there was a perfect
match between the moments we receive money in transactions and the moments we use money, we would not
need to hold any money at all for transactions. However, in the real world, there is not going to be an exact match
between when we receive money and when we need to make payments. Suppose, you receive `50,000 every month
as payment for your work. This payment comes once a month. However, you need to pay for several necessary
items over the month. In the course of the month, you have to hold some money for spending on these items.
How much money is needed for this purpose depends on the volume of transactions, which in turn depends on

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 80 Economics II

income. Therefore, the transactions demand for money depends on income. If the volume of income and output
produced in the goods markets increases, then clearly there will be a larger volume of transactions and exchanges
taking place. People will need to hold a larger volume of money to meet all these transactions and make payments.
The transactions demand for money is a demand for active balances because it is used as a means of payments in
national income-generating transactions.

4.3.2 Precautionary Demand for Money

People often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or
car repair bills, often require immediate payment. The need to have money available in such situations is referred
to as the precautionary motive for demanding money. The precautionary demand for money arises because of
uncertainties. According to Keynes, precautionary demands for money are those which are held to provide for
contingencies requiring sudden expenditure and for unforeseen opportunities of advantageous purchases, and also
to hold an asset of which the value is fixed in terms of money to meet a subsequent liability in terms of money. This

s
demand for money depends on income (Y).

es
As both the transactions demand and precautionary demand for money depend on income, we can express
these demands for money (L1) together:

Pr
dL1
L1 = L1 (Y ) , L1′ = >0 (4.6)
dY
y
sit
Keynes retained the influence of the Cambridge approach to the demand for money under which money
demand is assumed to be a function of income (Y). The transactions demand for money in Keynes’s version is
er

similar to the Cambridge version of the classical money demand function. Thus, Keynes’s transactions demand
iv

for money can be expressed in linear form as

Un

L1 = kPY (4.7)
Here, k is constant and similar to income velocity of money, P is price level which is assumed to be constant
in Keynes’s framework. Therefore, the transactions and precautionary demand schedule will be an upward rising
d

straight line passing through the origin as shown in Fig. 4.7.

or

4.3.3 Speculative Demand for Money

xf

There is one other reason why people have a demand for holding money balances. This is called the speculative
O

motive. People hold money as a financial asset just like stocks and
Y bonds. Holding money as a liquid asset is using money as a store
of value. Thus, the speculative demand for money is a demand
L1 = kPY for idle balances. An individual has to decide how to allocate the
financial wealth between alternative types of assets. Decisions
on the form in which to hold assets are portfolio decisions. For
the sake of simplicity, Keynes assumed that perpetual bonds
are the only non-money financial asset in the economy, which
compete with money in the asset portfolio of the people. Bonds
have returns in the form of interest rates, while money has no
return. On the other hand, money has liquidity, but bonds have
O L1
no liquidity. The more bonds held, the more interest received on
Fig. 4.7 Transactions and precautionary total financial wealth. The more money held, the more likely the
demand for money individual is to have liquidity. The portfolio decisions on how

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 Commodity and Money Market Equilibrium 81

much money to hold and on how many bonds to hold are really the same decision. This is because the sum of
the individual’s demand for money and demand for bonds has to add up to that person’s total financial wealth.
A decision to hold more money means a decision to hold less bonds. The wealth budget constraint implies that
when the money market is in equilibrium, the bond market also is in equilibrium. This implication allows us to
discuss assets markets entirely in terms of the money market.
Money does not earn any interest income. However, money is a certain asset in a sense that its capital value
in terms of itself is always fixed. In other words, the nominal value of a `10 note is always `10. Money is a liquid
asset. People create demand for money only because of its liquidity. Money is the most liquid asset and the cost
of holding money as an asset is the foregone interest rate. Thus, there is an inverse relationship between the
interest rate and the asset demand for money. If the interest rate goes up, the demand for liquidity goes down
and vice versa.
Bonds, on the other hand, yield interest income to their holders adjusted by capital gain or capital loss. It
can be shown algebraically that the price of a (perpetual) bond is given by the reciprocal of the market rate of

s
interest times the coupon rate of interest. Suppose the coupon rate (i.e., interest payable on a bond) is `1 per year

es
and the market rate of interest is 4% per year. Then, the market price of the bond will be `1/0.04 × 1 = `25. If
the market rate of interest rises to 5% per year, the market price of the bond will fall to `1/0.05 × 1 = `20. Thus,

Pr
bond price is seen as an inverse function of the interest rate. Bond prices keep on changing from time to time.
Therefore, they are subject to capital gains or losses. Thus, to a bond-holder, the return from bond-holding per

y
unit period (say a year) per `1 is the rate of interest ± capital gain or loss per year.
sit
er

A bond is a promise by a borrower to pay the lender a certain amount (the principal) at a specified
iv

date (the maturity date of the bond) and to pay a given amount of interest per year in the meantime. A
Un

perpetuity is a bond which promises to pay interest forever, but not to repay the principal on the bond.
Equities or stocks are claims to a share of the profits of an enterprise. The shareholder, or stockholder,
receives the return on equity in two forms: dividends and capital gain. The stockholders may receive a
d

certain amount for each share they own in the form of dividends. Sometimes firms decide not to distribute
profits to the stockholders but retain the profits and reinvest them by adding to the firms’ stocks of
or

machines and structures. In this case, the shares become more valuable, the price of the stock in the
market will rise, and stockholders can make capital gains. A capital gain is an increase in the price of
xf

an asset per unit of time.

O

The speculators are of two kinds: bulls and bears. Bulls are those who expect the bond prices to rise in the
future. Bears expect these prices to fall. In Keynes’s model, these expectations are assumed to be held with certainty.
Bulls, then, are assumed to invest all their idle cash into bonds and bears prefer more liquidity to bonds. To
move to the aggregate speculative demand for money, Keynes assumed that different asset holders have different
interest-rate expectations. Thus, at a very high rate of interest (and very low bond price), investors may behave
like bulls. Then, the speculative demand for money will be equal to zero. However, at a very low rate of interest
(very high bond price), investors will behave like bears and the demand for speculative balances will very high.
Thus, Keynes’s speculative demand for money is inversely related to the interest rate.
If we denote the speculative demand for money as L2 and the interest rate as r, Keynes’s speculative demand
function can be written as
dL
L2 = L2 ( r ) , L2′ = 2 < 0 (4.8)
dr

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 82 Economics II

r The geometric representation of Keynes’s liquidity

preference function or speculative demand for money
r1 function is shown in Fig. 4.8. Measuring L2 along
the horizontal axis and r along the vertical axis, the
speculative demand curve is shown by a negatively
sloped curve within a certain range of interest rates.
L2 = L2(r) It is vertical if the rate of interest is very high (≥r1), is
r2
negatively sloped if the rate of interest lies between r1
O L2
and r2, and becomes horizontal at the rate of interest r2.
As the rate of interest is very high at r1, every investor
Fig. 4.8 Speculative demand for money behaves like bulls in the asset market and nobody prefers
liquidity to bonds. Thus, at r1, liquidity preference is
zero and the speculative demand function is perfectly interest inelastic. The rate of interest is very low at r2 and

s
every investor in the asset market behaves like bears. As the interest rate is very low, everybody prefers liquidity

es
and the liquidity preference function becomes perfectly interest elastic. This phase in the speculative demand
function is known as liquidity trap in Keynes’s theory and this trap appeared during the phase of deep depression.

Pr
The liquidity trap refers to a situation when at a certain rate of interest the speculative demand for money becomes
perfectly elastic. This will come about when at that rate all the asset holders turn bears, so that none is willing to hold

y
bonds and everyone wants to move into cash. At the rate of interest r2, expansion of money supply cannot lower the
sit
rate of interest further. The people are willing to hold the entire extra amount of money in the form of cash at r2. The
extra liquidity created by the monetary authority gets trapped in the asset portfolios of the people without lowering r.
er

Keynes’s theory of liquidity preference has been called into question by Tobin (1958).1 In Keynes’s theory,
iv

there is no uncertainty in interest-rate expectations. Unlike Keynes, Tobin assumes that an individual investor does
Un

hold his interest-rate expectations with uncertainty in the form of capital loss. Liquidity preference is analysed
as behaviour towards risk under uncertainty. The degree of risk increases with the increase in the proportion
of bonds in the asset portfolio. Asset holders need higher compensation in the form of rate of interest for
d

undertaking higher risk. Thus, at higher interest rates, more bonds and less money will be held in the portfolio,
or

and at lower interest rates, less bonds and more money will be preferred. The result is a diversified asset portfolio
and a downward sloping asset demand curve for money with respect to the interest rate.
xf

Keynes’s theory of the speculative demand for money has also been criticized on the ground that bonds
O

are taken as representative of all non-money financial assets. In reality, however, a large number of non-money
financial assets are not similar to bonds. Examples of such assets include fixed deposits with commercial banks.
Substitution between them and money does not entail Keynes’s speculative motive, because they are not subject
to variation in their nominal capital values. In their case, their rates of return influence as simple opportunity-
cost variables without any element of speculation.
Also, as in Baumol−Tobin theory, the transactions demand for money also is interest elastic. The same can
be argued for the precautionary demand for money too. The explanation of the speculative demand for money
shows that this kind of demand will be an increasing function of total assets or wealth. If income is taken as a
proxy for wealth, the speculative demand also becomes a function of both income and the rate of interest.
Keynes’s money demand function can be specified as
dL1 dL
L = L1 (Y ) + L2 ( r ) , L1′ = > 0, L2′ = 2 < 0 (4.9)
dY dr

1
Tobin, James (1958). Liquidity preference as behavior towards risk, The Review of Economic Studies, 25, 65−86.

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 Commodity and Money Market Equilibrium 83

Here, L is the total demand for money which is an additive demand function with two separate components.
The first part, L1(Y), represents the transactions and precautionary demand for money. Keynes made both
an increasing function of the level of money income. In the Cambridge tradition, he tended to assume that
L1(Y) had a proportional form of the kind represented in Fig. 4.7. The second component, L2(r), represents the
speculative demand for money, which, as shown earlier, Keynes argued to be a declining function of interest rate.
As shown in Fig. 4.8, this relation was not assumed to be linear.
Keynes’s additive form of the demand function for money has been discarded by Keynesians and other
economists. In addition, we can write the Keynesian money demand function as

∂L ∂L
L = L (Y , r ) , > 0, <0 (4.10)
∂Y ∂r
Here, it is hypothesized that L is an increasing function of Y and a decreasing function of r.

s
4.3.4 Supply of Money

es
In developing the LM curve, we assume that the entire money supply is an exogenous variable that is directly
under the control of the central bank. The assumption that the money supply is exogenous is broadly correct,

Pr
although it is oversimplified, since strictly speaking the central bank (e.g., Reserve Bank of India) can directly
control only a small part of the stock of money. The theory of the demand for money is a theory about how the
y
sit
real value of money depends on income and the interest rate, but the theory of the money supply is a theory
of how the nominal quantity of money is controlled by the central bank. The real supply of money depends
er
not only on the behaviour of the central bank, but also on the price level. To complete our development of the
LM curve, we will assume that the price level is exogenous.
iv

4.3.5 Money Market Equilibrium: LM Curve

Un

The demand for money is the purchasing power of money (real balances). The supply of money M is determined
by the central bank, and its purchasing power is M/P, where P is the price level. It is assumed that the central
d

bank has full control of the nominal money supply. The money market is in equilibrium when the demand for
or

real balances equals the supply. We can write the equilibrium in the money market as
xf

M
= L (Y , r )
O

P
M
or, = L1 (Y ) + L2 ( r ) (4.11)
P
Here, we have assumed the expected rate of inflation to be zero and therefore the nominal and real rate
of interests are identical. Equation 4.11 shows several pairs of income (Y) and interest rate (r) that satisfy the
equilibrium condition in the money market.
The LM curve represents the pairs of income and interest rate that will keep the money market in equilibrium
with a given level of money supply and a given price level. The locus of all (y, r) combination points satisfying
money market equilibrium as given in equation 4.11 is called the LM curve. In other words, the combinations of
interest rates and income levels on the LM curve are such that the demand for real balances exactly matches the
available supply. The LM schedule, or the money market equilibrium schedule, shows all combinations of interest
rates and income levels such that the demand for real balances is equal to the supply. Along the LM schedule,
the money market is in equilibrium.

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 84 Economics II

LM The derivation of the LM

r curve in terms of a four-quadrant
diagram is shown in Fig. 4.9. In the
southeast quadrant of Fig. 4.9, the
line L1(Y) gives the transactions
r1 E1
and precautionary demand for
money, which is an increasing
L2(r) r2 E2 function of income, measured
L2 L22 1
L2 downwards. In the northwest
M O Y2 Y1 Y quadrant, L2(r) is the schedule
L1
2
representing the speculative
1 demand curve showing the
L1
speculative demand for money is

s
a decreasing function of interest

es
M
L1(Y)
rate. In the southwest quadrant,
we find out equilibrium in the

Pr
money market by equating the
L1 total demand for money to supply

y of it. A 45º line is drawn between

sit
Fig. 4.9 Derivation of LM curve
the transactions demand axis and
the speculative demand axis. The line is drawn at a distance from the origin on each axis equal to the total exogenously
er

given real money supply, M/P. At any point on the 45º line, the transactions demand and the speculative demand add
iv

up to the total money supply on each axis. This 45º line directly represents the money market equilibrium condition.
Un

We can now locate several pairs of (r, Y) that maintain the money market in equilibrium in the northeast
quadrant. At a given level of income at Y1, we can find L11 transactions demand for money from the schedule
L1(Y). We subtract this transactions demand from the money supply to find out the level of speculative demand
d

at L21 in maintaining money market equilibrium. This level of speculative demand shows the level of interest
or

rate r1 that will maintain money market equilibrium at income level Y1. Thus, we have a pair (Y1, r1) at point E1
in the northeast quadrant of Fig. 4.9. By repeating this process, we have another point E2. By joining all such
xf

points, we can draw the LM schedule.

O

4.3.6 Slope of LM Curve

The LM curve is upward sloping because, given a certain amount of real balances, an increase in income requires
an increase in the interest rate to keep the money market in equilibrium. For a particular LM curve, M and P do
not change. Thus, by taking the total differential of equation 4.11, we have

0 = L1′dY + L2′dr

dr L′
or, =− 1 (4.12)
dY L2′

Equation 4.12 provides the slope of the LM curve. Here, L1′ = ∂L1 / ∂Y is the slope of transactions demand
for money and is positive; L2′ = ∂L2 / ∂r measures the slope of the speculative demand curve and is negative.
Therefore, the slope of the LM curve, dr/dY > 0, is positive. A rise in income increases the transactions demand

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 Commodity and Money Market Equilibrium 85

for money. The LM curve is positively sloped. An increase in the interest rate reduces the demand for real balances.
To maintain the demand for real balances equal to the fixed supply, the level of income has to rise. Accordingly,
money market equilibrium implies that an increase in the interest rate is accompanied by an increase in the level
of income.
It is clear from equation 4.12 that the greater the responsiveness of the demand for money to income ( L1′), and
the lower the responsiveness of the demand for money to the interest rate ( L2′ ) , the steeper the LM curve. If the
demand for money is relatively insensitive to the interest rate, so that L2′ is close to zero, the LM curve is nearly
vertical. If the demand for money is very sensitive to the interest rate, so that L2′ is large, then the LM curve is
close to horizontal. The horizontal part of the LM curve represents liquidity trap.

4.3.7 Points off LM Curve r LM

We consider points off the LM schedule to characterize them as situations

of excess demand or excess supply of money. Any point on the LM curve

s
follows equilibrium in the money market in a sense that demand for real

es
balances equals the supply. Points below and to the right correspond to an B
E2
excess demand for real balances. Let us take a point E1 on the LM curve

Pr
where the combination of income and interest rate satisfies the money market
equilibrium condition. Let income level be increased while the rate of interest

y
A
remains the same as at point E1. An increase in income moves the combination E1
sit
point from E1 to A as shown in Fig. 4.10. As income is more at point A, demand
for money is higher than its supply. Thus, at point A, there is an excess demand O Y
er

for money. By a similar argument, we can say that points above and to the left Fig. 4.10 Points off the LM curve
iv

of the LM schedule correspond to an excess supply of real balances. Let us

Un

take another point E2 on the LM

curve where income and interest
LM LM1
rate are determined by following
d

r
money market equilibrium. Now,
or

at point B, income is less while

the interest rate is the same as at
xf

point E2. Lower the income level, r1 E1

O

interest rate remaining the same,

the lower will be the demand for L2(r) r2 E2
money. Thus, at point B, there is 2 1
L2 L2
an excess supply of money. L2
M1 M O Y2 Y1 Y
2
4.3.8 Shifts of LM Curve L1

The real money supply is held L11

constant along the LM curve.
It follows that a change in the M
real money supply will shift L1(Y)
M1
the LM curve. An increase in
the money supply results in an
L1
excess of money at points on the
initial LM curve and shifts the Fig. 4.11 Shift of the LM curve when money supply increases

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 86 Economics II

LM curve to the right (Fig. 4.11). An increase in the stock of real balances shifts the 45º line outwards in the
southwest quadrant from MM to M1M1. At the initial interest rate r1, the equilibrium income will be higher
to keep the money market in equilibrium. The equilibrium pair of income and interest rate shifts to the right
and, as a result, the LM schedule will shift to the right in the northeast quadrant. At each level of the interest
rate, the level of income has to be higher so as to raise the transactions demand for money and thereby absorb
the higher real money supply.
Problem 4.2 Suppose that the real money demand function is
L = 100 + 0.2Y − 200r
Assume that M = 300, P = 2.
Find out the LM curve equation.
What is the value of the interest rate when Y = 600?

Solution The LM curve represents money market equilibrium. Therefore, the equation of the LM curve is

s
es
M
= 100 + 0.2Y − 200r or, 150 = 100 + 0.2Y − 200r

Pr
P
or, 0.2Y − 200r = 50

y
sit
When Y = 600, 120 − 200r = 50 or, r = 0.35
dr
er

The slope of the LM curve, = 0.001

dY
iv

4.4 IS−LM Model

Un

We are now ready to put together the two parts of the Keynesian theory of aggregate demand: the IS and LM
d

curves. John Hicks, a Nobel laureate (1974), devised the IS-LM model based on Keynes’s theory. IS stands
or

for investment-savings and LM for liquidity-money. The IS-LM model describes the aggregate demand of
the economy using the relationship between output and interest rates. Hicks allowed investment to be a
xf

function of interest rate. The IS equation shows an equilibrium relationship between the real income and the
O

real rate of interest. The higher the rate of interest, the lower is investment, and consequently income. Hicks
also considered the demand for and supply of liquidity or money, which depend on income and the nominal
rate of interest. An increase in income results in a higher demand for money and an increase in the interest
rate will decrease the demand. The reason is that the more income a nation has, the more transactions will be
made; hence, the more money needed. However, the interest rate is the price of money, and an increase in the
price will cut the demand.
The task of the IS−LM model is to determine income and interest rate simultaneously by the interaction
of the product and money markets. When we put together the IS and LM curves, we will be able to describe
the simultaneous determination of the nominal interest rate and income in an IS−LM equilibrium. When we
build the IS−LM model, we will take the price level as fixed. Thus, we may get different equilibrium points, the
points of intersection between the IS and LM curves, corresponding to different price levels. The relationship
between the price level and the equilibrium value of income in the IS−LM model is called the Keynesian aggregate
demand curve.

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 Commodity and Money Market Equilibrium 87

Figure 4.12 shows that the interest rate and the level of output are determined by the interaction of the money
(LM) and product (IS) markets. In Fig. 4.12, we have combined the LM curve with the IS curve. The IS curve, given
in equation 4.1, represents values of the interest rate and income for which
the product market is in equilibrium. Any point on the IS curve satisfies r LM
the product market equilibrium condition. The LM curve, presented in
equation 4.11, denotes values of the interest rate and income for which
the quantity of money demanded is equal to the quantity supplied. At
any point on the LM curve, the money market is in equilibrium. The rE E

equilibrium of the IS−LM model occurs at point E, where the IS and

LM curves intersect. This is the only point at which both the product
market and the money market are in equilibrium simultaneously. IS
At point E in Fig. 4.12, the economy is in equilibrium, given the
price level, because both the goods and money markets are in equilibrium.

s
The demand for goods is equal to the level of output on the IS curve. O YE Y

es
In addition, on the LM curve, the demand for money is equal to the Fig. 4.12 Equilibrium in the IS−LM
supply of money. Accordingly, at point E, firms produce their planned model

Pr
amount of output (there is no unintended inventory accumulation or
rundown), and individuals have the portfolio compositions they desire.

y
What would happen if the economy were at a point other than point E? The answer is that there are two
sit
forces pulling the economy back to the point of intersection of the IS and LM curves. First, suppose that the
economy is at a point that is below the IS curve. Points below the IS curve are points for which investment exceeds
er

savings. Investors will bid up the interest rate in an attempt to secure funds and the interest rate will rise. A similar
iv

argument establishes that points above the IS curve are points for which savings exceed investment. Investors will
Un

be able to offer lower interest rates since there is an excess of savers in the market and the interest rate will fall.
At any point to the left of the LM curve, income is lower than a point that is on the LM curve but with
the same interest rate. Since income is lower, the quantity of money demanded will also be lower. It follows
d

that points to the left of the LM curve are points for which there is an excess supply of money. Households are
or

holding more money than they need to finance their daily transactions and they will try to spend this money by
demanding more commodities; the aggregate demand for goods and services will increase. As demand increases,
xf

firms will hire more workers and employment and income will rise until the economy is back on the LM curve.
O

A similar argument establishes that if the economy is to the right of the LM curve, there is an excess demand for
money. Households will buy fewer commodities and aggregate demand will fall. As demand falls, firms will lay
off workers and employment and income will fall until the economy is back on the LM curve.
Income and interest rates adjust to the disequilibrium in goods markets and assets markets. Specifically,
interest rates fall when there is an excess supply of money and rise when there is an excess demand. Income rises
when aggregate demand for goods exceeds output and falls when aggregate demand is less than output. The
system converges over time to the equilibrium at E. Thus, there are forces that move the economy towards point
E, the IS−LM equilibrium point.
4.4.1 Derivation of Aggregate Demand Curve
The major assumption in IS−LM equilibrium is that the price level is constant and that firms are willing to
supply whatever amount of output is demanded at that price level. Let us look at how equilibrium income in
the IS−LM model is different for different values of the price level. The aggregate demand curve links the price

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 88 Economics II

level to the aggregate quantity of commodities demanded. In the IS−LM model, the equilibrium output and the
interest rate are determined under the assumption that the price level remains the same. When the price level
changes and other factors remain the same, the position of the LM
r LM1 LM2 curve changes, and accordingly the equilibrium point will change.
Figure 4.13 derives the aggregate demand curve. In Panel A, we plot
the interest rate against income. We will use Panel A to show that
E1 the IS−LM equilibrium is different for different values of the price
r1 E2 level. We must know the price level to construct this diagram since
Panel A
r2 the real value of the supply of money depends on it. Given the price
level P1, the LM curve is LM1. The equilibrium point is determined
IS at E1 where output and interest rate are determined at Y1 and r1,
respectively. Tracing equilibrium income down to Panel B gives a
O Y1 Y2 Y point, E1, corresponding to the equilibrium point, on the Keynesian

s
aggregate demand curve.

es
Let the price level drops from P1 to P2. If price level falls to P2,
the supply of real balances will increase and the LM curve shifts in

Pr
P1 E1
the rightward direction to LM2 as shown in Panel A. Given the IS
P2 E2 curve, the equilibrium point shifts to E2, where output is determined
Panel B
y
at Y2. The price output combination point is plotted at E2 in Panel B.
sit
By joining all such points in Panel B, we have drawn a downward
sloping curve. This curve resembles the aggregate demand curve.
er

At every point on the aggregate demand curve, both the product

iv

Y1 Y2
market and the money market are in equilibrium.
Un

Fig. 4.13 Derivation of aggregate

demand curve 4.4.2 Mathematical Formulation of IS−LM Model
The intersection of the IS and LM schedules in the diagrams
d

corresponds to a situation in which both the IS and LM equations hold. The same interest rate and income
or

levels ensure equilibrium in both the goods and the money market. In terms of the equations, this means that
we have to solve the IS curve equation (4.1) and LM curve equation (4.11) simultaneously to get equilibrium
xf

values of Y and r. For simultaneous equilibrium, interest rates and income levels have to be such that both the
O

goods market and the money market are in equilibrium. We reproduce here the IS curve equation and the LM
curve equation as shown in equations 4.1 and 4.11, respectively, as
M
Y = C (Y − t(Y )) + I ( r ) + G ; = L1 (Y ) + L2 ( r )
P
By solving these equations, we will get equilibrium income and interest rate in the IS−LM model. To understand
how to calculate equilibrium income and interest rate in the IS−LM framework, let us consider the following
IS and LM curve equations:
Y = b (1 − t )Y − b1r + G (4.13)

M
m=
= l1Y − l2 r (4.14)
P
Here, m denotes real balances, l1 is income sensitivity of money demand, and l2 is interest sensitivity of
money demand.

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 Commodity and Money Market Equilibrium 89

In matrix form, equations 4.13 and 4.14 can be expressed as

1 − b(1 − t ) −b1  Y  G 
 = (4.15)
 l1 − l2   r   m 
By using Cramer’s rule, we can solve for equilibrium values of income and interest rate as
b1 m
G−
− l2G + b1 m l2
Y= = (4.16)
− l2 {1 − b(1 − t )} + l1b1 1 − b(1 − t ) − l1 b
1
l2
Equation 4.16 shows that the equilibrium level of income depends on two exogenous variables: government
spending (G) and the real money stock (m = M/P). Equilibrium income is higher the higher the level of government
spending and the higher is the stock of real balances.

s
es
m l
− {1 − b(1 − t )} + 1 G
m{1 − b(1 − t )} − l1G l2 l2
r= =

Pr
(4.17)
− l2 {1 − b(1 − t )} + l1b1 l
1 − b(1 − t ) − 1 b1
l2

y
sit
Equation 4.17 shows that the equilibrium interest rate depends on the parameters of fiscal policy captured
in the multiplier and the term G and on the real money stock, m. A higher real money stock implies a lower
er

equilibrium interest rate.

iv

4.5 Fiscal and Monetary Policies

Un

Equilibrium in both the goods and money markets is simultaneously attained where the IS and LM curves intersect,
that is, at point E in Fig. 4.12. Two points are worth emphasizing. First, the intersection of the two curves in
d

Fig. 4.12 determines the values of the rate of interest and income which are consistent with equilibrium in both
or

markets. Second, if the level of income is below that of full employment, then both fiscal and monetary policies
have a potentially important role to play in stabilizing the economy. We now briefly review what determines the
xf

relative effectiveness of fiscal and monetary policies in influencing aggregate demand and therefore the level of
O

output and employment.

r
4.5.1 Fiscal Policy Multiplier LM

The equilibrium levels of income and the interest rate change when E2
either the IS or the LM curve shifts. The fiscal policy multiplier r2
E1
shows how much an increase in government spending, or a cut r1
E3
in tax rate, changes the equilibrium level of income, holding the IS2
real money supply constant. Figure 4.14 shows the effects of an IS1
increase in government expenditure on equilibrium income and
interest rate. An increase in government spending shifts the IS
schedule out and to the right from IS1 to IS2. The shift of the
O Y1 Y2 Y3 Y
IS curve, given the LM curve at its initial position, results in a
rise in the level of income from Y1 to Y2 and an increase in the Fig. 4.14 Effects of an increase in
interest rate from r1 to r2 by the movement of equilibrium from government expenditure

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 90 Economics II

E1 to E2. Here, the change in income is Y1Y2, which is clearly less than the horizontal shift in the IS curve.
If, somehow the interest rate remains at r1, the increase in income (Y1Y3) equals the length of the horizontal
shift of the IS curve.
The increase in government spending does tend to increase the level of income. However, an increase in
income increases the demand for money. With the supply of money fixed, the interest rate has to rise to ensure
that the demand for money stays equal to the fixed supply. When the interest rate rises, investment spending
is reduced because investment is negatively related to the interest rate. Accordingly, the change in equilibrium
income is less than the change in the simple Keynesian model.
The government expenditure multiplier in the IS−LM framework can be obtained directly from the
expression of equilibrium income shown in equation 4.16. We allow Y to change when G changes with
fixed money supply and other parameters. Thus, by taking the total differential of equation 4.16 and keeping
dm = 0, we have
− l 2 dG dG

s
dY = =
−l2 {1 − b(1 − t )} + l1b1 1 − b(1 − t ) − l1 b

es
1
l2

Pr
dY 1

y
or, = (4.18)
dG 1 − b(1 − t ) − l1 b
sit
1
l2
er

Similarly, the change in interest rate due to change in government spending is obtained from equation 4.17:
iv

l1
dG
Un

−l1dG l2
dr = =
−l2 {1 − b(1 − t )} + l1b1 1 − b(1 − t ) − l1 b
d

1
l2
or

l1
xf

dr l2
or, = (4.19)
O

dG 1 − b(1 − t ) − l1 b
1
l2

Equations 4.18 and 4.19 provide the rate of change of income and interest rate due to the change in government
expenditure. The expression given in 4.18 is known as the government expenditure multiplier in the IS−LM
model. If we compare the IS−LM multiplier with the simple Keynesian multiplier, it would be clear that the
value of the multiplier in the IS−LM model is less than the value of multiplier in the simple Keynesian model.
This is because of the additional term in the denominator, − (l1/l2) b1, in equation 4.18. Here, l1/l2 is the slope of
the LM curve given in equation 4.14. It gives the increase in r that is needed for money market equilibrium with
the increase in Y. Since b1, the slope of the linear investment function, gives the change in investment that comes
from change in r, the expression − l1/l2 b1 then gives the decrease in investment that comes from the interest rate
increase as Y and r rise along the LM curve.
The tax rate is another important fiscal instrument by which the government can control aggregate demand.
To find out the tax cut multiplier, let us take the equilibrium condition in the product market as shown in

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 Commodity and Money Market Equilibrium 91

the IS curve equation (4.13) and the money market equilibrium condition is given in the LM curve equation
shown in (4.14):
Y = b (1 − t )Y − b1r + G
M
m= = l1Y − l2 r
P
To calculate the tax cut multiplier, we have to keep government expenditure and real money supply constant,
and we can allow the tax rate (t) to change. Taking the total differential of equations 4.13 and 4.14, we have the
following expressions:
dY = b ( dY − tdY − Ydt ) + b1dr
or, (4.20)
{1 − b(1 − t )} dy − b1dr = −bYdt

s
es
l1 (4.21)
l1dy − l2 dr = 0 or, dr =

Pr
dy
l2

y
sit
Substituting the value of dr from (4.21) into (4.20) gives us
er
l
{1 − b(1 − t )} dY − b1 1 dY = −bYdt
l2 (4.22)
iv

−bYdt
or, dY =
Un

l1
1 − b(1 − t ) − b1
l2
d

The numerator of equation 4.22 simply converts the tax change into the policy-induced change in consumer
or

expenditure. The term Ydt is the change in disposable income that comes directly from the change in tax rate.
Thus, the term bYdt is the change in consumption spending that comes from the change in disposable income.
xf

The negative sign implies that when tax rates go down, the policy-induced consumption expenditure goes up.
O

By comparing equations 4.18 and 4.22, we can say that the tax cut multiplier is similar to the government
expenditure multiplier.

4.5.2 Effectiveness of Fiscal Policy

An increase in government spending shifts the IS curve to the right, resulting in higher income and interest
rate (shown in Fig. 4.14). The economic explanation is that the additional expenditure creates income for those
who supply goods and services to the government. Again, the multiplier effect works to increase the aggregate
income beyond the initial increase in government expenditure. However, there is a difference here. The increase
in income increases the demand for money, which, given the supply of money, would increase the interest rate.
Thus, there will be drop in investment, which to some extent will negate the initial effect of the expansionary
fiscal policy. Nevertheless, because investment is not too sensitive to interest rate, this secondary effect would be
small. A tax cut will also shift the IS curve to the right and will have an expansionary effect.
One can verify, from the expression for the fiscal policy multiplier as shown in equation 4.18, that fiscal
policy will be more effective in influencing aggregate demand and therefore the level of output and employment

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 92 Economics II

when the more interest-elastic is the demand for money (the flatter is the LM curve), and the less interest-elastic
is investment (the steeper is the IS curve). In the limiting cases of a vertical LM curve (classical range), fiscal
expansion will have no effect on income. In this phase, the rise in the rate of interest will reduce private investment
by an amount identical to the increase in government expenditure producing full crowding out. At the other
extreme, a horizontal LM curve (liquidity trap) provides the full multiplier effect of the simple Keynesian model.
How effective the fiscal policy is depends on the rate of fall of private investment owing to the rise in interest
rate induced by the fall in speculative demand for money. The fall in investment due to the rise in interest rate along
the LM curve induced by the increase in autonomous spending is known as the crowding out effect. The government
expenditure multiplier is reduced by this crowding out effect. The effect depends on the slope of the LM curve.
Given the slope of the IS curve, the crowding out is higher the more inelastic the LM curve. Given the slope of the
LM curve, the crowding out is higher the more elastic the IS curve. An expansionary fiscal policy (increasing in G
or decreasing in T) is more effective in affecting the level of real income, and the lower is the crowding out effect.
If the LM curve is horizontal, there will be no crowding out effect and full expansionary effect will be obtained

s
(Fig. 4.15). The increase in government expenditure causes the level

es
of income to rise by Y1Y2. This amounts to the full multiplier times LM
the increase in G. If the increase in G is not tax financed and the r

Pr
money supply is fixed, the funds are obtained by borrowing from the IS6

non-bank private sector of the economy. This type of fiscal policy is a r IS5

y
pure fiscal policy. As the interest elasticity of the demand for money
6
sit
is infinite, a very small increase in interest rate resulting from deficit
financing will decrease the liquidity preference. Thus, a larger level r5
er

IS3 IS4
of transactions has to be financed by a fixed money supply. In the
iv

IS2
new equilibrium, the rate of interest will be the same as before. As a IS1
Un

result, private investment will be the same as before. Therefore, the r4

increase in income will equal the full multiplier times the increase r3
in government purchases. Thus, if the economy passes through deep
d

depression characterized by the liquidity trap in the money market,

or

O Y1 Y2 Y3 Y4 Y5 Y
the multiplier effect will be full. If the LM curve is horizontal, then
the interest rate will not change when the IS curve shifts. This is the Fig. 4.15 Expansionary effects at different
xf

pure Keynesian situation where the fiscal policy will be fully effective. cyclical positions
O

If the LM curve is upward rising as in the case of a general

Keynesian model, the crowding out effect is partial. In this case, the increase in G succeeds in increasing the
equilibrium income from Y3 to Y4. However, in this intermediate range, the need to finance the increased volume
of transactions forces the rate of interest up from r3 to r4. The level of private investment will fall because of this
increase in interest rate. The expansionary effect of the fiscal policy is therefore partially negated.
If the LM schedule is vertical, the expansionary effect will be fully crowded out and the value of the fiscal
policy multiplier is zero. The LM curve is vertical in a situation of full employment representing the classical case.
Thus, in the classical range, the increase in G has no effect on the level of income. As there are no idle money
balances available in the private sector of the economy, the government can borrow funds from the private sector
only at the cost of the proportional reduction in private investment. Interest rates must rise enough to make the
return on government bonds greater than the prospective yield on private investment. Any increase in G will
be matched by an equal reduction in private investment. Thus, the crowding effect is full and fiscal policy has
no effect on the level of income. Allocation of resources will change from the private sector to the public sector
without any change in the level of income.

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 Commodity and Money Market Equilibrium 93

The orthodox Keynesian faith in the effectiveness of fiscal policy has been challenged by, among others,
monetarists who typically argue that in the long run ‘pure’ fiscal expansion (i.e., expansion without any
accommodating changes in the money supply) will result in the crowding out or replacement of components of
private expenditure with relatively minor effects on aggregate demand, the level of income, and employment.
A number of reasons as to why crowding out can occur in the IS−LM framework have been put forward in the
literature, which do not rely on the demand for money being perfectly interest inelastic (a vertically sloped LM
curve), including expectations and wealth effects (Carlson and Spencer).2

4.5.3 Monetary Policy Multiplier

The monetary policy multiplier shows how much an increase in the real money supply increases the equilibrium
level of income, keeping fiscal policy unchanged.

dY = b ( dY − tdY ) + b1dr

s
or, (4.23)

es
{1 − b(1 − t )} dY − b1dr = 0

Pr
l1 1
l1dy − l2 dr = dm or, dr = dy − dm (4.24)
l2 l2
y
sit
By substituting dr from (4.24) into (4.23), we have
er

l 1 
{1 − b(1 − t )}dY − b1  1 dY − dm  = 0
iv

l l 
Un

2 2

b1
dm
d

l2
or, dY = (4.25)
or

l
1 − b(1 − t ) − 1 b1
l2
xf
O

Equation 4.25 provides the monetary policy multiplier. The smaller l2 and l1 and the larger b1, the more
expansionary the effect of an increase in real balances on the equilibrium level of income. Large b1 corresponds
to a very flat IS schedule. The monetary policy multiplier is illustrated in Fig. 4.16. An increase in M will shift
the LM curve to the right, by an amount given by the change in M. Let the initial LM curve be LM1. After the
increase in M, the new LM curve is LM2. As we can see the effect is an increase in income from Y1 to Y2 and a
reduction in interest rate from r1 to r2. Thus, an increase in money supply (everything else constant) will increase
the equilibrium level of income and decrease the equilibrium interest rate. The idea is that an increase in the
money supply, given the money demand, will create an excess of money in the money market. To eliminate
this excess of money, the theory of liquidity preference says that the interest rate must decrease. However, if
the interest rate decreases, investment will increase and therefore income will increase. As income increases,
money demand increases, helping to restore the equilibrium in the money market. The process ends at the new
equilibrium E2 determining new income and interest rate at Y2 and r2, respectively. It should be evident that a

2
Keith M. Carlson and Roger W. Spencer, “Crowding Out and Its Critics,” Federal Reserve Bank of St. Louis Review, December 1975, pp. 2−17.

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HE-9780199470549-Economics II.indb 93 31/05/16 6:44 PM

 94 Economics II

r LM1 decrease in money supply will have the reverse effects.

LM2 The interest rate will increase causing investment and
income to decrease. Again, the reduction in income, to
some extent, will modify the effects of the drop in money
E1
r1 supply. The reason is that the lower income will reduce
r2
the demand for money.
E2
4.5.4 Effectiveness of Monetary Policy
IS The effectiveness of monetary policy depends on the
cyclical position of an economy. Within the orthodox
Keynesian transmission mechanism, the effectiveness of
O Y1 Y2 Y
monetary policy depends on the degree to which the rate
Fig. 4.16 Monetary policy multiplier of interest falls following an increase in the money supply,

s
and the degree to which investment responds to a fall in

es
the rate of interest. We can verify that monetary policy will be more effective in influencing aggregate demand
and therefore the level of output and employment when the demand for money is more interest inelastic (the

Pr
steeper is the LM curve), and the investment is more interest elastic (the flatter is the IS curve). In the extreme
Keynesian cases of either a horizontal LM curve (liquidity trap) or a vertical IS curve (investment is completely

y
interest inelastic), the transmission mechanism breaks down and monetary policy will have no effect on the
sit
level of income. In the case of the liquidity trap, the interest rate is at the lowest possible level and the additional
liquidity would not have any effect on the interest rate and on investment.
er

Figure 4.17 shows how the monetary policy affects the level of income and the interest rate. If the IS schedule
iv

(IS1) cuts the LM curve in the Keynesian liquidity trap region, the increase in the money supply will not affect the
Un

level of income and the interest rate at all. A very little fall in the interest rate produces an unlimited preference
for liquidity so that all the added money balances move into idle holdings and none move into added transaction
balances. In equilibrium, therefore, the rate of interest remains the same. Investment is not stimulated and the
d

level of income remains unchanged. Thus, if liquidity trap prevails as in deep depression, monetary policy is
or

totally ineffective in expanding the economy, or in controlling inflation.

If the IS curve (IS2) cuts the LM curve in the upward rising part, the increase in the money supply succeeds
xf

in increasing the level of income along with the rise in interest rate.
LM
O

r LM1 Thus, there will be crowding out effect due to the fall in investment
IS3 because of the rise in interest rate induced by the increasing money
supply. In this case, part of the increase in money supply is absorbed
into active balance in the form of transactions demand for money
and the rest into liquidity preference. The interest rate declines
IS2 and investment will increase, but not to the full extent. The level of
IS1 income will rise only partially as shown in equation 4.25. Therefore,
if the LM curve is upward rising, known as the general Keynesian
range, the monetary policy is partially effective.
If the IS curve (IS3) cuts the LM curve in the vertical part
of the LM curve representing the cyclical phase as described by
O Y classical economists, the monetary policy will be fully effective.
Fig. 4.17 Expansionary effects of monetary In this phase, the prices of government bonds would be bid
policy up enough that other assets are relatively more attractive than

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HE-9780199470549-Economics II.indb 94 31/05/16 6:44 PM

 Commodity and Money Market Equilibrium 95

government bonds. There will be no liquidity preference because of high interest rates and wealth holders will
use added money balances to purchase other earning assets. In other words, the added money supply will move
into investment in other earning assets such as new securities or new investment in physical capital in the real
sector. New capital investment will raise the level of income, raising the transactions demand for money. Wealth
holders will continue to compete for earning assets, bond prices continue to rise, and interest rates continue to
fall until the point is reached where new investment raises the level of income exactly enough to absorb added
money balances into transactions.
From the earlier discussion, it should be evident that, while both fiscal and monetary policies can, in normal
circumstances, be used to influence the level of output and employment, the relative effectiveness of these two
policy instruments depends on the structural parameters of the model, that is, the relative slopes of the IS and LM
curves. Within the orthodox Keynesian approach, the demand for money has traditionally been viewed as being
highly responsive to changes in the rate of interest (generating a relatively flat LM curve), while investment has
been taken as being fairly unresponsive to changes in the rate of interest (generating a relatively steep IS curve).

s
es
Pr
SUMMARY
• The IS curve is the locus of combinations of the interest
y
of which the value is fixed in terms of money to meet
rate and level of income such that the product market
sit
a subsequent liability in terms of money.
is in equilibrium. • People hold money as a financial asset just like stocks
• The
er
IS curve is negatively sloped, implying that and bonds. Holding money as a liquid asset is using
an increase in the interest rate reduces planned money as a store of value. This is called the speculative
iv

investment spending and therefore reduces aggregate motive. The speculative demand for money is a demand
demand, reducing the equilibrium level of income. for idle balances. Keynes’s speculative demand for
Un

• The less sensitive investment spending is to changes money is inversely related to the interest rate.
in the interest rate, the steeper the IS curve. • The liquidity trap refers to a situation when at a certain
• The IS curve is shifted by changes in autonomous rate of interest the speculative demand for money
d

spending. An increase in autonomous spending, becomes perfectly elastic.

or

including an increase in government purchases, shifts • Money market equilibrium implies that an increase
the IS curve out to the right. in the interest rate is accompanied by an increase in
xf

• At points to the right of the curve, there is excess the level of income.
• The
O

supply in the goods market; at points to the left of LM curve is the schedule of combinations of
the curve, there is excess demand for goods. income and interest rates such that the money market
• In Keynes’s theory, money is demanded due to three is in equilibrium.
main motives: transactions motive, precautionary • The LM curve is positively sloped. Given the fixed
motive, and speculative motive. money supply, an increase in the level of income, which
• The transactions demand for money is using money as increases the quantity of money demanded, has to
a medium of exchange. People want to hold money for be accompanied by an increase in the interest rate.
transactions purposes to bridge the gap between the This reduces the quantity of money demanded and
earning point and the spending point. The transactions thereby maintains money market equilibrium.
demand for money is a demand for active balance • TheLM curve is shifted by changes in the money
because it is used as a means of payments in national supply. An increase in the money supply shifts the
income-generating transactions. LM curve to the right.
• Precautionary demands for money are those that are • Atpoints to the right of the LM curve, there is an
held to provide for contingencies requiring sudden excess demand for money, and at points to its left,
expenditure and for unforeseen opportunities of there is an excess supply of money.
advantageous purchases, and also to hold an asset

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HE-9780199470549-Economics II.indb 95 31/05/16 6:44 PM

 96 Economics II

• The interest rate and level of output are jointly LM curve is upward rising as in the case of a general
determined by the simultaneous equilibrium of the Keynesian model, the fiscal policy effect is partial. If
goods and money markets. This occurs at the point the LM schedule is vertical, the expansionary effect
of intersection of the IS and LM curves. will be fully crowded out and the value of the fiscal
• The fiscal policy multiplier shows how much an increase policy multiplier is zero.
in government spending, or a cut in tax rate, changes • The effectiveness of monetary policy depends on the
the equilibrium level of income, holding the real money degree to which the rate of interest falls following an
supply constant. increase in the money supply, and the degree to which
• The fall in investment due to the rise in interest investment responds to a fall in the rate of interest. If
rate along the LM curve induced by the increase in liquidity trap prevails as in deep depression, monetary
autonomous spending is known as the crowding out policy is totally ineffective in expanding the economy, or
effect. The effect depends on the slope of the LM curve. in controlling inflation. If the LM curve is upward rising,
• The monetary policy multiplier shows how much an known as the general Keynesian range, the monetary
increase in the real money supply increases the equilibrium policy is partially effective. If the IS curve cuts the LM
level of income, keeping fiscal policy unchanged. curve in the vertical part of the LM curve representing

s
the cyclical phase as described by classical economists,
• If the LM curve is horizontal, there will be no crowding

es
the monetary policy will be fully effective.
out effect and fiscal policy will be fully effective. If the

y Pr
sit
EXERCISES
er
4.1 What is an IS curve? 4.15 Explain graphically how the LM curve shifts with a
4.2 Why is the IS curve negatively sloped? change in money supply. [C.U., 2013]
iv

4.3 What is an LM curve? 4.16 Discuss Keynes’s theory of demand for money.
Un

4.4 Why is the LM curve positively sloped? [C.U., 2013]

4.5 Explain the concept of liquidity trap. 4.17 Define LM curve. Derive and explain the different
4.6 Explain how the IS curve is derived. slopes of the LM curve in its different segments.
d

4.7 Explain how the LM curve is derived. [C.U., 2015]

or

4.8 Show how equilibrium level of income and interest rate 4.18 Suppose that the government adopts an expansionary
are simultaneously determined in the IS−LM model. fiscal policy by way of increasing autonomous
xf

4.9 The relative effectiveness of the fiscal and monetary government expenditure. Show that the resulting
O

policies depends on the slopes of IS and LM curves. expansionary impact on the equilibrium income will
Explain. be less in the IS−LM model than that in the simple
4.10 Show with the help of a diagram that the extent of Keynesian model. [C.U., 2015]
change in national income arising from an increase in 4.19 Consider the following economy:
government expenditure depends on the elasticity of
C = 200 + 0.5Y
demand for money. [C.U., 2012]
4.11 How are interest rate and national income affected by a I = 200 − 500r
rise in the supply of money? [C.U., 2012] G = 150
4.12 Indicate briefly the aspects of effectiveness and L = 0.5Y − 250r
limitations of fiscal policy. M = 4900
4.13 Discuss with the help of the IS−LM model the
P = 10
effectiveness of fiscal policy in increasing national
income. [C.U., 2013] (a) Find out the equation of the IS curve.
4.14 Derive graphically the IS curve. [C.U., 2013] (b) Find out the equation of the LM curve.
(c) Find out the equilibrium values of Y and r.

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