Goods Market and IS Curve

In this section, we derive a goods market schedule, the IS curve. The IS curve shows a
combination of interest rates and the levels of output such that planned spending equals income.
The goods market equilibrium schedule is an extension of income determination with a 45 0 line
diagram. Now investment is no longer fully exogenous but also is determined by the interest rate.

The equilibrium in the goods market requires that Y=C-I and S=I, all the factor that cause the
change in consumption, saving or investment functions influence the determination of
equilibrium.

From the C +I approach, we have :

Consumption function C=C(y)
Investment function I = I(r)
Equilibrium condition S(y) = I(r)

In order to derive the IS curve we use the following three diagrams. The relation between interest
rate and income level is explained in figure 3.9 part A. It shows the inverse relationship between
investment and interest rate. The straight line in part B is drawn at 45 0 angle from the origin.
Whatever the amount of planned investment measured along the horizontal axis of part B,
equilibrium requires that planned saving measured along the vertical axis of part B by the same.
Therefore, all points along the 450 line in part B indicate equality of saving and investment. Part
C, brings in the saving function, showing that saving varies directly with income.

The IS curve in part D is derived from the other parts of the figure. For example, assume an
interest rate of nine percent in part A, indicating that investment is 20. In part B, to satisfy the
equality between saving and investment, saving must also be 20, as shown on the vertical axis. In
part C, saving will be 20 only at an income level of 120. Finally bringing together Y of 120 from
part C and r of nine percent from part A yields one combination of Y and r at which S=I and Y=
C+I.

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The IS curve is the schedule of combinations of the interest rate and level of income such that the
goods market is in equilibrium. It is negatively sloped because an increase in the interest rate
reduces planned investment spending and therefore reduces aggregate demand, thus reducing the
equilibrium level of income. At points to the right of the curve, there is excess supply in the
goods market, at points to the left of the curve, there is excess demand for goods.

S S
100 100
80 80
60 60
40 40
20 20
Y
40 80 120 160 200 20 40 60 80 100 I
(c) saving function (B) saving investment
S =S(Y) equality S= I

r r
10 10
9 9
8 8
7 7
6 6
5 5
4 4
3 IS 3
2 2
40 80 120 140 160 200 Y 20 30 60 80 100 I
(D) goods market equilibrium (A) investment function
S(Y) = I(r) I=I(r)

Figure 3.9 Derivation of IS curve

If we reduce interest rate to 5 percent, investment increase to 30.yielding an income level of 140
in part C. Therefore, we have 5 percent interest rate and 140 income combined in part B.

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We can apply the same procedure to all levels of interest rate and thereby generate all the points
that make up the IS curve. They have in common the property that they represent combinations
of interest rate and income at which the goods market clears.

3.5. Money Market and LM Curve

As you might recall, the Keynesian theory of the demand for money makes the transactions
demand (here combined with the precautionary demand) a direct function and makes the
speculative demand an inverse function of the interest rate.

Then, Md, the total money demand has been given as Md= K(y) +h(r). The supply of money
(Ms) is determined outside the model, it is exogenous. This gives us three set of equations

Demand for money Md= K (Y) + h(r)

Supply of money Ms = M/P

Equilibrium condition Md=Ms

On figure 3.10, the LM graph has been derived based on the above three equations. Part A shows
the speculative demand for money as a function of r; part B is drawn to show total money supply
of 100, all of which must be held in either transactions or speculative balances. The points along
the line indicate all the possible ways in which the given money supply may be divided between
Mt (transaction demand for money) and Msp(speculative demand for money). Noting that,
Msp=h(r). Part C shows the amount of money required for transactions purpose at each level of
income and is derived from the other parts as follows.

Assume in part A an interest rate of 6 percent, at which the public will want to hold 40 in 100
leaving 60 for transactions balances, an amount consistent with an income level of 120 as shown
in part C. Finally in part D, bringing together Y of 120 from part C and r of 6 percent from part
A yields one combination of Y and r at which Md= MS/p or at which there is equilibrium in the
money market. We can repeat the above process for each level of interest rate and income level
and we will come up with the upward sloping LM as shown in part D.

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 Mt Mt
100 100
80 80 Ms= 1100
60 60
40 40
20 20
0 Y 0 Msp
40 80 120 160 200 20 40 60 80 100
C) transaction’s demand B) supply of money
Mt= K(Y) Ms/P = Mt +Msp
r r
LM
10 10
8 8
6 6
5 5
4 4
2 Y 2
40 80 120 160 200 0 20 40 60 80 100 Msp
D) money market equilibrium A) speculative demand
Ms= K(y) + H (r) Msp = h(r)

Fig 3.10 Derivation of LM curve

The LM curve is the schedule of combinations of interest rates and levels of income such that the
money market is in equilibrium. It is positively sloped given the fixed money supply, because an
increase in the level of income, which increases the quantity of money demanded, has to be
accompanied by an increase in interest rate. This reduces the quantity of money demanded and
there by maintains money market equilibrium. At points to the right of the LM curve, there is an
excess demand for money and at points to its left; there is an excess supply of money.

3.6. IS – LM Equilibrium

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Equilibrium between the supply of and demand for goods is possible at all combinations of Y
and r indicated by the IS curve; similarly, equilibrium between all combinations of Y and r
indicated by the LM curve.However, there is only combination of Y and r at which the supply of
goods equals the demand for goods and the supply of money equals the demand for money. This
combination is defined by the intersection of IS and LM curves as shown on diagram 3.11.

r LM
IV I

r* E II

III

IS

Y* Y

Fig 3.11Equilibrium in the goods and money market

One might want to know what would happen in the IS-LM model if interest rate, other than the
equilibrium interest rate prevails in the economy. In this case, disequilibrium will arise in the
markets. Any combination of r and Y to the right of the IS curve gives us S>I and Y>(C+I). The
opposite is true for any combination of Y and r anywhere to the left of the IS curve. Similarly,
any combination of Y and r anywhere to the right of the LM curve is a combination at which
Md>Ms. Here, the opposite is also true for any combination to the left of the LM curve. This can
be summarized by the following table taking the four areas labeled by roman number on figure
3.11.

Table 3.1. Disequilibrium areas on the IS – LM Model

Area AR/e/d/s Goods market Money market

Area I I<S, (C+I) <Y Md<Ms
Area II I<S, (C+I) <Y Md>MS
Area III I>S, (C+I)>Y Md>Ms
Area IV I>S, (C+I)>Y Md<Ms

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From our analysis of the goods market, we know that a situation in which I>S or (C+I) >Y will
head to a rise in income and vice versa. Similarly we know that when Md>Ms interest rate tends
to rise and vice versa.

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