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The IS-LM Curve Model and the Modern Theory of Interest.

It has been shown by J.R. Hicks and others that with greater insights into the Keynesian
theory one finds that the changes in income caused by changes in investment or
propensity to consume in the goods market also influence the determination of interest
in the money market.

According to him, the level of income which depends on the investment and
consumption demand determines the transactions demand for money which affects the

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rate of interest. Hicks, Hansen, Lerner and Johnson have put forward a complete and
integrated model based on the Keynesian framework wherein the variables such as

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investment, national income, rate of interest, demand for and supply of money are inter-
related and mutually interdependent and can be represented by the two curves called
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the IS and LM curves.
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This extended Keynesian model is therefore known as IS-LM curve model. In this model
they have shown how the level of national income and rate of interest are jointly
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determined by the simultaneous equilibrium in the two interdependent goods and

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money markets.
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Goods Market Equilibrium: The Derivation of the IS Curve:

The IS-LM curve model emphasises the interaction between the goods and money
markets. The goods market is in equilibrium when aggregate demand is equal to
income. The aggregate demand is determined by consumption demand and investment
demand.

In the Keynesian model of goods market equilibrium we also now introduce the rate of
interest as an important determinant of investment. With this introduction of interest as
a determinant of investment, the latter now becomes an endogenous variable in the
model.

When the rate of interest falls the level of investment increases and vice versa. Thus,
changes in the rate of interest affect aggregate demand or aggregate expenditure by
causing changes in the investment demand. When the rate of interest falls, it lowers the
cost of investment projects and thereby raises the profitability of investment.

Thus IS curve relates different equilibrium levels of national income with various rates
of interest. As explained above, with a fall in the rate of interest, the planned investment
will increase which will cause an upward shift in aggregate demand function (C + I)
resulting in goods market equilibrium at a higher level of national income.

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The lower the rate of interest, the higher will be the equilibrium level of national
income. Thus, the IS curve is the locus of those combinations of rate of interest and the
level of national income at which goods market is in equilibrium.

How the IS curve is derived is illustrated in Fig. 24.1. In panel (a) of Fig. 24.1 the
relationship between rate of interest and planned investment is depicted by the
investment demand curve II. It will be seen from panel (a) that at rate of interest Or 0 the
planned investment is equal to OI0. With OI0 as the amount of planned investment, the
aggregate demand curve is C + I0 which, as will be seen in panel (b) of Fig. 24.1 equals
aggregate output at OY1 level of national income.
Therefore, in the panel (c) at the bottom of the Fig. 24.1, against rate of interest Or2,
level of income equal to OY0 has been plotted. Now, if the rate of interest falls to Or 2 the
planned investment by businessmen increases from OI 0 to OI1 [see panel (a)]. With this
increase in planned investment, the aggregate demand curve shifts upward to the new
position C + 11 in panel (b), and the goods market is in equilibrium at OY 1 level of
national income. Thus, in panel (c) at the bottom of Fig. 24.1 the level of national
income OY1 is plotted against the rate of interest, Or1.
With further lowering of the rate of interest to Or 2, the planned investment increases to

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OI2 (see panel a). With this further rise in planned investment the aggregate demand

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curve in panel (b) shifts upward to the new position C + I 2 corresponding to which goods
market is in equilibrium at OY 2 level of income. Therefore, in panel (c) the equilibrium
income OY2 is shown against the interest rate Or2.
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By joining points A, B, D representing various interest-income combinations at which
goods market is in equilibrium we obtain the IS Curve. It will be observed from Fig. 24.1
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that the IS Curve is downward sloping (i.e., has a negative slope) which implies that
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when rate of interest declines, the equilibrium level of national income increases.
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Why does IS Curve Slopes Downward?

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Lower rate of interest is associated with a higher level of national income and vice-versa.
This makes the IS curve, which relates the level of income with the rate of interest, to
slope downward.

Steepness of the IS curve depends on (1) the elasticity of the investment demand curve,
and (2) the size of the multiplier. The elasticity of investment demand signifies the
degree of responsiveness of investment spending to the changes in the rate of interest.

A large upward shift in the aggregate demand curve will bring about a large expansion in
the level of national income. Thus when investment demand is more elastic to the
changes in the rate of interest, the investment demand curve will be relatively flat (or
less steep). Similarly, when investment demand is not very sensitive or elastic to the
changes in the rate of interest, the IS curve will be relatively more steep.
The steepness of the IS curve also depends on the magnitude of the multiplier. The value
of multiplier depends on the marginal propensity to consume (mpc). It may be noted
that the higher the marginal propensity to consume, the aggregate demand curve (C + I)
will be more steep and the magnitude of multiplier will be large.

Thus, the higher the value of multiplier, the greater will be the rise in equilibrium
income produced by a given fall in the rate of interest and this makes the IS curve
flatter. On the other hand, the smaller the value of multiplier due to lower marginal
propensity to consume, the smaller will be the increase in equilibrium level of income
following a given increment in investment caused by a given fall in the rate of interest.
Thus, in case of smaller size of multiplier the IS curve will be more steep.

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Shift in IS Curve:
It is important to understand what determines the position of the IS curve and what

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causes shifts in it. It is the level of autonomous expenditure which determines the
position of the IS curve and changes in the autonomous expenditure cause a shift in it.
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As is well- known government increases its expenditure for the purpose of promoting
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social welfare and accelerating economic growth. Increase in Government expenditure

will cause a rightward shift in the IS curve.Similarly decrease in government
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expenditure will cause a leftward shift in the IS curve.

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Money Market Equilibrium:

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Derivation of the LM Curve:

The LM curve can be derived from the Keynesian theory from its analysis of money
market equilibrium. According to Keynes, demand for money to hold depends upon
transactions motive and speculative motive.

It is the money held for transactions motive which is a function of income. The greater
the level of income, the greater the amount of money held for transactions motive and
therefore higher the level of money demand curve.

Thus demand for money (Md) can be expressed as:

Md = L(Y, r)

Where Md stands for demand for money, Y for real income and r for rate of interest.
Thus, we can draw a family of money demand curves at various levels of income. Now,
the intersection of these various money demand curves corresponding to different
income levels with the supply curve of money fixed by the monetary authority would
gives us the LM curve.
The LM curve relates the level of income with the rate of interest which is determined by
money-market equilibrium corresponding to different levels of demand for money.

But the money demand curve or what Keynes calls the liquidity preference curve alone
cannot tell us what exactly the rate of interest will be. In Fig. 24.2 (a) and (b) we have
derived the LM curve from a family of demand curves for money.

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As income
increases, money demand curve shifts outward and therefore the rate of interest which
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equates supply of money, with demand for money rises. In Fig. 24.2 (b) we measure
income on the X-axis and plot the income level corresponding to the various interest
rates determined at those income levels through money market equilibrium by the
equality of demand for and the supply of money in Fig. 24.2 (a).
Slope of LM Curve:
It will be noticed from Fig. 24.2 (b) that the LM curve slopes upward to the right.

It is important to know the factors on which the slope of the LM curve depends. There
are two factors on which the slope of the LM curve depends. First, the responsiveness of
demand for money (i.e., liquidity preference) to the changes in income.

The greater the extent to which demand for money for transactions motive increases
with the increase in income, the greater the decline in the supply of money available for
speculative motive and, given the demand for money for speculative motive, the higher
the rise in tie rate of interest and consequently the steeper the LM curve.

The second factor which determines the slope of the LM curve is the elasticity or
responsiveness of demand for money (i.e., liquidity preference for speculative motive) to
the changes in rate of interest. The lower the elasticity of liquidity preference for
speculative motive with respect to the changes in the rate of interest, the steeper will be
the LM curve. On the other hand, if the elasticity of liquidity preference (money
demand-function) to the changes in the rate of interest is high, the LM curve will be
flatter or less steep.

Shifts in the LM Curve:

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Another important thing to know about the IS-LM curve model is that what brings
about shifts in the LM curve or, in other words, what determines the position of the LM

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curve. As seen above, a LM curve is drawn by keeping the stock or money supply fixed.
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Therefore, when the money supply increases, given the money demand function, it will
lower the rate of interest at the given level of income. This is because with income fixed,
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the rate of interest must fall so that demands for money for speculative and transactions
motive rises to become equal to the greater money supply. This will cause the LM curve
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to shift outward to the right.

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The other factor which causes a shift in the LM curve is the change in liquidity
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preference (money demand function) for a given level of income. If the liquidity
preference function for a given level of income shifts upward, this, given the stock of
money, will lead to the rise in the rate of interest for a given level of income. This will
bring about a shift in the LM curve to the left.

It therefore follows from above that increase in the money demand function causes the
LM curve to shift to the left. Similarly, on the contrary, if the money demand function
for a given level of income declines, it will lower the rate of interest for a given level of
income and will therefore shift the LM curve to the right.

Simultaneous Equilibrium of the Goods Market and Money Market:

The IS and the LM curves relate the two variables:

(a) Income and

(b) The rate of interest.

Income and the rate of interest are therefore determined together at the point of
intersection of these two curves, i.e., E in Fig. 24.3. The equilibrium rate of interest thus
determined is Or2 and the level of income determined is OY 2. At this point income and
the rate of interest stand in relation to each other such that (1) the goods market is in
equilibrium, that is, the aggregate demand equals the level of aggregate output, and (2)
the demand for money is in equilibrium with the supply of money (i.e., the desired
amount of money is equal to the actual supply of money). It should be noted that LM
curve has been drawn by keeping the supply of money fixed.

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The IS-LM curve model explained above has succeeded in integrating the theory of
money with the theory of income determination. And by doing so, it has succeeded in
synthesising the monetary and fiscal policies. Further, with the IS-LM curve analysis, we
are better able to explain the effect of changes in certain important economic variables
such as desire to save, the supply of money, investment, demand for money on the rate
of interest and level of income.