IS-LM Model in

Two Sector
Economy
IS-LM model: Hicks and Hansen Integration
of
the real and money markets
 Goods Market Equilibrium:
The IS Curve
To determine the goods market equilibrium there exist two approaches.
According to the AD – AS approach, the goods market equilibrium exists
where
Y = C(Y) + I (r).
According to the S –I approach, the goods market equilibrium exists where
S(Y) = I (r).
The IS curve is a graphic representation of the goods market equilibrium
showing the different combinations of the output levels and the interest rates
at which saving equal investment.
The IS curve is downward sloping showing an inverse relationship
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between
28/03/2023 2

income and the rate of interest

Derivati
on of IS
Curve

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 Derivation of IS Curve

• The derivation of IS curve can be made in terms of a four-

part diagram. In part (A), we have drawn investment
function that shows the inverse relationship between
investment and the rate of interest. Part (C) plots the
saving function that represents direct relationship
between income and saving. Part (B) is simply a 45°
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identity line, and part (D) plots the IS curve.
 IS Curve

• Slope of IS Curve- IS curve is negatively sloped. This is

because increase in interest rate causes investment
spending to rise which shifts the aggregate demand curve
up and raises the equilibrium income level. Also, increase
in interest rate causes investment to fall, which shifts
aggregate demand curve down and lowers the equilibrium
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income level.
 Shifts in IS curve

• Shifts in IS curve- Changes in factors apart from interest

rate that would shift the aggregate demand would shift
the IS curve. E.g. Increase in autonomous investment will
shift the IS curve to the right , while decrease in
autonomous investment will shift the IS curve to the left.

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 Money Market Equilibrium:
The LM Curve
The money market is in equilibrium when the demand for money is equal
to the supply of money or ms = md.
The supply of money is assumed to be exogenous or as ms = ms
The total demand for money can be expressed as md = mt+p + msp

The LM curve is a graphic representation of the money market equilibrium

showing the different combinations of the output levels and the interest
rates at which the demand for money is equal to the supply of money.
The LM curve is upward sloping showing that there is a direct relationship
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between income and the rate of interest.
Derivatio
n of LM
Curve

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 Derivation of LM Curve

• A four-part diagram may be used to derive the LM curve. In above

Fig. part(C) shows a proportional relationship between money income
and transaction demand for money (Mt= kPY). Part (A) represents
speculative demand for money [MS = f(r)]. In Part (B) is an identity
line that mechanically divides money supply into transaction and
speculative elements. Part (D) represents the LM curve.

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 LM Curve-

• Slope of LM Curve- The LM curve slopes positively. An

increase in interest rate reduces the demand for real
money balances. To maintain demand for real money
balances equal to the supply of money, the income level
has to rise. Therefore LM curve implies that an increase in
rate of interest is accompanied by an increase in the
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income.
 Shift in LM Curve-

• Shift in LM Curve- An LM curve is constructed for a given

supply of money. An increase in the money supply will
shift the LM curve to the right, while decrease in money
supply will shift the LM curve to the left.

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 Equilibrium in the Two Markets:
The Goods Market and Money Market
The IS curve represents all combinations of income and the rate of interest at
which the goods market is in equilibrium.
The LM curve represents all combinations of income and the rate of interest at
which the money market is in equilibrium.
It is only where the IS and LM curves intersect, point E, in Figure at which both the
goods and the money market are in equilibrium.
At all points, other than the point where the IS and LM curves intersect, there will
exist disequilibrium.
If there exist disequilibrium in the economy then the forces will be at work till the
final equilibrium is attained at the intersection of the IS-LM curves.
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 Equilibrium of the IS-LM curve-

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 A Shift in the IS-LM Curves
The equilibrium is disturbed due to a shift in the IS or LM curves.
The shifts in the IS curve can occur due to a shift in the investment function or the
saving (or consumption) function.
A rightward shift in the investment function leads to a rightward shift in the IS
curve.
The shift in the LM curve can occur due to a shift in the transactions demand,
speculative demand or the money supply function.
A rightward shift in the money supply curve leads to a leftward shift in the LM
curve.
A simultaneous shift in both IS and LM curves bring about a change in the income
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level and also a change in the interest rate.
 Effectiveness of Monetary and Fiscal
Policies
• The effectiveness of a policy in achieving the economic objectives (changes in the national
income ) depends on the elasticity of the IS and LM curves

• An expansionary fiscal policy shifts the IS curve to the right and leads to an increase in
both the income level and the interest rate.

• An expansionary monetary policy shifts the LM curve to the right and leads to an increase
the income level but a decrease in the interest rate.

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 Fiscal Policy relates to the utilization of government expenditure and taxation
to achieve some well defined objectives.
In the Keynesian range or the liquidity trap, fiscal policy is completely
effective.
In the classical range, fiscal policy is completely ineffective.

Effectiveness In the intermediate range, fiscal policy is effective but not as effective as in
the Keynesian range.

of
Fiscal
Policies

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  Monetary policy relates to changes in the supply of money by the central bank to
achieve the objectives relating to growth, employment and others.
 In the Keynesian range, monetary policy is ineffective whatever be the elasticity of the
IS curve.
 In the classical range, monetary policy is completely effective whatever be the elasticity
of the IS curve.

Effectiveness  In the intermediate range, monetary policy is effective but not as effective as in the
classical range.

of
Monetary
Policies

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 Thank You

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