Goods market and Money Market

Preface
• According to Prof. J. M. Keynes, national income is determined
at the level where aggregate demand (i.e., aggregate
expenditure) for consumption and investment goods (C+ I)
equals aggregate supply.
• Keynes in his simple analysis of equilibrium in the goods
market, he considers that investment is determined by the
rate of interest and marginal efficiency of capital and it is
independent of the level of national income.
• According to Prof. Keynes, rate of interest is determined in the
money market equilibrium by the demand for money and the
supply of money.
 Preface
• There is one flaw in this Keynesian model of money market
equilibrium. In this model whereas the changes in the rate of
interest in the money market affect investment and therefore the
level of income and output in the goods market, there is seemingly
no inverse influence of changes in goods market (investment and
income) on the money market equilibrium.
• Hicks, Hansen, Lerner and Johnson have put forward a complete and
integrated model based on the Keynesian framework where
investment, national income, rate of interest, demand for and
supply of money are interrelated and mutually interdependent and
can be represented by the two curves called IS and LM curves.
• The IS- LM model shows how the level of national income and rate
of interest are jointly determined by the simultaneous equilibrium in
the two interdependent goods and money markets.
 Goods Market: Equilibrium
• By Goods Market, we mean all the buying and selling of goods
and services.
• Goods Market Equilibrium:
• 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 goods market equilibrium we also introduce
the rate of interest as an important determinant of
investment.
• When the rate of interest falls the level of investment
increases and vice versa.
 Goods Market: Equilibrium
• When the rate of interest falls, it lowers the cost of
investment projects and thereby raises the profitability of
investment. The businessmen will therefore undertake
greater investment at a lower rate of interest.
• The increase in investment demand will bring about increase
in aggregate demand which in turn will raise the equilibrium
level of income.
 Goods Market: IS Curve Derivation
• The Derivation of the IS Curve:
• The IS curve seeks to find out the equilibrium level of national
income as determined by the equilibrium in goods market by
a level of investment determined by a given rate of interest.
• The IS curve shows different equilibrium levels of national
income with various rates of interest.
• The lower the rate of interest, higher will be the equilibrium
level of income.
• 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.
Goods Market: IS Curve Derivation
Goods Market: IS Curve Derivation
Goods Market: IS Curve Derivation
 Why does IS Curve Slope Downward?
• The decrease in the rate of interest bring about to increase in
the planned investment which increases the aggregate
demand (upward shift of aggregate demand) therefore leads
to the increase in the equilibrium level of national income.
This makes the IS curve to slope downward.
• The steepness of the IS curve depends on:
1. The elasticity of investment demand curve; and
2. The size of the multiplier.
 Shift in the IS Curve
• It is the autonomous expenditure which determines the
position of the IS curve and changes in the autonomous
expenditure causes a shift in it.
• By autonomous expenditure we mean the expenditure
(investment expenditure, government expenditure,
consumption expenditure) which does not depend on the
level of income and the rate of interest.
Shift in the IS Curve
 Money Market: Equilibrium
• By Money Market, we mean the interaction between demand
for money and the supply of money.
• Money Market Equilibrium:
• 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 on
transactions motive and speculative motive.
• Demand for money can be written as: Md = f(Y, r).
• The intersection of various money demand curves
corresponding to different income levels with the supply
curve of money fixed by the monetary authority would give us
the LM curve.
Money Market: Equilibrium
 Money Market: LM Curve Derivation
• We have derived the LM curve from a family of demand
curves for money. As income increases, money demand curve
shifts outward and therefore the rate of interest which
equates supply of money with demand for money rises.
• LM curve slopes upward to the right. This is because with
higher levels of income, demand curve for money (Md) is
higher and consequently the money market equilibrium (that
is, the equality of the given money supply with money
demand curve occurs at a higher rate of interest).
• This means that rate of interest varies directly with income.
Money Market: LM Curve Derivation
 Why LM curve slopes upward to the right?
• This is because with higher levels of income, demand curve
for money (Md) is higher and consequently the money market
equilibrium (that is, the equality of the given money supply
with money demand curve occurs at a higher rate of interest).
This means that rate of interest varies directly with income.
• The slope of LM curve:
• The slope of LM curve depends on two factors:
1. The responsiveness of demand for money to changes in
income. (Md = f(Y)); and
2. The elasticity or responsiveness of demand for money to the
changes in rate of interest.
 Shift in the LM Curve
• Factors that determine the position of LM curve: LM curve is
drawn by keeping the stock or money supply fixed. 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, the rate of interest
must fall so that demand for money for speculative and
transactions motive rises to become equal to the greater
money supply. This will cause the LM curve to shift outward to
the right.
• The other factor which causes a shift in the LM curve is the
change in liquidity preference for a given level of income.
 Shift in the LM Curve
• 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.
• If the money demand function (liquidity preference) 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.
 The derivation of Equation for IS Curve
• Problem 1: The following equations describe an economy:
C = 10 + 0.5Y;
I = 190 – 20r.
Derive the equation for IS curve.
• Solution:
IS curve describes the equation for product market
equilibrium at various combinations of level of income and
rate of interest.
Y = AD = C + I
Or, Y = 10 + 0.5Y + 190 – 20r
Or, Y = 400 – 40r.
Thus IS curve is: Y = 400 – 40r.
 The derivation of Equation for IS Curve
• Problem 2: The following equations describe an economy
C = 100 + 0.75Yd
I = 50 – 25r
T = G = 50
Where C is aggregate consumption, Yd is disposable income, I
is aggregate investment. T is taxes, G is government purchases
and r is the rate of interest. Derive the IS curve for the
economy.
• Solution: Y = C + I + G
Or, Y = 100 + 0.75 (Y – 50) + 50 – 25r + 50
Or, Y = 650 – 100r
Thus, IS equation : Y = 650 – 100r
 The derivation of Equation for LM Curve
• Problem 3: Given the following data about the monetary
sector of the economy:
Md = 0.4Y – 80r
Ms = 1200
Where, Md is demand for money, Y is the level of income; r is
the rate of interest and Ms is the supply of money.
Derive the equation for LM curve and give the economic
interpretation of this curve.
• Solution: For money market to be in equilibrium,
Md = Ms
Or, 0.4Y – 80r = 1200
Or, r = 1/200 × Y – 15
Thus LM equation: r = 1/200 × Y – 15
 The derivation of Equation for LM Curve
• Problem 3: Given the following data about the monetary
sector of the economy:
Md = 0.4Y – 80r
Ms = 1200
Where, Md is demand for money, Y is the level of income; r is
the rate of interest and Ms is the supply of money.
Derive the equation for LM curve and give the economic
interpretation of this curve.
• Solution: For money market to be in equilibrium,
Md = Ms
Or, 0.4Y – 80r = 1200
Or, r = 1/200 × Y – 15
Thus LM equation: r = 1/200 × Y – 15
 The derivation of Equation for LM Curve
• Problem 4: The following data is given for the monetary
sector of the economy:
Transaction demand for money, Mdt = 0.5Y,
Speculative demand for money, Mds = 105 – 1500r
and money supply Ms = 150.
Derive LM equation.
 Simultaneous Equilibrium of the Goods and Money
Market: IS-LM Model
• IS-LM Model, which stands for "investment-savings" (IS) and
"liquidity preference-money supply" (LM) is a Keynesian
model that shows how the market for economic goods (IS)
interacts with the loanable funds market (LM) or money
market.
• It is represented as a graph in which the IS and LM curves
intersect to show the short-run equilibrium between interest
rates and output.
• The IS- LM curves relate the two variables: income and the
rate of interest.
• The equilibrium rate of interest is determined at the point
where IS and LM curves cut to each other.
IS-LM Model
Effect of Changes in Supply of Money on the Rate of
Interest and Income Level
Effect of Changes in Government Expenditure on the
Rate of Interest and Income Level
 Fiscal Policy and Monetary Policy

• Fiscal policy is the use of government revenue collection

(taxes or tax cuts) and expenditure (spending) to influence a
country's economy.
• Monetary policy refers to the actions undertaken by a
nation's central bank to control money supply to achieve
macroeconomic goals that promote sustainable economic
growth.
Effects of Fiscal and Monetary policy on AD
 Effects of Fiscal and Monetary policy on AD

• The aggregate demand curve shifts due to any event that

shifts the IS curve or the LM curve (when P remains constant).
For instance, if M increases Y rises if P remains constant. As a
result aggregate demand curve shifts to the right as shown in
part (a) of Fig. 11.2. The converse is also true. A fall in M
reduces Y and shifts the aggregate demand curve to the left.
• Similarly for a constant price level, an increase in G or a cut in
T shifts the aggregate demand curve to the right, as shown in
part (b) of Fig. 11.2. The converse is also true. A fall in G or an
increase in T lowers Y or shifts the aggregate demand curve to
the left.
 IS- LM Model
(Joint Equilibrium of Income and Interest Rate)
• Problem 5: For an economy the following functions have been
given:
C = 100 + 0.8Y
I = 120 – 5r
Ms = 120
Md = 0.2Y – 5r
Find out (1) IS equation, (2) LM equation, (3) equilibrium level
of income and interest rate.
(1) IS curve:
For goods market equilibrium;
Y=C+I
Or, Y = 1100 – 25r
Hence, IS equation: Y = 1100 – 25r
 IS- LM Model
(Joint Equilibrium of Income and Interest Rate)
2) LM curve:
For money market equilibrium;
Md = Ms
Or, 0.2Y – 5r = 120
Or, r = 0.2/5 × Y – 24
Hence, LM equation: Or, r = 0.2/5 × Y – 24
(3) Equilibrium level of income and interest rate:
Substituting the value of r in the IS equation we have
Y = 1100 – 25r
Or, Y = 1100 – 25(0.2/5 × Y – 24)
Or, Y = 850
Thus the equilibrium level of income is 850.
 IS- LM Model
(Joint Equilibrium of Income and Interest Rate)
• To obtain the equilibrium rate of interest we substitute the
value of Y in LM equation and we get
r = 0.2/5 × Y – 24
Or, r = 0.2/5 × 850 – 24
Or, r = 34 – 24 = 10
Thus equilibrium rate of interest is 10%.
 IS- LM Model
(Joint Equilibrium of Income and Interest Rate)
• Problem 6: For an economy the following functions have been
given:
C = 100 + 0.8 Yd
I = 50 – 25i
G = 50
T = 50
Md = Y – 25r
Ms = 200
Find out (1) IS equation, (2) LM equation, (3) equilibrium level
of income and interest rate.
 Effectiveness of Fiscal Policy

• A given increase in g and shift in IS curve will yield a large

increase in y, if the economy begins at a point of high
unemployment and low interest rate. But if the g increase
comes in a tight economy near full employment , there will be
a little effect on y, with a large increase in r squeezing out an
amount of investment demand nearly equal to the g increase.
Effectiveness of Fiscal Policy
 Effectiveness of Monetary Policy

• With a given slope of IS curve, a given shift in the LM curve

due to an increase in the money supply will have a greater
effect on y at high levels of y and r that at low levels.
 Crowding out Effect

Fall in private investment due to increase in interest rate that takes

place with the increase in govt. expenditure. That is, increase in
govt. expenditure crowds out some private investment.
 Liquidity Trap

Liquidity trap is a situation when expansionary monetary policy

(increase in money supply) does not increase the interest rate,
income and hence does not stimulate economic growth.
 Warning!

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