Modern Theory of Interest: IS-LM Curve

Modern Theory of Interest
IS-LM Curve
(By Hicks & Hansen)
Classical Theory of Interest:
 Interest rate is a real variable
 Interest is determined by savings (S) & Investment (I)
 Equilibrium rate of interest is determined when Goods Market is equilibrium
(S=I)
Keynes Liquidity Preference theory of interest:
 Interest rate is a monetary variable
 Interest rate is determined by Demand for Money (L) & Supply of Money (M)
 Equilibrium rate of interest is determined when Money Market is equilibrium
(L = M)
Modern Theory of Interest: (ISLM)
 By Hicks & Hansen
 No Single theory is adequate
 Interest rate is determined by both Goods Market & Money Market
 Equilibrium rate of interest is determined when both Goods Market &
Money Market is equilibrium
 Goods Market Equilibrium (S=I)
 Money Market Equilibrium (L=M)
 General Equilibrium when both goods & Money market is equilibrium ( IS-
LM)
Goods Market Equilibrium(I=S)
Money Market Equilibrium (L=M)
IS-LM Model
The IS Curve
&
Goods Market Equilibrium (S=I)
Or
Product Market Equilibrium
Goods Market Equilibrium:
Total Income (Aggregate Supply) = Total Expenditure(Aggregate
Demand)
Total Income (Y) = C+S, Total Exp. (Y) = C+I

Condition for Equilibrium:
C+S = C+I
S=I
Savings (S) = Investment(I)
Savings Function:
 Savings (S) is a function of Income (Y)
S = f(Y)
Savings (S) increases when income increases (Y).
Investment Function:
 Investment (I) is a function of both the level of income (Y) &
the rate of interest (r).
I = f ( Y, r )
Investment (I) increases with increase in income (Y) and
decreases with increase in rate of interest (r )
The IS Curve
IS curve is the Saving(S) & Investment (I) equality curve
IS curve shows the equality between Savings (S) &
Investment (I) at various combination of the levels of
Income (Y) & the Rate of interest (r ).
IS curve represents the goods market equilibrium at
various combinations of (r ) & (Y)
Derivation of IS Curve
• “S” is the savings curve & when income
rises savings also rises
• “I” is the investment curve at a given
interest rate
• At a 5% rate of interest(r), I2 is the
investment curve
• When rate of interest (r) reduced to 4%,
Investment increases & it shifted up to I3 .
• When rate of interest (r ) increased to 6%,
investment decreases & it shifted down to
I 1.
• S is the savings curve which increases as
the level of income (Y) rises.
Figure “A”:
At E1, E2 & E3 goods market equilibrium (S=I)
At point E1: r=6% & Y=100
Figure “B” represents derivation of IS curve
A, B, C are the corresponding goods market equilibrium of E1, E2 & E3
“A” represents goods market equilibrium at r=6% with Y=100
“B” represents goods market equilibrium at r=5% with Y=200
“C” represents goods market equilibrium at r=4% with Y=300
“IS” curve is the connection of A, B & C points together
IS curve slopes downward
Why Does “IS” curve slopes downward?
 The IS curve slopes downward from left to the right
 As the interest rate (r) falls, Investment (I) increases and so does
Income (Y)
• Low interest rate (r ) represents, more investment (I) & more
income (Y)
• High interest rate (r) represents, Low investment (I) & low
income (Y).
The LM Curve
&
Money Market Equilibrium (L=M)
Money Market Equilibrium
Demand for Money (L) = Supply of Money (M)
Demand for money is the total liquidity preferences (L)
LM stands for Money market equilibrium
Demand for Money (Liquidity Preference) : L
• Total Demand for Money (L) is function of Rate of interest (r ) and level of
Income (Y)
L = f (Y, r)
 Transaction & precautionary motive demand for money positively related with
level of Income (Y)
 Speculative motive demand for money is inversely related with rate of interest
( r)
 With given income level (Y), total demand for money is inversely related with
the rate of interest (r )
 Total demand for money slopes downward due to inverse relationship with the
interest rate (r )
Supply of Money is constant at a given point of time & Supply curve is
vertical straight line.
The LM Curve:
 LM curve shows the equality between Demand for Money (L) &
Supply of Money (M) at various combination of the levels of
Income (Y) & the Rate of interest (r ).
 LM curve represents money market equilibrium
Derivation of LM Curve
MS
Figure –A
 L1 represents demand for money at the level of income Y1=100
 When the income increased to Y2=200, demand for money increases & shifted
right ward to L2.
 When the income further increased to Y3=300, demand for money increased &
shifted right ward to L3.
 MS represents the Money supply (M) curve. It is vertical straight line as money
supply is fixed at a point of time.
 Money Market is equilibrium at point E1, E2 & E3
 At E1, income (Y1=100) & rate of interest (r1 = 4%)
 At E2, Income (Y2=200) & rate of interest (r2 =5%)
 Ar E3, income (Y3=300) & rate of interest (r3=6%)
Figure - LM Curve
 LM curve derived in the figure-B
 Each point in the LM curve represents Demand for Money(L) &
Supply of Money (M) equality at combination of various levels
of the Rate of interest (r ) and various levels of the Income (Y).
 Point “A” in LM curve represents money market equilibrium
with rate of interest r= 4% & level of income Y1= 100.
 Similarly, Point “B” represents money market equilibrium with
rate of interest r =5% & level of Income Y2= 200.
 Point “C” represents Money Market equilibrium with rate of
interest r =6% & level of Income Y3= 200.
Why does LM curve slopes upward?
 Reason: When the national income (Y) increases, Demand
for money(L) increases in the economy, as a result the rate
of interest (r ) also increases.
LM Curve & Liquidity Trap
 The initial portion of the LM
curve is Horizontal straight line
due to liquidity trap.
 The remaining portion is
upward sloping.
 The liquidity trap is due to
unlimited demand for money at
a very low level of interest rate.
General Equilibrium
Both Goods & Money Market equilibrium
simultaneously
IS & LM Curve intersection point
General Equilibrium
 IS represents goods market Goods Market (IS) & Money
equilibrium (S =I) Market (LM) Equilibrium
 LM represents Money Market
equilibrium (L=M)
 At point “E” both Goods & Money
Market are equilibrium.
 Equilibrium rate of interest r=5%
 Equilibrium level of National Income
Y2=200.
 Economy is equilibrium at point “E”
Shifts in IS Curve
Shifts in IS curve:
 IS curve shifts to the right when the Investment (I) of an economy
increases with given interest (r )
 IS curve shifts to the left when the Investment (I) of an economy
decreases with given interest
 IS curve shifts to the left when the savings (S) increases with given
income (Y) .
 IS curve shifts to the right when savings (S) decreases with given
income.
Shifts in IS Curve
Investment Increases Rightward Shift
Investment Decreases Leftward Shift
Savings Increases Leftward Shift
Savings Decreases Rightward Shift
Tax Rate increases Leftward Shift
Tax Rate Decreases Rightward Shift
Govt. Spending Increases Rightward Shift
Govt. Spending Decreases Leftward Shift
Note: When Savings & Taxes increases, Consumption exp & Aggregate demand
decreases. Due to national income decreases & IS shifts to left
Rightward Shift- IS
Curve
-Investment Rises
-Savings Decreases
Leftward Shift-IS
Curve
-Investment Decreases
-Savings Rises
Fiscal Policy Impact
on
Economy
Govt. Spending Impact
on Economy
 Govt. Spending increased
 IS curve shifted to right
 New equilibrium E1
 Aggregate Demand increased &
National Income increased to Y1
 Demand for money increased due
to higher national income Y1
 As a result interest rate increased
to R1
Fiscal Policy Impact on IS curve & Economy
Fiscal Policy IS - Shifts Interest Changes in
Rate (r) National Income
Expansionary Fiscal Policy
Govt. Spending Right Increase Increase
Increases
Taxes Decreases Right Increase Increase
Contractionary Fiscal Policy
Govt. Spending Left Decrease Decrease
Decreases
Taxes Increases Left Decrease Decrease
Shifts in LM curve
Shifts in LM curve:
Shifts-LM
Money Supply-Increases Right
Money Supply-Decrease Left
Demand for Money-Increases Left
Demand for Money-Decrease Right
When Money Supply increases, interest rate (r ) decreases, LM shifts to right

When Money supply decreases, interest rate (r ) rises, LM shifts to left
When Demand for money increases, interest rate (r ) rises, LM shifts to left
When Demand for money decreases, interest rate ( r) decreases, LM shifts to right
Monetary Policy Impact
on
National Income
LM & Monetary Policy
 Money Supply increased
 LM shifts to right-LM1
 New Equilibrium-E1
 Interest Rate decreased to R1
 Due to lower interest rate (r),
Investment, Employment &
National Income increased to Y1.
Note: when money supply decreases, LM curve
shifts Left , interest rate rises, investment,
employment and National income decreases.
Shifts-LM Interest Rate (r) Changes in
National Income
Money Supply Increases Right Decrease Increase
Money supply Decreases Left Increase Decrease
Demand for Money Increases Left Increase Decrease
Demand for money Decreases Right Decrease Increase
Shifts-LM Interest Rate (r) Changes in
National Income
Expansionary Monetary Policy
Money Supply Increases Right Decrease Increase
Contractionary Monetary Policy
Money supply Decreases Left Increase Decrease

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Modern Theory of Interest

Total Income (Y) = C+S, Total Exp. (Y) = C+I

When Money Supply increases, interest rate (r ) decreases, LM shifts to right

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