We cannot solve equation 3. Once these combinations are plotted on the r — Y plane, we get a curve which Hicks-Hansen called the IS curve.
The Derivation of IS Curve: The IS curve is derived from goods market equilibrium. The IS curve shows the combinations of levels of income and interest at which goods market is in equilibrium, that is, at which aggregate demand equals income. Aggregate demand consists of consumption demand, investment demand, government expenditure on goods and services and net exports.
Consumption demand is function of disposable income.
Investment depends on rate of interest. With a given level of income, a higher rate of interest reduces investment demand and a lower rate of interest leads to more investment, that is, investment is negatively related to rate of interest.
Given the value of autonomous expenditure, we can obtain value of Y at different rates of interest to draw an IS curve. It is worth noting that the value of autonomous A determines the intercept of the IS curve, d in the term di in equation 3 shows the sensitivity of investment to the changes in rate of interest and determines the slope of IS curve.
Since fall in interest rate increases investment spending, it will raise aggregate demand and thus the equilibrium level of income. Besides, the slope of the IS curve depends on the size of income multiplier.
The following equations describe an economy: At 2 per cent rate of interest, level of income is We have now two combinations of interest and income. We can plot these and obtain IS curve.
This is done in Figure In the last section we have derived the IS curve taking government expenditure G on goods and services without considering taxation and transfer payments by it.
Whereas a tax reduces disposable income, transfer payment raises it. Further, whereas transfer payments are assumed as lump sum amount, tax can be lump sum tax or levied as proportion of income. Equation 4 represents IS curve in case of proportionate income tax.
It may be noted in the context of IS equations 3 and 4 that a change in autonomous spending A as a result of any of its components will cause a shift in IS curve. Derivation of LM Curve: Having derived algebraically equation for IS curve we now turn to the derivation of equation for LM curve.
It will be recalled that LM curve is a curve that shows combinations of interest rates and levels of income at which money market is in equilibrium, that is, at which demand for money equals supply of money. We explain the derivation of LM curve in two steps. First, we show how money demand depends on interest rate and level of income.
The demand for real money balances depends on the level of real income and interest rate. Demand for real money balances increases with the rise in level of income and decreases with rise in rate of interest.
Let us assume that money demand function is linear. Parameter h represents Low much demand for real money balances decreases when rate of interest rises. Besides, we assume the price level P to remain constant.
To be precise it gives us the equilibrium interest rate for any given value of level of income Y and real money balances. In drawing LM curve, real money balances are assumed to be constant.
Let us state some conclusions about LM curve as given by equation 7. First, since in equation 7 for LM curve, the coefficient k of income Y is positive, LM curve will slope upward. That is, higher income requires higher interest rate for money market to be in equilibrium, given the supply of real money balances.
Second, since the coefficient of real money balances is negative, the expansion in real money balances will cause a shift in the LM curve to the right, and decrease in the real money balances will shift LM curve to the left.
If demand for money is not much sensitive to level of income, then k will be small. Therefore, in case of small k i. Given the following data about the monetary sector of the economy: Derive the equation for LM function 2.
Give the economic interpretation of the LM curve. Draw LM curve from the above data Solution:Keynesian income determination theory can explain macroeconomic problems once we incorporate money market in our analysis.
It is the rate of interest, determined by the demand for money and the supply of money, that integrates goods market and money market. Economics- ISLM Analysis, Study notes for Economics. Chirst Church Law College.
Chirst Church Law College. Economics, Economics. 39 pages. Assume that at a level of national income, Y1, the demand for money is L' Money market equilibrium: deriving the LM curve. O O R at e of in te re st R at e of. The IS-LM Curve Model (Explained With Diagram)!
The Goods Market and Money Market: Links between Them: The Keynes in his analysis of national income explains that national income is determined at the level where aggregate demand (i.e., aggregate expenditure) for consumption and investment goods (C +1) equals aggregate output. Thus in the income-expenditure model, if G rises a series of events will raise Y, until a new equilibrium is reached at which there is enough extra savings.
Review: Macro Notes Section The notion of equilibrium, and how the macroeconomy is supposed to move . For the liquidity preference and money supply curve, the independent variable is "income" and the dependent variable is "the interest rate." The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium.
Introduction to Macroeconomics TOPIC 4: The IS-LM Model Anna g Morin CBS - Department of Economics (because we want an analysis in terms of goods),!We divide by the price level (GDP de Figure: E ect on the interest rate of an increase in income Introduction to Macroeconomics TOPIC 4: The IS-LM Model.
The nancial market - LM.