macro-economics is-lm approach-1

Is-lmApproach-1

UGC-NET PAPER-2 (ECO),pgt Eco, UPSC, IES

Chanakya group of economics

Macro-economics

detailed analysis by- gobind rawat

Part-1 ,IS approach- goods market equilibrium.

Part-1 – IS- goods market equilibrium.

Part-2 – LM- Money market equilibrium.

Part-3 – simultaneous equilibrium model & previous year

questions..

IS-LM approach also called as Hicks-Hansen approach

Intro-

IS-LM model developed by J.R.Hicks in 1937. and

Extended by Alvin Hansen

ISLM

Product/goods

market.

Money market.

Equality of investment (I) and

saving (S).

Equality of money demand (L) and

money supply M)

It has been asserted that in the Keynesian model whereas the changes in rate of interest in the money market affect investment and therefore the level of income and output in the goods market,

In other words, in Keynes’ simple model the level of national income is shown to be determined by the goods market equilibrium.

The rate of interest, according to Keynes, is determined by money market equilibrium by the demand for and supply of money.

In this simple analysis of equilibrium in the goods market Keynes considers investment to be determined by the rate of interest along

with the marginal efficiency of capital and is shown to be independent of the level of national income.

Keynesian views

based on the Keynesian framework wherein the variables such as 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 the IS and LM curves.

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 determined by the simultaneous equilibrium in the two interdependent goods and money markets.

Hicks, Hansen, Lerner and Johnson have put forward a complete and integrated model

1.Goods Market Equilibrium:

Like Keynes ROI is an important determinants of investments.

The goods market is in equilibrium when aggregate demand is equal to income. The aggregate demand is determined by

consumption demand and investment demand.

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.

Thus IS curve relates different equilibrium levels of national income with various rates of interest.

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.

Now, if the rate of interest falls to Or2 the planned investment by businessmen increases from OI0 to OI1

the aggregate demand curve shifts upward to the new position C + 11 in panel (b),

With OI0 as the amount of planned investment, the aggregate demand curve is C + I0which, as will be seen in panel (b) equals aggregate output at OY1 level of national income.

the relationship between rate of interest and planned investment is depicted by the investment demand curve II.

at rate of interest Or0 the planned investment is equal to OI0.

against rate of interest Or2, level of income equal to OY0 has been plotted.

It will be observed that the IS Curve is downward sloping (i.e., has a negative slope)

which implies that when rate of interest declines, the equilibrium level of national income increases.

the level of national income OY1 is plotted against the rate of interest, Or1.

and the goods market is in equilibrium at OY1 level of national income.

Similarly so on

By joining points A, B, D representing various interest-income combinations at which goods market is in equilibrium we obtain the IS Curve.

General eqm is occur where both goods mkt

and money mkt are interact with each other.

IS- LM approach

Goods market equilibrium

Money market equilibrium

IS represent- investment and saving

LM represent- money demand and money supply.

IS- goods mkt eqm

LM- money mkt eqm

RO

I

income

IS

LM

IS 1Y

0 X

IS CURVE

It shows investment saving relationship.

The independent variable is interest rate and dependent

variable is level of national income..thats why

Interest rate –y axis

Level of income – x axis

Slope of is curveIS curve is negatively slope

The slope of IS depend on-

1-sensitivness (elasticity)

2.Size of multiplier.

SHIFT IN is curve

IS Curve shift right IS Curve shift leftR

OI

IS

LM

IS 1

Income

RR

1

RO

I

IS 1

LM

IS

IncomeR

1R

E

E1

E1

E

Increase in savingIncrease in consumption

Autonomous increase in

investment

SHIFT IN is curve

Why IS Curve shift right Why IS Curve shift left

Reduction in saving

Decrease in consumption

Auto investment is independent of income and ROI.

Is-lmApproach-2



Macro-economics


Part-2 , LM Approach- Money market equilibrium.

2.Money Market Equilibrium:

The LM curve can be derived from the Keynesian theory from its analysis of money market equilibrium.

The demand for money also depends on the rate of interest which is the cost of holding money.

According to Keynes, demand for money to hold depends upon transactions motive, precaution motive and speculative motive.

It is the money held for transactions motive which is a function of income.

Md – L(Y, r)

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

In dia. (b) we measure income on the X-axis and plot the income level

corresponding to the various interest rates

The LM curve tells what the various rates of interest will be at different levels of income.

As income increases, money demand curve shifts outward and therefore the

rate of interest which equates supply of money, with demand for money rises.

determined at those income levels through money market equilibrium

by the equality of demand for and the supply of money in (a).

As the income increases, say from Y0 to Y1 the demand curve for money shifts from Md0 to Md1 that is,

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.

with an increase in income, demand for money would increase for being

held for transactions motive, Md or L1=f(Y).

In the new equilibrium position, with the given stock of money supply, money held under the transactions motive will increase whereas the money held for speculative motive will decline.

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.

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.

Slope of lm curve

The LM curve slope is upward from left to right

LM curve is positively sloped..

LM curve depend upon –

and interest rate..

level of income

SHIFT IN lm curve

LM Curve shift right LM Curve shift leftR

OI

ISLM

Income

R2

R

RO

I

LM1

IS

IncomeR

R1

LM1 LM

E

E1

E1

E

Why LM Curve shift right Why LM Curve shift left

SHIFT IN LM curve

1.Increase in money supply.

2.Decrease in demand for

money.

1.decrease in money supply.

2.increase in demand for

money.

(4) The quantity of money.

Thus, the IS-LM curve model is based on:

(1) The investment-demand function,

(2) The consumption function,

(3) The money demand function, and

IS

LM

Effect of Changes in Supply of Money on the Rate of Interest and Income Level:

with the increase in the supply of money, more money will be available for speculative motive at a given level of income which will cause the interest rate to fall. As a result, the LM curve will shift to the right.

With this rightward shift in the LM curve, in the new equilibrium position, rate of interest will be lower and the level of income greater than before.

where with a given supply of money, LM and IS curves intersect at point E.

With the increase in the supply of money, LM curve shifts to the right to the position LM’, and with IS schedule remaining unchanged,

new equilibrium is at point G corresponding to which rate of interest is lower and level of income greater than at E.

Now, suppose that instead of increasing the supply of money, Central Bank of the

country takes steps to reduce the supply of money.

and the IS curve remaining un-changed, in the new equilibrium position (as shown by point T

the rate of interest will be higher and the level of income smaller than before.

With the reduction in the supply of money, less money will be available for speculative motive

at each level of income and, as a result, the LM curve will shift to the left of E,

Changes in the Desire to Save or Propensity to Consume:

When people’s desire to save falls, that is, when propensity to consume rises, the aggregate demand curve will shift upward and, therefore, level of national income will rise at each rate of interest.

suppose with a certain given fall in the desire to save (or increase in the propensity to consume), the IS curve shifts rightward to the dotted position IS’. With LM curve remaining unchanged,

As a result, the IS curve will shift outward to the right.

the new equilibrium position will be established at H corresponding to which rate of interest as well as level of income will be greater than at E.

Thus, a fall in the desire to save has led to the increase in both rate of interest and level of income.

the new equilibrium position will be reached to the left of E, say at point L corresponding to which both rate of interest and level of national

income will be smaller than at E.

On the other hand, if the desire to save rises, that is, if the propensity to consume falls,

aggregate demand curve will shift downward which will cause the level of national income

to fall for each rate of interest and as a result the IS curve will shift to the left.

With this, and LM curve remaining unchanged,

Is-lmApproach-3



Macro-economics


Part-3 , simultaneous equilibrium model & previous year

questions...

Simultaneous changes in IS-LM curve

Simultaneous changes in IS-LM curve

If investment and money supply increases simultaneously then IS-LM curve

shift right.

New eqm will be set on new IS-LM curve, but ROI remain same.

RO

I

Income

IS

E

IS1

E1

LMLM1

R

Effectiveness of monetary and fiscal

policy

Effectiveness of monetary policy

In Lm curve

RO

IIncome

IS

LM

Horizontal(Perfect elastic)

flat(elastic)

more

steep(inelastic)

less

vertical(Perfect inelastic)

1.Monetary policy is perfectly

ineffective when LM curve is

horizontal.

2.MP less effective -LM flat

3.MP more effective –LM steep

4.MP perfectly effective – LM

verticalR

R1

A-B= Keynesian range

AB

C

B-D= intermediate range D

Above D= classical range

y2y1

RO

IIncome

RR

1R

2

y2 y1 y


In is curveHorizontal

Perfect elastic

flatElastic(more)

steepInelastic

(less)

verticalPerfect

inelastic


effective when IS curve is horizontal.

2.MP more effective -IS flat

3.MP less effective –IS steep

4.MP perfectly ineffective – IS

vertical


In Lm curve

RO

IIncome

IS

LM

Horizontal(Perfect elastic)

flat(elastic)

more

steep(inelastic)

less

vertical(Perfect inelastic)


ineffective when LM curve is

horizontal.

2.MP less effective -LM flat

3.MP more effective –LM steep

4.MP perfectly effective – LM

verticalR

R1


AB

C



y2y1

Effectiveness of FISCAL policyIn Lm curve

RO

IIncome

IS

LM

HorizontalPerfect elastic

flatelastic

steepinelastic

verticalPerfect

inelastic

1.Fiscal policy is perfectly effective

when LM curve is horizontal.

2.FP more effective -LM flat

3.FP less effective –LM steep

4.FP perfectly ineffective – LM

verticalR

R1

y

RO

IIncome

RR

1R

2

y2 y1 y

Effectiveness of FISCAL policy


Perfect elastic

flatelastic

steepinelastic

verticalPerfect

inelastic

1.Fiscal policy is perfectly ineffective

when IS curve is horizontal.

2.FP less effective -IS flat

3.FP more effective –IS steep

4.FP perfectly effective – IS vertical

Ugc net Previous questions

RO

IIncome

RR

1R

2

y2 y1 y



Perfect elastic

flatElastic(more)

steepInelastic

(less)

verticalPerfect

inelastic


effective when IS curve is

horizontal.

2.MP more effective -IS flat

3.MP less effective –IS steep

4.MP perfectly ineffective – IS

vertical

RO

IIncome

RR

1R

2

y2 y1 y



Perfect elastic

flatelastic

steepinelastic

verticalPerfect

inelastic







In Lm curve

RO

IIncome

IS

LM

RR

1


AB

C



y2y1

SHIFT IN is curve

IS Curve shift right IS Curve shift leftR

OI

IS

LM

IS 1

Income

RR

1

RO

I

IS 1

LM

IS

IncomeR

1R

E

E1

E

E1

fiscal policy is more effective when

1. LM curve is less elastic.2. IS curve is less elastic.3. LM curve is more elastic.4. IS curve is more elastic.

A. 1,and 2. B. 2 and 3

C. 3 and 4. D. 1 ,2and 4.


In Lm curve

RO

IIncome

IS

LM

HorizontalPerfect elastic

flatelastic

steepinelastic

verticalPerfect

inelastic

1.Fiscal policy is perfectly effective

when LM curve is horizontal.

2.FP more effective -LM flat

3.FP less effective –LM steep

4.FP perfectly ineffective – LM

verticalR

R1

y

RO

IIncome

RR

1R

2

y2 y1 y



Perfect elastic

flatelastic

steepinelastic

verticalPerfect

inelastic






Q1. In Keynesian range the monetary policy will be

A. Perfectly effective.

B. Perfectly ineffective.C. More effective.D. Less effective.

Q2. in classical range the fiscal policy will be

A. More effectiveB. Less effectiveC. Perfectly effectiveD. Perfectly ineffective.

Q3. increase in propensity to consume lead to

A. Decrease in ROI and increase in income.B. Increase in ROI and decrease in income.C. Increase in ROI and increase in income.D. Increase in money supply and demand for money.

Q4. increase in demand for money lead to

A. IS Curve shift right.B. LM curve shift right.C. IS curve shift left.

D. LM curve shift left.

Ans keys

1. B

2. D3. C

4. D

Is-lmApproach-3



Macro-economics


Part-3 , simultaneous equilibrium model & previous year

questions...

macro-economics is-lm approach-1

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