Is-LM Assignment Auto Saved)

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Deriving the IS curve

As the interest rate goes up people start putting more money in the

bank and hence Investment comes down. Now since planned

expenditure E= C + I + G, planned expenditure is reduced. Now

according to equilibrium in keynesian cross E= actual expenditure i.e.

Income. So as the Investment reduces income also reduces. And

Investment reduced because interest rate went up that means

Income (I) is inversely proportional to Interest rate (r).


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Deriving the LM curve

For deriving the LM curve we assume that price level is fixed and money supplyis constant. This way Supply of real money balance is fixed in the market it

does not depend on interest rate or income. On the other hand demand for

real money balance in the market increases as Income increases and decreases

as the interest rate increases. Now if the Income level in the market rises

demand curve will shift up as a result equilibrium interest rate goes up.

That means with the increase in interest rate Income rises. This is what is

shown in the LM curve.


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Equilibrium in the IS-LM Model

IS curve depicts the relation between income (Y) and interest rate (r) in the

Goods market. Whereas LM curve explains the relation between income and

interest rate in market for real money balance. Intersection point of these twocurves gives us that value of Income for which Interest rate (r) will be the same

in both the markets. All this is concluded under the assumption that fiscal

policy, G and T, monetary policy M, and the price level P as exogenous.


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How changes in Fiscal Policy changes the Short-Run Equilibrium

Changes in Government Purchases

Suppose if government expenditure increases by delta G.

The Keynesian cross tells us that, at any given interest rate, this change in fiscal

policy raises the level of income by Delta G/(1 MPC).Therefore, as Figure 11-1

shows, the IS curve shifts to the right by this amount. The equilibrium of the

economy moves from point A to point B. The increase in government

purchases raises both income and the interest rate.

Changes in Taxes

Suppose if there is a decrease in taxes of DT. The tax cut encouragesconsumers to spend more and, therefore, increases planned expenditure. The

tax multiplier in the Keynesian cross tells us that, at any given interest rate, this

change in policy raises the level of income by DT MPC/(1 MPC).


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How changes in Monetary Policy changes the Short-Run Equilibrium

A change in the money supply changes the interest rate that balances the

money market for any given level of income and, thereby, shifts the LM curve

Consider an increase in the money supply. An increase in M leads to an

increase in real money balances M/P, because the price level Pis fixed in the

short run. The theory of liquidity preference shows that for any given level of

income, an increase in real money balances leads to a lower interest rate.

Therefore, the LM curve shifts downward.

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Is-LM Assignment Auto Saved)