IS LM Model of Income Determination

Introduction

The IS-LM model stands for "Investment-Savings, Liquidity-Money," is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the money market (LM). It is represented as a graph in which the IS and LM curve intersect to show the short-run equilibrium between interest rates and output. In IS-LM model, the LM is a stock equilibrium which represents the beginning of period whereas IS is a flow equilibrium which represents the end of the period.

This model was proposed by Hicks and Hansen. So, it is also called the Hicks-Hansen model. The IS-LM curve explains how product market and money market attain equilibrium at the same level of income and interest rates. The IS curve represents the product market whereas the LM curve represents the money market.

Derivation of IS curve and product market equilibrium

The IS curve is derived at the equilibrium in the product market, with the real interest rate on the vertical axis and real output on the horizontal axis. When the product market is in equilibrium, the IS curve shows real interest rate (r) for any income level (Y). This curve is called IS because at all the points on the curve the desired investment (I_d) is equal to desired national saving (S_d).

Graphical Representation

The IS curve is derived jointly from the saving and investment curves. This curve shows the equality between saving and investment at each level of income at different interest rates.

The graph shows the product market equilibrium for two different levels of outputs: 4000 and 5000. The higher national saving i.e. 5000 increases the desired national saving and the saving curve shifts to the right. When the output is 4000, the real interest rate that clears the product market is 7% and the market clearing interest rate for 5000 is 5%.

Connecting various rates of interest with their corresponding income levels IS curve is obtained in figure (b). It is clear from the figure that the higher level of income increases the volume of saving. The greater volume of saving decreases the rate of interest. Thus the IS curve is downward sloped, indicating the inverse relationship between income level and rate of interest.

Derivation of LM curve and money market equilibrium

The LM curve represents the money market equilibrium. The money market is in equilibrium only if the quantity of money demanded is equal to the currently available money supply. The equality in money supply and demanded is shown by money supply money demand diagram. The vertical axis represents the real interest rate (r) whereas the horizontal axis represents the money measured in real terms. The MS line shows the economy’s real money supply (M/P). The nominal money supply (M) is set by the central bank and for a given price level (P), the real money supply (M/P) is fixed and hence the MS curve is vertical.

Graphical Representation

In the figure the money demand curve, for y = 4000 shows the real demand for money when output is 4000 and the money demand curve, for Y = 5000 shows the real demand for money when output is 5000.The real money supply is fixed at 1000. When the output is 4000, the real interest rate that clears money market is 3% and when output is 5000, the interest rate is 5%. The money demand curve shifts to the right when output increases.

Connecting the points of rates of interest at different income, we derive the LM curve. It slopes upward which indicates the given the money supply when the liquidity preference increases.

Determination of equilibrium income

To determine the equilibrium of economy as a whole, the labor market, product market and money market are put together. A situation in which all market are simultaneously equilibrium is called general equilibrium.

The figure shows complete IS – LM model illustrating how equilibrium is obtained. In figure three different curves are used:

• The full employment (FE) line along which the labor market is in equilibrium.
• The IS curve, along which the product market is in equilibrium.
• The LM curve, along which the money market is in equilibrium.

The economy is in general equilibrium when quantities supplied are equal to quantities demanded in every market. The general equilibrium point E lies in all three curves which indicate the simultaneous equilibrium of money market, product market, and labor market.

References

Dwivedi, D. N. (2010). Macroeconomic theory and policy. New Delhi: Tata McGraw-Hill Education.

Bernake and Abel, Macroeconomics, Singapore, Pearson Education latest edition