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Tanima Dutta, Lovely Professional University Unit-18: IS - LM Analysis

Unit-18: IS - LM Analysis Notes

Contents
Objectives
Introduction
18.1 IS Curve and Its Derivation (Product Market Equilibrium)
18.2 LM Curve and Its Derivation (Money Market Equilibrium)
18.3 Summary
18.4 Keywords
18.5 Review Questions
18.6 Further Readings

Objectives

After studying this unit, students will be able to:
y Know the derivation of IS Curve,
y Know the derivation of LM Curve.

Introduction

Now we’ll analyse the simultaneous determination of equilibrium GDP interest rate. Besides
from equilibrium interest rate, equilibrium GDP presents a partial approach of complex economy
equilibrium. Interest rate affects the investment level so to actual GDP level also. Similarly GDP level
affects the interest rate in the economy by the demand of money. When interest rate is increasing
then on special rise in investment, an economy can’t make a rise the GDP level till diversified range.
Similarly interest rate can’t be reduced till the limit of extent of increase in money supply because
increase in money supply (by low interest rate and high investment) and high GDP make an increment
in supply of money, which means the increment in interest rate. Therefore, the Traditional/Classical
view that interest rate is a real phenomenon and is determined by savings and investment only.
And J. M. Keynes view that it is only a monetary phenomenon and it is determined by supply and
demand of money, these both views are challenged. J. R. Hicks and Hensen have established a
new approach by IS-LM Analysis, which integrates the real and monetary phenomenon both. The
simultaneous determination of interest rate and actual GDP and the alternative derivation of AD
curve is the cornerstone of IS-LM Analysis. In the determination of Actual GDP and Interest rate,
because J. R. Hicks and Hensen synthesise both the real and monetary phenomenon, so their approach
is called as Hicks-Hensen Synthesis. The equilibrium of IS-LM Curves means the determination on
the equilibrium level of actual GDP and equilibrium interest rate by equality between investment and
saving and equality between supply and demand of money. This approach of interest determination
is called as the Modern Theory of interest rate determination. Current chapter explains how the IS and
LM Curves are derived and how the balanced actual GDP and interest rate are determined. Besides it

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