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Unit 9: General Equilibrium of an Economy: IS-LM Analysis

3. Equality of demand for money and supply of money determines money market Notes
equilibrium.

9.2 The Product Market Equilibrium – The IS-curve

To simplify the analysis, we shall consider a two sector model, i.e., we assume a closed economy
without any government spending or taxes. In such an economy, the expenditures on goods and
services can exist only in the form of business expenditure and investment goods. We continue
to assume that consumption (hence saving) is a function of income. In addition, we now assume
that investment is endogenous and is a function of the rate of interest. Thus from the C+I
approach, we have three equations to cover the product market.
C = C (Y) (the consumption function) (1)
I = I (r) (the investment function) (2)
Y = C(Y) + I (r) (the equilibrium condition) (3)
From the saving-investment approach, the three equations covering the product market can be
written as.
S = S (Y) (the saving function) (4)
I = I (r) (the invest function) (5)
S(Y) = I(r) (the e.g. condition) (6)
Equations (2) & (5) are same and indicate that investment is a function of the rate of interest.
(Figure 9.2a).
Figure 9.2

(a) (b)

(c)

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