Page 168 - DECO201_MACRO_ECONOMICS_ENGLISH

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

9.5 Summary Notes

IS-LM stands for simultaneous equality of injections and leakages, and of demand for
money and supply of money. Equality of injections and leakages determines national
output, i.e., product market equilibrium. Equality of demand for money and supply of
money determines money market equilibrium.
The IS-curve is also a locus of points showing alternate combinations of interest rates and
income (output) at which the commodity market clears. That is why the IS-curve is called
the commodity market equilibrium schedule.
The IS-curve is negatively sloped because a higher level of interest rate reduces investment
spending, thereby reducing aggregate demand and thus the equilibrium level of income.

The LM-curve is a line of points showing alternative combinations of the rate of interest
and the level of income that bring about equilibrium in the money market.
The LM-curve is positively sloped. This means that an increase in the interest rate reduces
the demand for money.
For general equilibrium, the interest rates and income levels have to be such that both the
goods and money market are in equilibrium.
The interest rate and level of output are determined by the interaction of money (LM) and
commodity (IS) markets.
The equilibrium levels increase and interest rates change when either the IS or LM-curve
shifts.

9.6 Keywords

Autonomous Spending: Spending that is considered necessary regardless of income level, such
as government spending, basic living expenses and investing.
Investment Goods: Goods that are purchased with the expectation of earning a favorable return.

Investment Multiplier: The change in national income which would result from a unit change in
investment.
IS-curve: is also a locus of points showing alternate combinations of interest rates and income
(output) at which the commodity market clears.
LM-curve: It is a line of points showing alternative combinations of the rate of interest and the
level of income that bring about equilibrium in the money market.

Speculative Demand for Money: is the desire to have money for transactions other than those
necessary for living.
Transaction Demand for Money: It results from the need for liquidity for day-to-day transactions
in the near future.

9.7 Review Questions

1. Describe an IS-curve. How is it derived?
2. Define the LM-curve and explain its derivation.

3. Explain the effect of an increase in investment on an IS-curve?

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