The IS Сurve constructing

The IS Сurve construction

The LM Curve deriving

3. The IS-LM Model

Precautionary Measure – запобіжний захід

The model of aggregate demand called the IS – LM model is the leading interpretation of Keynes’s theory. The goal of the model is to show what determines national income for any given price level.

The two parts of the IS – LM model are the IS curve and the LM curve. IS stands for “investment’’ and “saving, ’’ and the IS curve represents what’s going on in the market for goods and services. LM stands for “liquidity’’ and “money, ’’ and the LM curve represents what’s happening to the supply and demand for money.

The IS Сurve constructing

To determine how income changes when the interest rate changes, we can combine the investment function with the Keynesian-cross diagram. Because investment is inversely related to the interest rate, an increase in the interest rate from r 1 to r 2 reduces the quantity of investment from I (r 1) to I (r 2).The reduction in planned investment, in turn, shifts the planned-expenditure function downward, as in panel (b).The shift in the planned-expenditure function causes the level of income to fall from Y 1 to Y 2. Hence, an increase in the interest rate lowers income.

The IS curve, shown in panel (c), summarizes this relationship between the interest rate and the level of income. In essence, the IS curve combines the interaction between r and I expressed by the investment function and the interaction between I and Y demonstrated by the Keynesian cross. Because an increase in the interest rate causes planned investment to fall, which in turn causes income to fall, the IS curve slopes downward.

For the IS curve, the independent variable is the interest rate and the dependent variable is the level of income (even though the interest rate is plotted vertically).

In equilibrium, all spending is desired or planned; there is no unplanned inventory accumulation (or, equivalently, when " leakages" from the circular flow equal " injections").

The IS curve is defined by the equation

Y = C(Y - T) + I(r) + G + NX(Y)

where Y represents income, C(Y − T) represents consumer spending as an increasing function of disposable income (income, Y, minus taxes, T), I(r) represents investment as a decreasing function of the real interest rate, G represents government spending, and NX(Y) represents net exports (exports minus imports) as a decreasing function of income. In this equation, the level of G is presumed to be exogenous, meaning that it is taken as a given.

The IS curve describes equilibrium in the product market in terms of r and Y. The IS curve is downward sloping because as the interest rate falls, investment increases, thus increasing output.