A Presentation on

IS LM Model
(Graphical Approach)
 The Goods and The Money Market
Equilibrium
Equilibrium of the goods market is achieved when
the goods market is cleared, i.e. , according to
Keynes, planned saving is equal to planned
investment.

S=I
OR

Y=C+I
Equilibrium of the money market requires equality
between the supply of and the demand for money.

Ms = Md
Equilibrium in the Goods Market
In developing the IS model, investment is
considered as a function of rate of interest ,
consumption and saving as functions of
income.
Investment Function : I = I(r)
Consumption Function : C = C(Y)
Saving Function : S = S(Y)
Equilibrium in the goods market is achieved
when : -
S(Y) = I(r)
However, this relationship may be shown
graphically as follows
 IS Curve

Re-translation of Simple Keynesian model at

equilibrium (Investment = Saving).

A plot of equilibrium output for various

interest rates within the market for goods and
services.
Determining Output
Note two characteristics of ZZ:
Because its assumed that the
consumption and investment
Relations are linear, ZZ is,
in general, a curve
rather than a line.
ZZ is drawn flatter than a 45-
degree line because its
assumed that an increase in
output leads to a less than one
for-one increase in demand.
Deriving the IS Curve
Deriving the IS Curve
(a) An increase in the interest rate
decreases the demand for goods
at any level of output, leading to
a decrease in the equilibrium level of
output.
(b) Equilibrium in the goods market
implies that an increase in the
interest rate leads to a decrease in
output.
Properties of IS Curve
Downward Sloping,
i C, I Y*
Increase/Decrease in autonomous expenditure

will shift the IS curve Rightward/Leftward.

The steepness or flatness of the IS curve
describes the elasticity or responsiveness of C
and I to the nominal interest rate.
-- Steep IS curve: inelastic.
-- Flat IS curve: elastic.
Shifts in IS Curve due to
taxes
An increase in taxes
shifts the IS curve to
the left.
Equilibrium in the Money Market
Money Market Equilibrium is achieved
when the supply of money and demand
for money are equal.
Ms = M d
Money Demand is made of two parts : -
Msp : Speculative Demand for Money
Mt : Transactionary Demand for Money
Md = Msp + Mt
 LM Curve
Depicts equilibrium in the Money market (L =
M), as well as the Bond Market (by Walras
Law).

A plot of the equilibrium interest rate for

various levels of output or income, within the
money market for a given level of the nominal
money supply.
Deriving the LM Curve
An increase in income leads, at a given
interest rate, to an increase in the
demand for money. Given the money
supply, this increase in the demand for
money leads to an increase in the
equilibrium interest rate.
Equilibrium in the financial markets
implies that an increase in income leads
to an increase in the interest rate. The
LM curve is therefore upward sloping .
Deriving the LM Curve
Properties of LM Curve
Upward sloping,
Y L i*
Increase/Decrease in the real money supply
shift the LM curve Rightward/Leftward.
The steepness or flatness of the LM curve
describes the elasticity or responsiveness of
money demand (L) to the nominal interest rate.
-- Steep LM curve: inelastic.
-- Flat LM curve: elastic.
Shifts in LM Curve due to change in
Money Supply
An increase in money
causes the LM curve
to shift down.
Two Market Equilibrium
The intersection point of the IS and LM
curve denotes the equilibrium point
between the two markets.

There is only one combination of Y and r

at which both the goods market and the
money market are in equilibrium
simultaneously.
The Equilibrium Curve
Fiscal and Monetary
policies
Fiscal contraction, refers to fiscal policy that reduces
the budget deficit.
An increase in the deficit is called a fiscal expansion.
Taxes affect the IS curve, not the LM curve.
Monetary contraction, refers to a decrease in the
money supply.
An increase in the money supply is called
monetary expansion.
Monetary policy does not affect the IS curve,
only the LM curve.
For example, an increase in the money supply
shifts the LM curve down.
Effects of Fiscal and Monetary
Policy
Outcome of the
Recession
Increased Uncertainty.
Fall in Consumer and Business
Confidence.
This all resulted in : -
Lower Spending, IS curve shifted
towards left.
Reduced Stock Prices, Discouraged
Investment
Conclusion
IS Curve represents the equilibrium of the
goods market.
LM Curve represents the equilibrium of the
money market.
The point of intersection of the two curves is
the point of equilibrium of both the markets
simultaneously.
By taking both fiscal and monetary measures
using the IS LM model recession can be
checked out.