The internal environment of an organization consists of various subsystems. Internal environment of the organization (management)
Equilibrium in the money market
Optimal condition for the money market is the balance between the demand for money and its supply. Equilibrium in the money market is established when the demand for money and its supply are equal, when the amount of money supplied is equal to the amount of money that households and firms want to have. Graphically, equilibrium in the money market is achieved at the intersection of the money demand curves D m and their supply S m. Suppose that the government and the central bank of a country pursue a policy of constant money supply. The money supply graph S m will look like a vertical straight line.
The point of intersection of the money demand and money supply schedules determines the equilibrium price and equilibrium volume.
Equilibrium in the money market develops at the interest rate r 0 and the mass of money Q m0.
Equilibrium interest rate- the price paid for the use of borrowed money. Given the supply of money, an increase in the demand for it increases the rate loan interest. Conversely, with a constant demand for money, an increase in the money supply reduces the interest rate, and a decrease in the money supply increases it.
Suppose the interest rate rises to r 1 . Since the money supply is constant relative to the interest rate, it will not change. The demand for money will fall. Under these conditions, people will strive to get rid of extra money. Since they serve as an alternative to money securities, then the demand for them will increase and exceed supply, which will cause an increase in prices for securities and a decrease in interest rates. A fall in interest rates will increase the demand for money. As long as the interest rate is above r 0, these processes will lower its level and ultimately equalize the quantities of money supply and demand (D m = S m).
Suppose the interest rate falls to r 2 . The money supply will remain unchanged. The demand for them will increase. Under these conditions, people will be released from securities. Since money serves as an alternative to them, the demand for them will increase and exceed the supply of money. This will cause securities prices to fall and interest rates to rise. A rise in interest rates will lead to a fall in the demand for money. As long as the interest rate is below r 0, these processes will increase its level and ultimately equalize the quantities of money supply and demand (D m = S m).
IS curve
The IS curve is the equilibrium curve in the product market. It represents the locus of points characterizing all combinations of Y and R that simultaneously satisfy the identity of income, the functions of consumption, investment and net exports. At all points of the IS curve, investment and savings are equal. The term IS reflects this equality (Investment - Savings).
The simplest graphical derivation of the IS curve involves the use of the saving and investment functions.
Similar conclusions can be obtained using the Keynesian cross model.
Algebraic derivation of the IS curve
The IS curve equation can be obtained by substituting Equations 2, 3 and 4 into the basic macroeconomic identity and solving it for R and Y.
Characterizes the angle of inclination of the IS curve relative to axis 1, which is one of the parameters comparative effectiveness fiscal and monetary policy.
The IS curve is flatter provided that:
1) sensitivity of investment (d) and net exports (k)
to the dynamics of interest rates is high;
2) the marginal propensity to consume (b) is high;
3) the marginal tax rate (-) is low;
4) the marginal propensity to import (m9) is low;
Under the influence of an increase in government spending G or a decrease in taxes T, the IS curve shifts to the right. Changing tax rates also changes the angle of its inclination. In the long run, the slope of IS can also be changed by income policy, since high-income families have a relatively lower marginal propensity to consume than low-income families. The remaining parameters (d, n and m) are practically not affected by macroeconomic policy and are mainly external factors that determine its effectiveness.
The LM curve is the equilibrium curve in the money market. It records all combinations of Y and Ji that satisfy the demand function for money at the value of money supply Ms specified by the Central Bank. At all points on the LM curve, the demand for money is equal to its supply. The term LM reflects this equality (Liquidity Preference = Money Supply)
IS-LM model and its significance
The IS-LM model is a joint equilibrium model of the commodity and money markets. It is a Keynesian type (demand-side) model that describes the economy in short term and serves as the basis modern theory aggregate demand.
The IS-LM model was developed by the English economist John Hicks in 1937 in the article “Keynes and the Neoclassics” and became widespread after the publication of the book “Monetary Theory and Fiscal Policy” by the American economist Alvin Hansen in 1949 (therefore the model is sometimes called the Hicks model -Hansen).
The IS (investment-savings) curve describes the equilibrium of the goods market and reflects the relationship between the market interest rate R and the level of income Y that arises in the market for goods and services. The IS curve is derived from a simple Keynesian model (the equilibrium model of aggregate expenditures or the Keynesian cross model), but differs in that part of aggregate expenditures and, above all, investment expenditures now depend on the interest rate.
The interest rate ceases to be an exogenous variable and becomes an endogenous value determined by the situation in the money market, i.e. inside the model itself. The dependence of part of total expenses on the interest rate results in the fact that for each interest rate there is exact value the value of equilibrium income and therefore an equilibrium income curve for the commodity market can be constructed - the IS curve. At all points of this curve, equality of investment and savings is observed (and at more in a broad sense the amount of injections is equal to the amount of withdrawals), which explains the name of the curve (Investment=Savings).
The LM (liquidity-money) curve characterizes the equilibrium in the money market, which exists when the demand for money (primarily determined by the property of absolute liquidity of cash) is equal to the supply of money. Since the demand for money depends on the interest rate, there is an equilibrium curve for the money market - the LM curve (Liquidity preference=Money supply), each point of which is a combination of income and interest rates that ensures monetary equilibrium.
The intersection of the equilibrium curves of the commodity (IS) and money (LM) markets gives the only values of the interest rate R (equilibrium interest rate) and the level of income Y (equilibrium level of income), ensuring simultaneous equilibrium in these two markets.
The IS-LM model allows you to: 1) show the relationship and interdependence of the commodity and money markets; 2) identify factors influencing the establishment of equilibrium both in each of these markets separately, and the conditions for their simultaneous equilibrium; 3) consider the impact of changes in equilibrium in these markets on the economy; 4) analyze the effectiveness of fiscal and monetary policies; 5) derive the aggregate demand function and determine the factors influencing aggregate demand; 6) analyze stabilization policy options at different phases of the economic cycle.
The IS-LM model retains all the premises of the simple Keynesian model:
1) the price level is fixed (P=const) and is an exogenous quantity, therefore nominal and real values all variables are the same;
2) aggregate supply (volume of output) is completely elastic and capable of satisfying any volume of aggregate demand;
3) income (Y), consumption (C), investment (I), net exports (X) are endogenous variables and are determined within the model;
4) government spending (G), money supply (M), tax rate (t) are exogenous quantities and are formed outside the model (set from the outside);
5) GNP = NNP = ND, since only households pay taxes and there are no indirect taxes on businesses. The exception is the assumption of a constant interest rate. If in the Keynesian cross model the interest rate is fixed and acts as an exogenous parameter, then in the IS-LM model it is endogenous and is formed within the model; its level changes and is determined by changes in the situation (equilibrium) in the money market. Planned autonomous expenses now depend on the interest rate.
Model IS-LM
Model IS-LM(investment (I), savings (S), (liquidity preference = demand for money) (L), money (M)) - a macroeconomic model that describes the general macroeconomic equilibrium, formed by a combination of equilibrium models on goods (IS curve) and money (LM curve) markets. The model was developed by English economists John Hicks and Alvin Hansen and first used in 1937.
Model
Each point on the IS curve corresponds to equilibrium in the goods market, which is determined by the ratio of GDP (Y) and interest rate (i). The IS curve models two dependencies:
- Dependence of investment volume on interest rate. The higher the interest rate, the lower the investment. (Transfer costs. This means that at a high rate, a low-income business ceases to function - investments are taken away from it). Consequently, national production falls, and with it national income. (However, if this is a reaction to increased prices for resources, this is a reduction in production activity that is appropriate to the situation. Production in this situation can be increased by introducing new technologies.)
In turn, each point on the LM curve corresponds to equilibrium in the money market. The LM curve models the dependence of the interest rate on national income. The higher the income, the higher the interest rate (higher income → higher consumption expenses → higher demand for cash → higher interest rate).
Only at the point of intersection of the curves is equilibrium achieved between both markets.
Interpretation
The IS-LM model allows you to visualize the relationship between such macroeconomic variables as the interest rate, money supply, price level, demand for cash, demand for goods, and the production level of the economy. Changes in one or more of these quantities lead to a shift in the point of intersection of the LM and IS curves, which in turn determines the level of production (and income) of the economy, as well as the corresponding level of interest rates.
see also
Notes
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Historical Dictionary of Gallicisms of the Russian Language - (model of aggregate demand and aggregate supply) macroeconomic model that considers macroeconomic equilibrium in conditions of changing prices in the short-term and long-term periods
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(IS/LM model) is a macroeconomic model that describes the general equilibrium in the economy and is formed as a result of the merger of two equilibrium models in the goods (IS) and money (LM) markets.
The IS-LM model (income-expenditure model) combines money markets and product markets into unified system. This model was originally (in 1937) proposed by the English economist J. Hicks and later supplemented by the American E. Hansen as an interpretation of the essence of Keynesian theory. This model is typical for a closed economy.
An increase in the interest rate from (\mathrm r)_1 to (\mathrm r)_2 reduces investment and planned expenses, which leads to a reduction in output and income from (\mathrm V)_1 to (\mathrm V)_2. A reduction in income also reduces savings. Namely, the IS curve shows this relationship between the rate of income, interest, investment and savings.
An increase in government spending by \mathrm(AG) will shift the planned spending curve upward, which will cause an increase in output. An increase in income will increase savings and investment at the same interest rate. A decrease in government purchases, while other components of the basic macroeconomic identity remain unchanged, will reduce income, savings and investment. Thus, the IS curve can be used to analyze the impact of fiscal policy on output.
The LM curve fixes all combinations of output volume (\mathrm V) and interest rate (\mathrm r) when the money supply is equal to the demand for money. The price level is considered as fixed, which is typical for Keynesian short term analysis economy. In this case, the supply of money in real terms is fixed and does not depend on the interest rate. At the same time, the demand for money depends on the interest rate, which represents the opportunity cost of holding money: the higher the interest rate, the higher the income that you give up by holding money in the form of cash. Therefore, the demand for money is inversely proportional to the interest rate.
(\mathrm(MP))^\mathrm D\;=\;\mathrm L(\mathrm r).
The LM curve is shown in the figure.
Two equations of the IS-LM model:
(\mathrm(IS))\;\mathrm V\;=\;\mathrm C(\mathrm V\;-\;\mathrm T)\;+\;\mathrm I(\mathrm r)\;+\ ;\mathrm G,
(\mathrm(LM))\;\mathrm M/\mathrm P\;=\;\mathrm L(\mathrm V,\;\mathrm r).
The parameters \mathrm M , \mathrm P , \mathrm G , \mathrm T are accepted in this model as exogenous quantities.
At the point of intersection of the curves, real expenses are equal to planned ones, and demand for real cash equal to their offer. This model is used to analyze the income impact of short-term changes in fiscal and monetary policies.
Basics of economic theory. Lecture course. Edited by Baskin A.S., Botkin O.I., Ishmanova M.S. Izhevsk: Publishing House "Udmurt University", 2000.
Questions Equilibrium in commodity markets, IS curve Equilibrium in the money market, LM curve Joint equilibrium in commodity and money markets in the IS-LM model IS-LM model in the short and long term. Model IS-LM with flexible prices. Correlation between IS-LM and AD-AS models
Disadvantages of the Keynesian model The Keynesian macroeconomic model (“income and expenditure”) in the interpretation of the Keynesian cross is useful because it shows what determines income in the economy at a certain level of planned investment. However, it is an oversimplification, since the level of planned investment is fixed; the economy finds itself in a situation of either inflation or unemployment; there is no price level in the model; everything is measured by real indicators, while the problems of inflation are discussed
IS-LM model as overcoming the contradictions of the Keynesian cross model The analysis is carried out in two sectors of the economy: in the real sector, in which the equilibrium condition is I = S; in the monetary sector, where the equilibrium condition is the equality of the demand for liquidity and the money supply L = M The purpose of constructing the model is to determine conditions of joint equilibrium in two markets – commodity and money
Equilibrium in commodity markets. IS curve Limitations and assumptions Closed economy Fixed fiscal policy parameters (government spending and taxes do not change) The analysis is the same as in the Keynesian cross model The consumption function and savings depend on income C=C(Y) S=S(Y) S(Y)>0 Equality between savings and investments ensures equilibrium in commodity markets S(Y)=I(r) But, along with the consumer function, an investment function is introduced. Investment decisions are made depending on the height of the interest rate I=I(r) I(r) 0 Equality between savings and investments ensures equilibrium in commodity markets S(Y)=I(r) But, along with the consumer function, an investment function is introduced. Investment decisions are made depending on the height of the interest rate I=I(r) I(r)" >
A graphical explanation of the establishment of equality between investment and savings through the mutual adjustment of interest rate and national income levels. First situation When r=r 0 investments are planned at the level I=I 0 In order for investments in such a volume to be made, savings in the amount of S 0 are required (I 0 = S 0) In order for the economy to save S 0, it is necessary income Y 0 (Determined through the savings function) We get the first point on the graph (Y,r) The second situation, the interest rate decreases to r 1, planned investments increase to I 1, savings should be increased to S 1 and income - to Y 1, we get the second point on the graph (Y,r) r I S Y r0r0 r1r1 I 1 I 0 I=S I=I(r) S=S(Y) S1S1 S0S0 Y 0 Y 1 IS
Conclusions Each interest rate corresponds to a certain level of national income. By connecting all the points on the graph (Y,r), we obtain the IS curve, each point on which gives us a combination of interest rate and income at which equilibrium will be established in the commodity markets. The IS curve shows that, the higher the interest rate, the lower the level of planned investment and, therefore, the lower the level of income
IS model based on the Keynesian cross We start with the investment schedule. We determine I On the Keynesian cross chart, we transfer planned expenses upward by I On Y,r graph plot the points (Y 0, r 0) and (Y 1, r 1) and connect them. The resulting curve is the IS curve r r0r0 r0r0 r1r1 r1r1 I 0 I 1 I I r Y Y E I Y 0 Y 1 C+I 0 +G C+I 1 +G IS
Algebraic construction of the IS curve (1) The economy is closed, the consumption and investment functions are linear Then Y= C(Y-T)+I(r)+G Let the consumption function be represented as C=a+b(Y-T), where a and b are positive parameters a - autonomous consumption, b - marginal propensity to consume The investment function is presented in the form I = c-dr, where c and d are positive parameters c - autonomous investments d - a parameter that determines how investments react to the interest rate. The higher this ratio, the more sensitive the investment is to the interest rate, and vice versa. Since investments fall when the interest rate increases, d is preceded by the sign -
Algebraic construction of the IS curve (2) Substitute the equations of consumption and investment into the identity of national accounts and transform it Y=+(c-dr)+G Y-bY=a-bT+c-dr+G Y(1-b)= (a +c)+(G-bT)-dr Y= (a+c)/(1-b) + 1/(1-b)G – b/(1-b)T – d/(1-b) r This equation expresses the IS curve algebraically. It gives the parameters of the level of income Y for any interest rate r and fiscal policy variables G and T For constant G and T, it shows the relationship between Y and r
The economic meaning of the coefficients 1/(1-b) – expenditure multiplier – b/(1-b) – tax multiplier d/(1-b) – coefficient showing the sensitivity of Y to changes in r and determines the slope of IS The larger d, the more sensitive to changes in the interest rate of the investment, and, consequently, income. A small change in the interest rate leads to a large change in income - the IS curve is flat. And vice versa, the greater the propensity to consume, the greater the multiplier. This means that even small changes in investments caused by changes in interest rates will lead to significant changes In income, the IS curve is flat. Conversely, the “-” sign before the coefficient d/(1-b) indicates that the IS curve has a negative slope
Shifts of the IS curve The IS curve is constructed for a certain fiscal policy, that is, G and T are constant. When fiscal policy changes, the IS curve shifts. Since the coefficient before government spending (expenditure multiplier) is positive, an increase in government spending shifts the IS curve to the right, a reduction - to the left. Example: an increase in government spending E Y Y r Y 0 Y 1 G×(1/1-b) G E0E0 E1E1 IS 0 IS 1
Construction of the LM curve Let's start from the second quadrant Income Yo causes the need for money to secure Lcd transactions. 0 The remaining part of the money must be absorbed by speculative demand (demand for money as property) Lim.o On the graph in quadrant 4, we determine the interest rate ro at which the population and firms would voluntarily hold the remaining money. On the graph in the first quadrant we get a point corresponding to the pair Y 0 and r 0. We repeat the same for a new level of income (more income more money for transactions less money as property, the population and firms will voluntarily refuse to store money only if the interest rate increases, the rate increases) We get new pair values of Y 1, r 1 and connect the points on the graph. This is the LM curve, each point on which shows such a combination of income and interest rate at which equilibrium is established in the money market
Algebraic construction of the LM curve In equilibrium in the money market, the demand for money is equal to its supply M/P=L(Y,r) Let the demand function for money be linear L(Y,r)=eY – fr where e and f are positive e – shows , how much the demand for money increases with an increase in income f - determines how much the demand for money falls with an increase in the interest rate. The “-” sign before the percentage indicates feedback between interest rate and money demand
Algebraic construction of the LM curve Let us write the equilibrium condition in the money market M/P = eY – fr We transform it so that the interest rate is on the left r = (e/f)Y – (1/f) (M/P) This equation gives us the quantity the interest rate that ensures the equilibrium of the money market at any value of income and real money supply. The LM curve graphically represents this equation for different values of Y and r at fixed values of M/P
The meaning of the coefficients Since the coefficient of Y is positive, the LM curve has a positive slope: higher income requires a higher interest rate to ensure equilibrium in the money market. Since the coefficient of real cash holdings (M/P) is negative, their decrease shifts the LM curve upward , and increasing - down the coefficient e/f determines the slope of the curve. If the value of e is small, i.e. the demand for money is little sensitive to changes in income, then the LM curve is flat (required small change in interest rates to compensate for a slight increase in the transaction demand for money) if f is small (i.e., the demand for money weakly depends on the interest rate), then the LM curve is steep, since a shift in the demand for money due to a change in income leads to a significant change percent
Shift of the LM curve Since the LM curve is constructed for a certain money supply in real terms, a change in this supply (primarily as a result of monetary policy) will cause a shift of the curve - the Central Bank reduces the money supply from M1 to M2, which will cause a fall in the money supply in in real terms from (M/P)1 to (M/P)2. For any reason this level income Y, a reduction in the money supply increases the interest rate, which balances the money market. The LM curve shifts upward to the left - An increase in the money supply - a downward shift of the LM curve to the right r r M/P (M/P) 2 (M/P) 1 r2r2 r1r1 r2r2 L Y Y A decrease in the money supply LM 1 LM 2
Interpretation of the LM curve from the point of view of the quantity theory of money According to the quantity theory MV=PY In this case, the velocity of circulation of money V is assumed to be constant. This means that for any price level only the supply of money determines the level of income. In other words, the level of income does not depend on the interest rate and the LM curve must be vertical r LM Y
Interpretation of the LM curve from the point of view of the quantity theory of money A normal LM curve with a positive slope can be obtained from the quantity theory of money only by removing the premise constant speed circulation of money In reality, the demand for money also depends on the interest rate: a higher interest rate increases the cost of holding money and reduces the demand for money. Since people react to a higher interest rate by reducing the supply of money, each monetary unit in the economy changes hands faster, those. the velocity of circulation of money increases. Therefore, we can write MV(r)=PY V=V(r) V(r)>0, that is, the velocity of circulation is positively related to the interest rate 0, that is, the velocity of circulation is positively related to the interest rate">
MV(r)=PY This equation of the quantity theory of money gives an LM curve with a positive slope. Since an increase in the interest rate increases the velocity of circulation, it increases Y for a given M and P For a given r and P, an increase in M leads to an increase in Y. The LM curve shifts to the right. A decrease in M causes the LM curve to shift to the left. Thus, the quantity theory of money gives the same curve LM, as the theory of liquidity preference, only in a different interpretation
Joint equilibrium in the commodity and money markets in the IS-LM model The IS-LM model is used to explain the functioning of the economy in the short run, when the price level is fixed. The model consists of two equations Y= C(Y-T)+I(r)+G IS M/P=L(r,Y) LM fiscal policy G and T monetary policy M exogenous price level P variables
Joint equilibrium in the goods and money markets Given G, T, M and P, the IS curve gives such combinations of income and interest rate that ensure equilibrium in the market for goods and services, and the LM curve gives such combinations of r and Y that satisfy the equilibrium in the money market. market r Economic equilibrium in the IS-LM model, this is the intersection point that simultaneously satisfies the equilibrium conditions in both commodity and money markets (at the point of intersection of the two curves, real expenses are equal to planned ones, and the demand for real money is equal to the supply of money) LM IS Y Y* r *
The IS-LM Model as a Theory of Aggregate Demand The IS-LM model can be used to construct the aggregate demand curve. Since aggregate demand reflects the relationship between the price level and income, it is necessary to remove the premise of fixed prices. Initial situation: price level P 1, IS and LM intersect at point Y 1. Let us note in the second graph the combination of P 1 and Y 1 Prices have risen to P 2. When permanent offer money, real cash balances decrease and the LM curve shifts upward. New equilibrium IS and LM in point Y 2. Let us mark the combination of P 2 and Y 2 on the second graph. By connecting the first and second points on the second graph, we obtain the curve AD r LM(P 1) LM(P 2) Y 2 Y 1 Y Y P P2P2 P1P1 AD
Movement along the aggregate demand curve and a shift in the aggregate demand curve A change in the level of income in the IS-LM model, resulting from a change in the price level, represents a movement along the aggregate demand curve (graphs on the previous slide) A change in the level of income in the IS-LM model at a fixed level prices (for example, as a result of contractionary fiscal policy) – shift of the curve AD r LM Y 2 Y 1 Y Y P P AD 2 IS 1 IS 2 AD 1
Literature Agapova T.A., Seregina S.F. Macroeconomics. Ch. 9. Galperin V.M., Grebennikov P.I. and others. Macroeconomics. Chapters 3, 4, 6. Mankiw N.G. Macroeconomics. Ch.9, 10. Sachs J.D., Larren F.B. Macroeconomics. Global approach. Ch. 12. Livshits A.Ya. Introduction to market economy. M
1. Introduction
2. Equilibrium of commodity and money markets
2.1. Equilibrium in the goods market
2.2. Equilibrium in the money market
2.3. Equilibrium in the IS-LM model. Basic equations of the model
3. Relative effectiveness of fiscal and monetary policies in the IS-LM model. Displacement effect
3.1. Fiscal policy
3.2. Monetary policy
4. Analysis of the interaction of commodity and money markets when changing fiscal and monetary policies within the framework of the IS-LM model
5. Economic policy in the IS-LM model with changes in the price level. Derivation of the AD curve from the IS-LM model
5.1. Stimulating fiscal policy when price levels change
5.2. Expansionary monetary policy when price levels change
6. Conclusion
7. References
1. Introduction
Economists have always looked for models that would enable the economy to move closer to perfect condition without crises of unemployment and inflation or macroeconomic equilibrium.
The basis for economic growth is investment, that is, investment in the economy. But, from time to time, negative phenomena such as unemployment, declining living standards and inflation occur.
The IS-LM model shows what measures need to be taken in changing economic conditions under the influence of various factors to maintain macroeconomic equilibrium.
In the IS-LM model (investment - savings, liquidity preference - money), the commodity and money markets will appear as sectors of a single macroeconomic system.
The commodity market refers not only to markets for consumer goods and services, but also to the market for investment goods. Demand consumer goods is associated mainly with income, while investment ones are associated with interest rates.
The money market is a mechanism for buying and selling short-term credit instruments such as treasury bills and commercial paper.
One of the components of the macroeconomic equilibrium of the commodity market is the demand for investment (entrepreneurs), the other is the supply of savings (population). In the general case, they do not coincide, so the macroeconomic equilibrium of the commodity market is very unstable. The factors here will be different: household income, household financial assets, price levels, inflation expectations and income growth expectations, debt levels, tax rates, interest rates.
The IS-LM model (or Hicks model) is a model of commodity-money equilibrium that allows us to identify economic forces, defining the aggregate demand function. The model allows us to find such combinations of the market interest rate and income at which equilibrium is simultaneously achieved in the commodity and money markets. Therefore, the IS-LM model is a specification of the AD-AS model. Wide use received after the publication of A. Hansen’s book “Monetary Theory and Fiscal Policy” in 1949, then it also began to be called the Hicks-Hansen model.
2. Equilibrium of commodity and money markets
2.1. Equilibrium in the goods market
The IS curve is the equilibrium curve in the product market. The condition for this equilibrium is the equality of the volumes of aggregate demand and aggregate supply. At all points of the IS curve, investment and savings are equal. The term IS reflects this equality (Investment = Savings).
Since investment is a negative function of the interest rate and consumption is a positive function of real income, we can write the aggregate demand equation as follows.
And the proposal, in accordance with the Keynesian interpretation, has the form:
![](https://i1.wp.com/mirznanii.com/images/11/95/8959511.png)
It follows that an equilibrium state in the commodity market can only occur if the following equality is observed:
All points of the IS curve are points of equality of savings and investments at different meanings interest rate and national income.
Thus, the IS curve does not reflect the functional relationship between the interest rate and income, but a set of equilibrium situations in the goods market, which are obtained as a result of the projection of the saving function and the investment function.
The IS curve has a negative slope because a decrease in the interest rate increases investment and, therefore, aggregate demand, increasing the equilibrium value of income.
Figure 1,a shows the savings function: as income increases from Y 1 to Y 2, savings increase from S 1 to S 2.
Figure 1,b shows the investment function: an increase in savings reduces the interest rate from R1 to R2 and increases investment from I 1 to I 2. In this case, I 1 =S 1, and I 2 =S 2.
Figure 1c shows the IS curve: the lower the interest rate, the higher the level of income.
The IS curve may shift when factors other than the interest rate change. This:
Level of government procurement;
Level of consumer spending;
Net taxes;
Changes in investment volumes.
Suppose that as a result of government actions, the volume of government spending increased (G 1 >G 0). This will lead to an increase in the equilibrium volume of production and income (Y 1 >Y 0). At the same interest rate, the equilibrium amount of income will be greater than before. The IS 0 curve will move to the right, to the IS 1 position (Figure 2).
The same effect will occur if the investment plans of entrepreneurs change, which will lead to a shift in the investment demand curve Id, and therefore to a shift in the line of total expenses, followed by a shift in the IS curve (Figure 3).
When government spending G increases or taxes T decrease, the IS curve shifts to the right. A change in tax rates t also changes the angle of its inclination. The remaining parameters (d, n and m’) are practically not affected by macroeconomic policy.
2.2. Equilibrium in the money market.
The LM curve is the equilibrium curve in the money market. It records all combinations of Y and i that satisfy the money demand function at the value of money supply Ms specified by the Central Bank. At all points on the LM curve, the demand for money is equal to its supply. Such equilibrium in the money market is achieved only if, as income increases, the interest rate rises. The term LM reflects this equality (Liquidity Preference = Money Supply).
Figure 4a shows the money market: an increase in income from Y1 to Y2 increases the demand for money and, therefore, increases the interest rate from i1 to i2.
Figure 4b shows the LM curve: the higher the income level, the higher the interest rate.
The total demand for money is a function of income and the interest rate:
Thus, equilibrium in the money market suggests the following condition:
At a given level of income, the money market equilibrium will be at the point of intersection of the L0 curve with the money supply line Ms (Figure 5a).
If the level of income changes (grows), this will lead to an increase in the demand for money (a shift of the curve L 0 to position L 1) and an increase in the interest rate from i 0 to i 1. As a result, we get a set of equilibrium situations at the points of intersection of supply lines with money demand curves L 0, L 1, etc. This means that everyone paired value interest rates and income will correspond to the equilibrium state of the money market. Graphically, the money market equilibrium line will be represented by the LM curve as a positive function of the interest rate and national income. Figure 5, b shows that an increase in income from Y 0 to Y 1 increases the demand for money (L 0 → L 1) and, therefore, increases the interest rate from i 0 to i 1.