The lower the rate of interest is, the more investment there will be in the economy, so the supply and demand comes into equilibrium at a higher level of output or income.

So if money supply is constant, increasing Y means you get an increase in i; decreasing Y means you get a decrease in i. In equilibrium, all spending is desired or planned; there is no unplanned inventory accumulation.

The levels of investing and consumption are determined by the marginal decisions of individual actors. C is aggregate consumer spending a difference between disposable income and taxesI is planned investments, and G is government spending. That is, the IS is the set of all Y and r combinations that satisfy the output market equilibrium condition that total demand given income Y and the cost of borrowing r must equal total supply: The second relationship deals with the money market, where the quantity of money demanded increases with aggregate income and decreases with the interest rate.

The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors though not necessarily in other sectors, such as labor markets: The downward sloping flow-equilibrium curvenormally not a straight line as here portrayedis called the IS curve in textbooks and we will follow that naming convention here.

Given expectations about returns on fixed investment, every level of the real interest rate i will generate a certain level of planned fixed investment and other interest-sensitive spending: The vertical axis represents the real interest rater.

However, fiscal policy can increase output which would cause a shift outward of the IS curve. This explains the downward slope of the IS curve.

A decline reverses the direction of the analysis. If b increases, then this slope gets steeper. So to sum up: Remember that an increase in a or an increase in G, or a decrease in T, shifts the planned expenditure curve up, so you get a higher equilibrium level of Y.

Notice the Y on the left hand side stands for income because consumption demand depends on income while the Y on the right hand side stands for total supply.

The LM curve is upward sloping, as income in the economy increases, the interest rate increases The LM curve shifts down when there is an increase in nominal money supply a monetary expansion or a fall in prices rare. Thus the IS curve is a locus of points of equilibrium in the "real" non-financial economy.

The downward sloping money demand curve can be written like this: This requires that the level of income rise at the given world real interest rate to bring desired money holdings back into line with the unchanged money supply and preserve asset equilibriumthe LM curve shifts to the right.

This is the familiar upward sloping LM curve in Y,r space. This condition is equal to the condition that planned investment equals saving.

So just equate the two equations: Since this is a non-dynamic model, there is a fixed relationship between the nominal interest rate and the real interest rate the former equals the latter plus the expected inflation rate which is exogenous in the short run ; therefore variables such as money demand which actually depend on the nominal interest rate can equivalently be expressed as depending on the real interest rate.

Given expectations about returns on fixed investment, every level of the real interest rate i will generate a certain level of planned fixed investment and other interest-sensitive spending: Multiple scenarios or points in time may be represented by adding additional IS and LM curves.

The IS curve is downward sloping, as the interest rate increases, income in the economy decreases The IS curve shifts out to the right when there is an increase in government spending a fiscal expansion or an increase in consumer confidence that would increase autonomous consumer spending or increase the marginal propensity to consume.

Although generally accepted as being imperfect, the model is seen as a useful pedagogical tool for imparting an understanding of the questions that macroeconomists today attempt to answer through more nuanced approaches.

The conditions of asset stock and goods market flow equilibrium as presented in the previous topic are, respectively 1. Roy HarrodJohn R. If you are not completely familiar with the derivation and meaning of these equations you should review the previous two topics again. When we incorporate these elements an additional line has to be added to the graphthe horizontal rZ line in Figure 4.

This is sometimes referred to as "the Keynesian Cross. Income is at the equilibrium level for a given interest rate when the saving that consumers and other economic participants choose to do out of this income equals investment or, equivalently, when "leakages" from the circular flow equal "injections".

In a an economy that is closed to international trade, an increase in the money supply in Figure 2 will shift LM to the right causing the interest rate to fall as the public tries to reestablish portfolio equilibrium by purchasing assets.

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Introduction to Macroeconomics TOPIC 4: The IS-LM Model Anna g Morin CBS - Department of Economics August Introduction to Macroeconomics TOPIC 4: The IS-LM Model. The IS-LM Model In topic 2 The Goods Market, we isolated the goods market from The nancial market - LM relation If income increases, the demand for money increases.

The IS-LM model describes the aggregate demand of the economy using the relationship between output and interest rates. In a closed economy, in the goods market, a rise in interest rate reduces aggregate demand, usually investment demand and/or demand for consumer durables.

May 28, · IS/LM equation Economics? consider the following IS/LM Model: C=+ (Y-T) I= r g= t= (M/P)d=2Y- r M/P= a) derive the IS relation b) derive the LM relation c) solve for equilibrium real output and the equilibrium interest rate d) suppose G increases to find the effect of fiscal expansion on show more consider the Status: Resolved.

The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates and assets market (also known as real output in goods and services market plus money market, as abscissa).

Jun 24, · The IS relation is the other building block of the ISLM model, along with the LM relation.

The LM relation shows us how the interest rate depends on income in the economy through the relationship between supply and demand in the money market.

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IS–LM model - Wikipedia