Question

Why is the IS curve downward sloping and what kind of policies would shift the IS curve? Why is the LM curve upward sloping and what kind of policies would shift the LM curve?

Answer 1

IS curve is downward sloping from left to right because of negative relationahip between income and interest.Since any point on the IS curve shows the equality between Investment and Saving. Where S is a direct function of income and investment is a decreasing function of interest rate.So as the interest rate falls, investment and income increases because taking loans become cheaper. And as the rate of interest increases, investment and income decreases because taking loans become costlier. So thats why IS curve slopes downward.

Government's expenditure and tax policies or fiscal policies have the capacity to shift the IS curve either right or left. With this example you can understand how this shiftment takes place. Suppose government increases its expenditure then it will affect the AD. And it will increase the level of income in the country which shift the IS curve to the right. Now equilibrium also shifted to new point and national income shifted from Y1 to Y2 which is shown in the below diagram. Now interest rate risen to r2 from r1 which has shown in the below diagram.

So because of increase in the rate of interest there is reduction in private investment. A increase in taxes will shift the IS curve to the left because it will reduce the aggregate demand since less amount will be left for the spending and it will decrease the income and reduce the interest rate and it will increase the private investment. This kind of policies will shift the IS curve.

Basically LM curve shows the money market equilibrium. It slopes upward because demand for money will increase as the income increases and in turn will increase the rate of interest. So any point on the LM curve shows the equality between demand for money and supply of money.

Central Bank's expansionary and contractionary monetary policies would shift the LM curve to the right or left. Suppose Central Bank conduct expansionary policy ​​​​​​through buying of securities in the open market so it will increase the supply of money in the economy and it will shift the LM curve to the right from LM1 to LM2 which has shown in the below diagramNow interest rate has come down to r2 which will encourages the investment and investment will increases the income to Y2. And if Central Bank conduct contractionary monetary policy through selling of securities in the open market.Then it will shift the LM curve to the left and it will increase the rate of interest hence reduction in the investment and income.