Question

Explain the ISLM model fully and discuss the model's main conclusions and macroeconomic policy usefulness.

Answer 1

IS-LM model:

This is Keynesian model.

This is the model of finding the equilibrium rate of interest and national income.

IS = Investment saving [Demand and supply equilibrium at each point on IS curve]

LM = Liquidity preference (demand) of money and supply of money [Money demand is equal to money supply (equilibrium) at a fixed price level]

IS reflects in goods and services market, which shows relation between interest rate (r) and national income (Y). It has an inverse relationship, which means at increasing interest rate lower would be the national income, or vice versa.

The equation or function of IS, Y = C + I (r) + G + NX

The investment (I) depends on r. It means at lower interest rate higher would be the investment (I), which leads to increase in Y; or vice versa.

IS curve is downward slopping because of the following reasons:

1) Investment (I) and interest rate (r) have inverse relationship and investment is a function of Y.

2) Saving (S) is a function of Y, because saving increases as Y increases. Planned saving should equal to planned investment in the IS model.

Shifting of IS curve:

This curve shifts toward right if (I = S) increases at an unchanged interest rate. It happens because of higher propensity to invest.

This curve shifts toward left if (I = S) decreases at an unchanged interest rate. It happens because of lower propensity to invest.

LM reflects in money market, which shows relation between interest rate (r) and national income (Y). It has a positive relationship, which means at increasing interest rate higher would be the national income because of supplying higher amount of money; or vice versa. Therefore, LM curve is upward slopping from left to right.

LM curve is upward slopping because of the following reason:

If demand for money increases it increases the interest rate (r), since supply is limited in the short-run; income would be high because of earning higher interest. Therefore, income rises along with interest rises; makes the curve upward sloping.

Shifting of LM curve:

This curve shifts toward right because of increasing money supply in the market. Increasing supply decreases the interest rate (because the additional amount of money is invested in the bond market, which increases the demand of bond and its price; ultimately reduces the market interest rate); therefore, a right shift of LM is necessary to equate the income level.

The curve shifts toward left if money supply decreases.

The curve shifts toward left if liquidity preference of money increases.

The curve shifts toward right if liquidity preference of money decreases.