Question

Hello can someone please explain the is lm curves step by step for me?

Answer 1

IS curve: The goods market equilibrium schedule is the IS curve. It shows combinations of interest rates and levels of output such that planned spending equals income.

Figure 1 shows a investment schedule . It shows the planned investment at each rate of interest . Since higher rates of interest reduce the profitability of additions to the capital stock, imply lower planned investment. Lower the interest rate, higher is the planned investment.

Figure 2 shows how the IS curve is derived. At an interest rate r1, equilibrium in the goods market is at point E with an income level of Y1 (shown in the upper part) .In the lower part of the figure , it is shown by E'. Now, fall in the interest rate to r2 raises aggregate demand , increasing the level of spending at each income level. Then, new equilibrium level is Y2. In the lower part , it is shown by point F . This shows the nw equilibrium in the goods market to an interest rate r2.

IS curve is a locus of points showing alternative combinations of interest rates and income (Output) at which the goods market clears. This is the reason why the IS curve is called the goods market equilibrium.

LM Curve: The money market equilibrium schedule is the LM curve. To se the equilibrium in the money market : we have to see demand and supply side . Supply of money is determined by the central bank and it is assumed to be given at the level M.

Figure 3 shows the demand for money as a function of the interest rate and real income. The higher the rate of interest , lower the quantity of money demanded at a fixed level of income. An increase in income raises the demand for money and shifts the money demand schedule to the right.

Figure 4 shows the how the LM curve is derived. Supply of money is fixed and shown by the vertical line. Two money demand curves L1 and L2 correspond to two different income levels. When the income level is Y1 , the demand curve for money is L1 and the equilibrium rate of interest is r1. It is shown by the point E' on the LM curve . At a higher income level (Y2) , the equilibrium rate of interest is r2, which yields point F' on the LM curve.

LM curve is a locus of points showing alternative combinations of rate of interest and the level of income that brings about equilibrium in the money market. (LM curve shows all combinations of interest rates and levels of income such that demand for money equals supply).