Question

4. The major advantage of the IS-LM model compared to the simple model developed earlier is that is introduces the effect of interest rates on the economy. Explain the effect that interest rates have on spending by households and firms, and show how this can be illustrated graphically through the Ap demand schedule?

Answer 1

INVESTMENT SAVINGS (IS) & LIQUIDITY PREFERENCE FOR MONEY SUPPLY(LM) MODEL

IS -LM is a macro economic tool which represents the relationship between interest rates and asset market.

IS CURVE--- This investment saving curve represents the relationship between real gdp and real interest rate.This curve is downward sloping which shows,as the real interest rate increases,the level of spending decreases

EFFECT OF CHANGE IN INTEREST RATE ON HOUSEHOLDS AND FIRMS

Increase in interest rate decreases the consumption expenditure of households and investment expenditure of firms,while fall in interest rate tends to increase both consumption and investment expenditure of households and firms

see the graph below-----

IS graph------

LM CURVE----

This curve represents the change in quantity of money demanded due to change in interest rate. As we know,quantity of money is demanded by households and firms and govt.

EFFECT OF CHANGE IN INTEREST RATE ON MONEY DEMAND BY HOUSEHOLDS AND FIRMS

The law of demand holds that as the interest rate increase,people prefer to hold lesser money and supply more money

So, the more the rate of interest,the more is money supply by households and firms,so there is a positive slope of LM curve

see the LM curve-----

EQUILIBRIUM RATE OF INTEREST-----

The equilibrium point E represents the intersection of both IS-LM curves in such a way that determines equilibrium real gdp(Y) and equilibrium rate of interest (I).