Presented by Group IV : Sayam Roy Sanchari Dasgupta Sameer ranjan Padhy Satyabrata Dhal Seba surabhu Nayak Satyajit

Panda

GOODS MARKET & FINANCIAL MARKET

NATIONAL INCOME FINANCIAL MARKET COMMODITY MARKET AGGREGATE DEMAND & OUTPUT Basic IS-LM Model INTEREST RATES

MONEY MARKET
DEMAND & SUPPLY

BOND MARKET
DEMAND & SUPPLY

IS-LM Model emphasizes the interaction between the goods and financial market. Keynesian model states that income affects spending which in turn determines output. IS-LM Model (by Hicks and Hansen in 1939) adds the effect of interest rates on spending, and thus income and the dependence of financial market on income.

Equilibrium in the Goods Market

Assuming a closed sector economy (no govt. spending or taxes)

From the Consumption (C) + Investment (I) approach :C = C(Y) (consumption a function of income) I = I(r) (investment a function of rate of interest) Y = C(Y) + I(r) ( the equilibrium condition)
From the Saving- Investment approach : S = S(Y) (savings a function of income) I = I(r) (investment a function of rate of interest) S(Y) = I(r) ( the equilibrium condition)

Derivation of IS- Curve

In fig A, at interest rate r1, equilibrium in the goods market at E, with an income level of Y1. Same point denoted by E1 in fig B. With fall in interest rate to r2, aggregate demand increases. New equilibrium income Y2. F1 is the corresponding point in fig B.
Aggregate Demand AD I

AD = Y

A
E

C + I1

C+I2

Income Output

Y1

Y2

B
Interest rate r1

E1

r2

F1

Derivation of IS- Curve

Commodity market equilibrium schedule as it shows alternate combinations of r and Y at which commodity market clears. Downward sloping as increase in r reduces I, thus reducing AD hence reducing the Y. Curve steepness depends on how sensitive I is to change in r.
Aggregate Demand AD I

AD = Y

A
E

C + I1

C+I2

Income Output

Y1

Y2

B
Interest rate r1

E1

r2

F1

Equilibrium in the Money Market

Equilibrium in the money market exists when the demand for money = supply of money. By Keynesian theory, md (total money demand) = m1 (transactions demand) + m2 (speculative demand) m1 = kY. (proportional to level of income) m2 = h(r). (inverse function of rate of interest) Therefore md = kY + h(r).

ms (total money supply) = ma (amount determined by monetary authorities) md = ms (equilibrium condition)

Hence

ms = md = kY + h(r)

Derivation of LM Curve
In fig B, ms = vertical line M (fixed by central bank). Two demand for money curves L1 & L2 corresponds to two income levels Y1 & Y2 at equilibrium rate of interest r1 & r2 respectively. At r1 we get point E1 in fig A.

A
r2 Interest rate

F1

M r2

B
F

r1

E1

r1

L2

L1

Income Output

Y1

Y2

Quantity of money

 At Y2, corresponding r2, we get point F1 in fig A. Money market equilibrium schedule as it shows alternate combinations of r and Y that bring equilibrium in money market. Upward sloping as increase in r accompanied by increase in Y to maintain md = ms (as md decreases with increase in r).

Derivation of LM Curve

A
r2 Interest rate

F1

M r2

r1

E1

r1

L2

L1

Income Output

Y1

Y2

Quantity of money

Two market equilibrium

The intersection point of the IS and LM curve denotes the equilibrium point between the two markets ( E). At E, interest rate (r0) & income level ( Y0) are such that : Public holds the existing quantity of money. Planned spending (desired expenditure) = output.
Interest rate M I

E r0

L Y0

Income Output