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Unless “i” is
Unless “Y” is
O
Planned Investment Spending
Derivation of IS Curve
AD =C +I +G +NX
[ ] [
= a +b(Y −tY +J ) + I −θi + G + NX ] [ ] [ ]
= A + b(1 − t )Y −θi
E q u ilib riu m in G o o d s m a rke t : Y = A D
Y = A +b(1 −t )Y −θi
Y =
A− θi
1−b(1 − t)
i =
A
−
[1 −b(1 −t ) ]
Y ( IScurve )
θ θ
Graphical derivation of IS
AD
Curve
AD=Y
θi2
1 - t)Y –
A+b(
E2
– θi1
1 - t)Y
A+b (
A-θi2
E1
A-θi1
O Y
Y1 Y2
IS Curve
i
i1 E1
i2 E2
IS
O Y
Y1 Y2
IS Curve
C(Y) = 10+0.5Y
I(i) = 200-2000i
Y=10+0.5Y + 200-2000i
Y = 420-4000i
Asset Markets – LM Curve
Asset markets are the markets in which
money, bonds, stocks, houses and other
forms of assets are traded
Money market
Nominal demand for money is the
individual’s demand for a given number
of rupees
Real demand for money is the demand for
money expressed in terms of number of
units of goods that money will buy. It is
equal to nominal demand for money
divided by the price level
Demand for Money
Demand for money is demand for real
balances because people holds money
for what it will buy
Higher the price level, more nominal
balances in order to be able to buy the
same amount of goods
Demand for real balances depends on level
of real income and interest rate
L =kY-hi: k,h>0
Parameters k and h reflects the sensitivity
of the demand for real balances to the
level of income and interest rates
Demand of Money
Equilibrium in money market = Dm =Sm
(real)
Nominal quantity of money M and Price
level P are assumed constant
Interest Rate
K▲Y
L2=kY2 - hi
L1=kY1 - hi
LM
i2 E2 i2 E2
i2 E1 E1
i2
L2
L1
O O
Y1 Y2 M/P
Msp= 150-1500i
Md = 0.5Y+150-1500i
150=0.5Y+150-1500i
Y = 3000i
Equilibrium - IS LM
Points on IS curve indicates equilibrium
in the goods market. Points on the LM
curve indicates equilibrium in the
money market.
Simultaneous equilibrium in goods and
money market is possible at a point of
intersection between IS and LM curves
IS LM
IS = Y = 420-4000i
LM = Y = 3000i
IS=LM
420-4000i = 3000i
i = 0.06
i = 6%
Equilibrium
i
I LM
ESG
ESM
II EDG ESG IV
i ESM EDM
EDG
EDM
III IS
O Y Y
Region Goods Market Money Market
Disequilibri Output Disequilibri Output
I um
ESG Falls um
ESM Falls
II EDG Rises ESM Falls
III EDG Rises EDM Rises
IV ESG Falls EDM Rises
The Transmission mechanism
The mechanism by which the changes in
monetary policy affect aggregate demand is
called transmission mechanism
Increase in real money supply causes a portfolio
disequilibrium at prevailing interest rates and
the level of income i.e. people are holding
more assets than they want. They tries to get
rid of excess money by buying financial
assets and thus causes interest rates to fall
Fall in interest rates induces an increase in
investment expenditure and also possibly
consumption expenditure, thereby increasing
the aggregate demand and ultimately income
Transmission Mechanism
Increase in real money supply
Excess Mt
More money supply for Msp
Low Interest rates
High consumption
High investment
More output
Increase in national income