Joint balance of real and monetary sectors of the economy (model IS-LM).
The IS-LM model characterizes the implications of equilibrium in both the goods and the money market. The IS curve shows the combinations of interest rate and the level of output that are consistent with equilibrium in the goods market. An increase in the interest rate leads to a decline in output. The IS curve is downward sloping. The LM curve shows the combinations of the interest rate and the level of output consistent with equilibrium in the money market. Given the real money supply, a increase in output leads to an increase in the interest rate. The LM curve is upward sloping.
Any point on the downward-sloping IS curve corresponds to equilibrium in the goods market. Any point on the upward-sloping LM curve corresponds to equilibrium in money market. Only at point A are both equilibrium conditions satisfied. The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in both markets. IS-LM model is derived from IS and LM equations: IS relation: Y = C (Y - T) + I (Y, i) + G The supply of goods is equal to the demand for goods. In other words, the production (Y) equals demand, which is the sum of consumption, investment, and government spending.Consumption is a function of disposable income (income minus taxes). LM relation: M/P = Y*L(i) M/P - real money supply Y – real income Real money supply equals real money demand. Shifts of curves in result of fiscal or monetary policies Fiscal policy: A fiscal expansion shifts the IS curve to the right, leading to an increase in output and an increase in the interest rate. A fiscal contraction shifts the IS curve to the left, leading to a decrease in output and a decrease in the interest rate. Monetary policy: A monetary expansion shifts the LM curve down, leading to an increase in output and a decrease in the interest rate. A monetary contraction shifts the LM curve up, leading to a decrease in output and an increase in the interest rate.
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