Answer to Question #194457 in Macroeconomics for MUHAMMAD ARSHAD

Question

Derive the IS LM curves and explain how the general macroeconomic equilibirum can be reached

Answer 1

Derivation of IS curve :

In panel (a) of the diagram, the relationship between planned investment and rate of interest is being depicted by the investment demand curve II. It would be seen that at Or₀ rate of interest the planned investment would in turn equal to OI₀. With OI₀ as being the amount of planned investment, in panel (b) the aggregate demand curve is C + I₀ which equals aggregate output at level of national income OY₁.

In the panel (c),against Or_2 rate of interest , level of income would be equal to OY₀ which has been plotted. If the rate of interest falls to Or₂ the planned investment would increase by businessmen from OI₀ to OI₁. With this increase in planned investment, the aggregate demand curve would tend to shifts upward to the new position C + 11 in panel (b), and at level of national income OY_1,the goods market tends to be in equilibrium. Thus, in panel (c),the level of national income OY₁ is being plotted against Or₁ rate of interest.

With further lowering of the rate of interest to the point Or₂, the planned investment would increase to OI₂.With this further rise in planned investment ,the aggregate demand curve in panel (b) would tend to shifts upward to the new position C + I₂ in turn corresponding to which goods market is in equilibrium at level of income OY₂.In panel (c) the OY₂ ,the equilibrium income is being shown against the Or_2 interest rate.

By joining of the points A, B, D which tend to represent various interest-income combinations at which goods market is in equilibrium we would in turn obtain the IS Curve. It would be observed that the IS Curve is in turn downward sloping which implies that the equilibrium level of national income increases, when rate of interest declines.

Derivation of LM Curve :

The intersection of various money demand curves being corresponding to different levels of income with the supply curve of money being fixed by the monetary authority would in turn give the LM curve.

The LM curve relates the level of income with the interest rate being determined by money-market equilibrium which corresponds to different levels of demand for money. The LM curve depicts the various rates of interest will be at different income levels given the money quantity and family of demand curves for money.

The money demand curve or what Keynes in turn calls as the liquidity preference curve alone could not state what exactly the rate of interest would in turn be. In diagram (a) and (b), the LM curve has been derived from a family of demand curves for money.

As income tends to increase, the money demand curve would in turn shift outward and hence the rate of interest which in turn equates supply of money with demand for money would be rising. In panel (b) we tend to measure income on the X-axis and plot the income level being corresponding to the various rates of interest being determined at those levels of income through equilibrium of money market by the equality of demand and supply of money in (a).