Is-LM Model of Macroeconomic Analysis

IS-LM analysis is a macroeconomic model to analyze the effect of fiscal policy measures and monetary policy measures by studying the goods market relationship between the rates of interest the national income assuming the money market in equilibrium and deriving the IS curve. Then studying the relationship between rate of interest and national income assuming the money market is at equilibrium. This gives the LM curve. Then putting the IS and LM curve together and finding the intersection where the two markets are in equilibrium at the same time.

Deriving the IS curve

Say at an interest rate r0 investment level is I0 and the equilibrium in goods market national income is Y0.  Say the money supply is increased in the money market and the interest rate is r1. If money supply is increased the r1 will be less than r0. As interest rate is lesser the investors will invest in the goods market and there fore the aggregate demand will increase by the change investment and a new equilibrium is reached at Y1. As I0 is less than I1 and consumption spending is same Y1 will be greater than Y0. However, r0 is greater than r1 as explained before. In this way, when the money market is at equilibrium one can get the goods market equilibrium for different interest rates. That is the IS curve where the savings and Investment equals in the goods market. That is Y and r is inversely related.  If the investment is sensitive to interest rates and it is elastic then the IS curve also will be elastic. If not sensitive then the IS curve will be inelastic.

In the same way LM curve in the money market equilibrium can be worked for different national Income levels. At a higher level of income the money demand schedule will shift right because increased demand for money at all the possible interest rates. That is if national income rises then money demand will increase and there fore interest rate will rise. That is given the supply of money is constant for every possible national income  the interest rate will be higher. That is the LM curve is positive in slope and the relationship of Y to interest rate is positive for all the equilibrium points of interest rates given the goods market at equilibrium. If the demand for money is less sensitive to changes in the interest rate then the LM curve will be steeper. If they are sensitive they will be elastic or less steep.