Understanding IS-LM Model & Key Economic Concepts
Key Economic Concepts
Income: All the profits that are added to the total budget of an entity, public or private. Income encompasses the monetary and non-monetary elements that accumulate and consequently generate a consumption-profit cycle.
Interest Rate: The price that must be paid to obtain money once a loan is approved. It is expressed as a percentage; the more money requested, the higher the interest.
Nominal Interest Rate: The interest rate before taking inflation into account.
Real Interest Rate: Measures the amount of goods we will obtain tomorrow based on the goods we sacrifice today.
Loanable Funds Market Equilibrium
Equilibrium in the Market for Loanable Funds: The higher the real interest, the higher the amount offered and the lower the amount of loanable funds demanded. There is an interest rate at which the demand and offered amount of loanable funds are equal: this is the equilibrium real interest rate.
LM Curve
LM Curve: Represents all combinations of income (Y) and nominal interest (I) for which the money market is in equilibrium. It shows all points where various combinations of interest rate and real income levels achieve equilibrium in the money market.
The LM curve is defined by: M/P = L(i, Y)
Where:
- M/P represents the amount of real money (M = nominal money, P = price level).
- L is the real demand for money, a function of interest rate (i) and GDP/real income (Y).
IS Curve
IS Curve: The IS curve slopes downward, reflecting an inverse relationship between real interest rates and the level of output/income in an economy. When interest rates fall, output tends to increase. This inverse relationship occurs because when interest rates decrease, the country’s money supply increases (as money is cheaper), leading to increased consumption and production.
The IS Curve is formulated by the following relationship:
Y = C + c(Y – T) + I(r) + G
Where:
- Y: Production or income
- C: Consumption
- c: Marginal propensity to consume
- T: Taxes
- I: Investment
- r: Real interest rate
- G: Government spending
IS-LM Model
The IS-LM model (“Investment-Savings” and “Liquidity preference-Money supply”) is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph where the IS and LM curves intersect, showing the short-run equilibrium between interest rates and output.
Characteristics of the IS-LM Graph
- The IS-LM graph consists of two curves: IS and LM. Gross Domestic Product (GDP), or Y, is on the horizontal axis, increasing to the right.
- The interest rate (i or R) makes up the vertical axis.
- The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when money markets and the real economy are in balance. Multiple scenarios or points in time may be represented by adding additional IS and LM curves.
Equilibrium Interest Rate
The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.
Fiscal and Monetary Policies
Fiscal Policy: Responsible for maintaining the balance between taxes and public spending.
Monetary Policy: Aims to maintain price stability and control inflation; implemented by the central bank.