THE IS-LM FRAMEWORK: EQUILIBRIUM IN THE

MONETARY SECTOR

COURSE CODE: ECO 323

COURSE TITLE: INTERMEDIATE
MACROECONOMICS1
LECTURER-IN-CHARGE: DR. NWAOGWUGWU, I.C

DEPARTENT OF ECONOMICS AND BUSINESS

STUDIES,
COLLEGE OF MANGEMENT AND SOCIAL SCIENCES,
REDEEMER’S UNIVERSITY,
EDE, OSUN STATE.
CONTENTS
  The IS-LM model

 The IS curve

 The LM curve

 Money market equilibrium and the

LM curve(equilibrium in the
monetary sector)

 Properties of the LM curve

 Simultaneous equilibrium of goods

in the real and monetary
sectors( IS-LM equilibrium)

 References

Group A members

Names Matric Numbers

Iyoha, Osetale P. RUN/ECO/17/6848
Labode, Oluwatosin E. RUN/ECO/17/6849
Ajigbon Ayomide RUN/ECO/17/6847
Arikawe Ayomide RUN/ECO/16/6349
Ideh Onokheronaye RUN/ECO/16/6353
Lanre Oluwatodimu RUN/ECO/16/6358

IS-LM MODEL
The IS–LM model, or Hicks–Hansen model is a
macroeconomic tool that shows the relationship between
interest rates (ordinate) and assets market. The
intersection of the "investment–saving" (IS) and "liquidity
preference–money supply" (LM) curves models "general
equilibrium" where supposed simultaneous equilibrium
occurs in both interest and assets markets. The
investment/saving (IS) curve is a variation of the income-
expenditure model incorporating market interest rates
(demand), while the liquidity preference/money supply
equilibrium (LM) curve represents the amount of money
available for investing (supply).The IS–LM model explains
changes in national income when price level is fixed
short-run. The IS–LM model also shows why an aggregate
demand curve can shift. The model explains the decisions
made by investors when it comes to investments with the
amount of money available and the interest they will
receive.
Despite many shortcomings, the IS-LM model is used not
only to analyze economic fluctuations, but also to suggest
potential levels for appropriate stabilization policies. It
has been one of the main tools for macroeconomic
teaching and policy analysis. The IS-LM model describes
the aggregate demand of the economy using the
relationship between output and interest rates. In a
closed economy, in the goods market, a rise in interest
rate reduces aggregate demand, usually investment
demand and/or demand for consumer durables. This
lowers the level of output and results in equating the
quantity demanded with the quantity produced. This
condition is equal to the condition that planned
investment equals saving. The negative relationship
between interest rate and output is known as the IS
curve. The second relationship deals with the money
market, where the quantity of money demanded
increases with aggregate income and decreases with the
interest rate.
The model is presented as a graph of two intersecting
lines in the first quadrant.
The horizontal axis represents national income or real
gross domestic product and is labelled Y. The vertical axis
represents the real interest rate, r. Since this is a non-
dynamic model, there is a fixed relationship between the
nominal interest rate and the real interest rate (the
former equals the latter plus the expected inflation rate
which is exogenous in the short run); therefore variables
such as money demand which actually depend on the
nominal interest rate can equivalently be expressed as
depending on the real interest rate.

THE IS CURVE

For the investment-saving curve, the independent

variable is the interest rate and the dependent variable is
the level of income. The IS curve is drawn as downward-
sloping with the interest rate (I) on the vertical axis and
GDP (Y) on the horizontal axis. The initials IS stand for
"Investment and saving equilibrium." It is used to
represent the locus of all equilibria where total spending
(consumer spending + planned private investment +
government purchases + net exports) equals an
economy's total output (equivalent to real income, Y, or
GDP). The IS curve is a locus of points of equilibrium in
the "real" (non-financial) economy. Each point on the
curve represents the equilibrium between the Savings
and Investment (S=I).

Given expectations about returns on fixed investment,

every level of the real interest rate (I) will generate a
certain level of planned fixed investment and other
interest-sensitive spending. Income is at the equilibrium
level for a given interest rate when the “savings” that
consumers and other economic participants choose to do
out of this income equals” investment” or equivalently,
when "leakages" from the circular flow equal "injections."
The multiplier effect of an increase in fixed investment
resulting from a lower interest rate raises real GDP. This
explains the downward slope of the IS curve. In summary,
this line represents the causation from falling interest
rates to rising planned fixed investment, national income
and output.

The IS (Investment and savings equilibrium) equation is

given as:

Y = C(Y-T(Y)) +I(r) +G+NX(Y)

Where
Y = national income or real GDP
C(Y-T(Y)) = consumption or consumer spending which is a
function of disposable income
(Y-T(Y)) = disposable income which is equal to national
income minus tax (which is a function of income)
I(r) = Investment which is a function of the real interest
rate
G = Government spending/expenditures
NX(Y) = Net exports, where imports depend on income
(Y)
THE LM CURVE

For the “liquidity preference” and “money supply” curve,

the independent variable is "income" and the dependent
variable is "the interest rate." The LM curve is the set of
all Y and r combinations that satisfy the money market
equilibrium condition, real money demand must equal the
given real money supply. The curve shows the
combinations of interest rates and levels of real income
for which the money market is in equilibrium. It is an
upward-sloping curve representing the role of finance and
money. The LM function is the set of equilibrium points
between the liquidity preference (demand for money)
function and the money supply function (as determined
by banks and central banks).

Each point on the LM curve reflects a particular

equilibrium situation in the money market equilibrium
diagram, based on a particular level of income. In the
money market equilibrium diagram, the liquidity
preference function is simply the willingness to hold cash
balances instead of securities. For this function, the
nominal interest rate (on the vertical axis) is plotted
against the quantity of cash balances or liquidity on the
(horizontal axis).

Two basic elements determine the liquidity preference

and therefore the position and slope of the function:

 Transactions demand for money: This includes both

the willingness to hold cash for everyday transactions
and a precautionary measure (money demand in case
 of emergencies). Transactions demand is positively
related to real GDP (represented by Y, and also referred
to as income). As GDP increases, so does spending and
therefore transactions. GDP is considered exogenous to
the liquidity preference function, changes in GDP shift
the curve. For example, an increase in GDP will
increase transactions which will increase the demand
for money for given interest rates, and cause the
Liquidity preference curve to shift to the right.

 Speculative demand for money: This is the

willingness to hold cash instead of securities as an
asset for investment purposes. Speculative demand is
inversely related to the interest rate. As the interest
rate rises, the opportunity cost of investing in securities
increases, because the increased interest rate
payments on savings are lost. In addition, as interest
rates rise, the required rate of return for investors to
make a profit on speculative investments rises,
decreasing demand for these investments. So, as
interest rates rise, speculative demand falls.

The LM (Liquidity preference and money supply

equilibrium) equation is given as:

M/P = L (I, Y)

Where
M/P = the real money supple where M is the actual
amount of money in the economy and P is the overall
price level
L (I, Y) = the real demand for money which is a function
of the interest rate (I) and national income (Y)

Money market equilibrium

diagram (LM equilibrium)
On the LM curve, the interest rate is plotted against real
GDP (whereas the liquidity preference and money supply
functions plot interest rates against the quantity of cash
balances), an increase in GDP shifts the liquidity
preference function rightward and hence increases the
interest rate. Hence, the LM function is positively sloped
and thus, upward sloping.
The LM curve is upward sloping because, it shows the
possible interest rate and real GDP values that allow for
equilibrium to exist in the money market. We can see
from the LM equation that “I” and “Y” both enter on the
right hand side in the real demand for money function.
Since people demand less money when the interest rate
is high, “L” has a negative relationship with “I”. But
people demand more money when their income rises so
“L” has a positive relationship with Y. This means that if
“I” goes up, “Y” goes up as well so that “L” doesn’t
change. And if “I” goes down, “Y” must fall as well so “L"
doesn’t change. This means that they have a positive
relationship hence the upward slope.

The money supply function is plotted on the same graph

as the liquidity preference function. The money supply is
determined by the central bank decisions and willingness
of commercial banks to loan money. Though the money
supply is related indirectly to interest rates in the very
short run, the money supply in effect is perfectly inelastic
with respect to nominal interest rates (assuming the
central bank chooses to control the money supply rather
than focusing directly on the interest rate). Thus the
money supply function is represented as a vertical line –
money supply is a constant, independent of the interest
rate, GDP, and other factors.

MONEY MARKET EQUILIBRIUM AND THE

LM CURVE (Equilibrium in the monetary
sector)
The money market refers to the market in which money,
bonds, stocks, and other forms of income- earning assets
are traded. Here we restrict ourselves to the money
market.

To study equilibrium in the money market, we have to

refer to both sides of the market; supply side and the
demand side. The supply (or nominal quantity) of money
(M) is determined by the Central Bank. So we assume it
to be given at the level M.

For equilibrium to be established, three equations are

needed:

Demand for money: md = k(Y) + h(r)

Supply of money: m s = ma
Equilibrium condition: md = ms

Where ;

K(Y) and h(r) reflect the sensitivity of the demand for

money to the level of income (Y) and the interest rate (r)
respectively.

ma is the stock of money that exists at any point in time.

It is determined by the monetary authorities.

md is the demand for money

DERIVATION OF THE LM CURVE

Part A shows the speculative demand for money as a
function of interest rates.

Part B shows that the total money supply is absorbed

partly for speculative purposes and partly for transaction
purposes. Thus, the money stock is divided between m sp
and mt.

Part C shows the amount of money required for

transaction at a particular level of income.

Part D shows the LM-Curve which is derived from the

other parts.
For an example, assume that in part A an interest rate of
6% is required for the public to hold N40 as speculative
balance. In part B, we therefore see that of the total stock
of money of N100, N60 will be available for transaction.
And this amount of N60 is quite consistent with an
income level of N120 as shown in part C. finally, part D
reveals that the level of income of N120 and interest rate
of 6% gives one combination of Y and r at which the
supply of and the demand for money are equal.

Properties of the LM Curve

1. The LM curve is the schedule of combinations of
interest rates and levels of income such that the money
market is in equilibrium.

2. The LM curve is positively sloped. Given the fixed

money supply, an increase in the level of income, which
increases the quantity of money demanded, has to be
accompanied by an increase in the interest rate. This
reduces the quantity of money demanded and thereby
maintains money market equilibrium.

3. An increase in money supply shifts the LM curve to the

right.

4. At all points to the right of the LM curve, there is an

excess demand for money, and at points to its left, there
is an excess supply of money.
SIMULTANEOUS EQUILIBRIUM OF GOODS
IN THE REAL AND MONETARY SECTORS
(IS-LM EQUILIBRIUM)

For simultaneous equilibrium, interest rates and income

levels have to be such that both the goods market and
the money market are in equilibrium.

The figure above shows that the interest rate and the
level of output are determined by the interaction of the
money (LM) and commodity (IS) markets. Both markets
clear at point E. Interest rates and income levels are such
that the public holds the existing quantity of money.
REFERENCES
 Macroeconomicanalysis.com/macroeconomics-
Wikipedia/is-lm-model

 https://onlinelibrarz.wiley.com/dai/pdf/10.1002/
jid.3380060204

 Economicsdiscussion.net/is-lm-curve-model/is-lm-
withdiagram-an-overview/20848

 Olivier Blanchard, Macroeconomics, Pearson

international edition(5th edition)

 Isaac Chii Nwaogwugwu, Ph.D, Lecture notes on

macroeconomics run 300l