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Algebraic Analysis of IS – LM
Model (With Numerical
Problems)
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The article mentioned below provides an algebraic analysis of

IS-LM model.

The Derivation of IS Curve: Algebraic Method:

The IS curve is derived from goods market equilibrium. The IS curve
shows the combinations of levels of income and interest at which goods
market is in equilibrium, that is, at which aggregate demand equals
income.

Aggregate demand consists of consumption demand, investment

demand, government expenditure on goods and services and net
exports.
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Consumption demand is function of disposable income. Disposable
income is level of income minus taxes (Yd = Y – T) where Yd stands for
disposable income and T for taxes. However, in a two-sector model
where we do not incorporate taxation by the government, Yd = Y.

Investment depends on rate of interest. With a given level of income, a

higher rate of interest reduces investment demand and a lower rate of
interest leads to more investment, that is, investment is negatively
related to rate of interest. Thus,

I = I – di

Therefore, we have the following equation for aggregate demand (AD)

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1/1-b is the income multiplier and b is marginal propensity to consume.
Given the value of autonomous expenditure, we can obtain value of Y at
different rates of interest to draw an IS curve. It is worth noting that the
value of autonomous (A) determines the intercept of the IS curve, d in
the term di in equation (3) shows the sensitivity of investment to the
changes in rate of interest and determines the slope of IS curve. Since
fall in interest rate increases investment spending, it will raise
aggregate demand and thus the equilibrium level of income. Besides,
the slope of the IS curve depends on the size of income multiplier. Privacy - Terms
Problem 1:

The following equations describe an economy:

C = 10 + 0.5 Y (Consumption function)

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I = 190-20i (Investment function)

Derive the equations for IS curve and represent it graphically.

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At 2 per cent rate of interest, level of income is 320.

We have now two combinations of interest and income. We can plot

these and obtain IS curve. This is done in Figure 20.18.

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IS Curve: Three-Sector Model with Taxation and Transfer
Payments:
In the last section we have derived the IS curve taking government
expenditure G on goods and services without considering taxation and
transfer payments by it. In fact the concept of consumption function
conceives consumption as a function of disposable income and is
therefore written as

C = a + bYD …(1)

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Now, disposable income YD is obtained from deducting tax and adding
transfer payments by the government. Thus

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YD = Y – T + R

where T is tax revenue and R is the transfer payments by the

government. Whereas a tax reduces disposable income, transfer
payment raises it.

Further, whereas transfer payments are assumed as lump sum amount,

tax can be lump sum tax or levied as proportion of income. If we
assume proportionate income tax, then,

T = tY

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where t is the proportion of income which is taken away by way of tax.

…(2)

Let us derive IS equation incorporating proportionate income tax and

lump sum transfer payments.

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where 1/1-b(1-t) is the value of multiplier in case of proportionate

income tax. Equation (4) represents IS curve in case of proportionate
income tax.

It may be noted in the context of IS equations (3) and (4) that a change
in autonomous spending (A) as a result of any of its components will
cause a shift in IS curve.

Problem 2:

The following equations describe an economy:

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Derivation of LM Curve: Algebraic Analysis:
Having derived algebraically equation for IS curve we now turn to the
derivation of equation for LM curve. It will be recalled that LM curve is
a curve that shows combinations of interest rates and levels of income
at which money market is in equilibrium, that is, at which demand for
money equals supply of money.

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We explain the derivation of LM curve in two steps. First, we show how
money demand depends on interest rate and level of income. It is worth
noting that in their demand for money people care more about the
purchasing power of money, that is, people’s demand is for real money
balances rather than nominal money balances. Real money balances are
given by M/P where M stands for nominal money demand and p for
price level.

The demand for real money balances depends on the level of real
income and interest rate. Thus Md = L(Y, i). Demand for real money
balances increases with the rise in level of income and decreases with
rise in rate of interest. Let us assume that money demand function is
linear. Then

L(Y, i) = kY – hi k, h > 0 …(5)

Parameter k represents how much demand for real money balances

increases when level of income rises. Parameter h represents Low much
demand for real money balances decreases when rate of interest rises.
The equilibrium in the money market is established where demand for
real money balances equals supply of real money balances and is given
by

M/P = kY – hi …(6) Privacy - Terms

Money supply (M) is set by the central bank of a country and we
assume it to remain constant for a period. Besides, we assume the price
level (P) to remain constant.

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Solving the equation (6) for interest rate we have

i = 1/h (kY – M/P) …(7)

The above equation (7) describes the equation for LM curve. To be

precise it gives us the equilibrium interest rate for any given value of
level of income (Y) and real money balances. In drawing LM curve, real
money balances are assumed to be constant.

Thus LM curve describes money market equilibrium for different values

of income and rate of interest, given a fixed value of real money
balances (M/P). Thus, given the real money balances (M/P), we can
obtain a rate of interest for different values of income.

Let us state some conclusions about LM curve as given by equation (7).

First, since in equation (7) for LM curve, the coefficient (k) of income
(Y) is positive, LM curve will slope upward. That is, higher income
requires higher interest rate for money market to be in equilibrium,
given the supply of real money balances.
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Second, since the coefficient of real money balances is negative, the
expansion in real money balances will cause a shift in the LM curve to
the right, and decrease in the real money balances will shift LM curve to
the left.

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From the coefficient of income k/h, we can know whether LM curve is

steep or flat. If demand for money is not much sensitive to level of
income, then k will be small. Therefore, in case of small k (i.e. low
sensitivity of interest with respect to changes in income), small change
in interest rate is required to offset a small increase in money demand
caused by a given increase in income.

Problem 3:

Given the following data about the monetary sector of the

economy:

Md = 0.4 Y – 80i

Ms = 1200 crores.

where Md is demand for money, Y is level of income, Ms is rate of

interest and M is the supply of money
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1. Derive the equation for LM function

2. Give the economic interpretation of the LM curve. Draw LM curve

from the above data

Solution:

For money market to be in equilibrium:

Md = Ms

0.4 Y – 80 i = 1200

80 i = 0.4 Y – 1200

i = (0.4Y/80) – (1200/80)

i = (1/200) Y – 15 ….. (i)

Thus we get the following LM function:

i = (1/200) Y – 15

Alternatively, LM equation or function can also be stated as:

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Y = 200i + 3000 …(ii)

LM curve means what would be rate of interest when money market is

in equilibrium, given the level of income. Thus, if level of national
income is Rs. 4000 crores, then using LM equation (i) we have

i = (1/200) x (4000 – 15)

= 20 – 15 = 5%

Thus, at income of Rs. 4000 crores, rate of interest will be 5 per cent
when money market is in equilibrium.

Now, if level of income is Rs. 4400 crores, equilibrium rate of interest

will be

i = (1/200) Y – 15

= (1/200) x (4400 – 15)

= 22 – 15 = 7%

With two combinations of interest rate and income level when money
market is in equilibrium we can draw LM curve as shown in 20.19.
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Problem 4:

The following data is given for the monetary sector of the

economy:

Transaction demand for money, Mt = 0.5Y. Speculative demand for

money, Msp = 105 – 1500 i

Money supply Ms = 150

Derive LM equation from the above data

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Solution:

Total demand function for money can be obtained by adding up the

transactions demand for money (M) and speculative demand for money
(Msp). Thus

Md = Mt + Msp

Md = 0.5 Y + 105 – 1500i

In money market equilibrium

IS – LM Model: Algebraic Analysis (Joint Equilibrium

of Income and Interest Rate) Privacy - Terms
The intersection of IS and LM curves determines joint equilibrium of
income and interest rate. Mathematically, we can obtain the
equilibrium values by using the equations of IS and LM curves derived
above. Thus,

Joint determination of equilibrium values of income and interest rate

requires that both the IS and LM equations hold good. In this way both
the goods market and money market equilibrium will be achieved at the
same interest and income levels in the two markets. To find such
equilibrium values we substitute the interest rate from the LM equation
(ii) into the IS equation (i). Doing so we have

The equation shows that the equilibrium level of income depends on

exogenously given au­tonomous variables (A) such as autonomous
consumption, autonomous investment, government expenditure on
goods and services, and the real money supply (M/P) and further on the
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size of multiplier (1/1-b). It will be noticed from equation (iii) that
higher the autonomous expenditure, the higher the level of equilibrium
income. Further, the greater the real money supply, the higher the level
of national income.

Problem 5:

For an economy the following functions are given:

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Problem 6:

Consider the following economy:

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Problem 7:

Consider an economy with the following features:

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Problem 8 (Four-Sector Model):

The major macro aggregates for an economy are given as

follows:

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Problem 9:

The following data are given for an economy:

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Problem 10:

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