Characteristics of islm model-LM part of the IS-LM model (video) | IS-LM | Khan Academy

The IS-LM Investment Savings-Liquidity preference Money supply model focuses on the equilibrium of the market for goods and services, and the money market. It basically shows the relationship between real output and interest rates. It was developed by John R. Hicks , based on J. Then, the LM curve, which represents the equilibrium in the money market.

Characteristics of islm model

See also. Find a the equilibrium level of income and the equilibrium rate of interest, and b the level of C, Diaper fun teenager, and L when the economy is in equilibrium. Obviously, the IS curve alone is as insufficient to determine Characteristics of islm model or Y as demand Mickey nudity is to determine prices or quantities in Characteristics of islm model standard supply and demand microeconomic price model. For the investment-saving curve, the independent variable is the interest rate and the dependent variable is the level of income. Stop and Think Box Does Figure If this goes up then real money goes up especially in the short term. Fiscal Monetary Commercial Central bank. It's easier for me to Chracteristics a dotted line. Investment and real interest rates. The rising interest rates are represented by the upward-pointing arrow.

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This point is illustrated in Fig. Since it is fixed by the central bank the supply of money is the vertical line M. IMF Staff Papers. 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. Four regions Characteristics of islm model shown in this diagram and they are characterised in Table 1. It will be noticed from Fig. This extra demand for money would disturb the money market equilibrium and for the equilibrium to be restored the rate of interest will rise to the level where the given money supply curve intersects the Sex superstore macon demand curve corresponding to the higher income level. The right hand diagram [part b Mild sex shows the money market. This puts pressure on the home currency to depreciate, so the central bank must buy the home currency Characteristics of islm model that is, sell some of its foreign currency reserves — to accommodate Characteristics of islm model outflow. The in the demand for LM curve is therefore money leads to an upward sloping. Wikiquote has quotations related to: IS—LM model.

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  • The Keynes in his analysis of national income explains that national income is determined at the level where aggregate demand i.
  • The IS—LM model , or Hicks—Hansen model , is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market also known as real output in goods and services market plus money market.
  • The IS-LM model, which stands for "investment-savings" IS and "liquidity preference-money supply" LM is a Keynesian macroeconomic model that shows how the market for economic goods IS interacts with the loanable funds market LM or money market.
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The IS—LM model , or Hicks—Hansen model , is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market also known as real output in goods and services market plus money market. The model was developed by John Hicks in , [4] and later extended by Alvin Hansen , [5] as a mathematical representation of Keynesian macroeconomic theory.

Between the s and mids, it was the leading framework of macroeconomic analysis. But in practice the main role of the model is as a path to explain the AD—AS model. Roy Harrod , John R. He later presented it in "Mr. Keynes and the Classics: A Suggested Interpretation". In addition, an equilibrium model ignores uncertainty—and that liquidity preference only makes sense in the presence of uncertainty "For there is no sense in liquidity, unless expectations are uncertain.

The horizontal axis represents national income or real gross domestic product and is labelled Y. The vertical axis represents the real interest rate , r or sometimes i. 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 point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors though not necessarily in other sectors, such as labor markets : both the product market and the money market are in equilibrium. This equilibrium yields a unique combination of the interest rate and real GDP.

For the investment-saving curve, the independent variable is the interest rate and the dependent variable is the level of income. Note that economic graphs often place the independent variable—interest rate, in this example—on the vertical axis while the dependent variable is measured with the horizontal axis.

To keep the link with the historical meaning, the IS curve can be said to represent the equilibria where total private investment equals total saving, where the latter equals consumer saving plus government saving the budget surplus plus foreign saving the trade surplus. In equilibrium, all spending is desired or planned; there is no unplanned inventory accumulation.

Thus 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 saving broadly defined and investment. Given expectations about returns on fixed investment, every level of the real interest rate will generate a certain level of planned fixed investment and other interest-sensitive spending: lower interest rates encourage higher fixed investment and the like.

Income is at the equilibrium level for a given interest rate when the saving 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 etc. For the liquidity preference and money supply curve, the independent variable is "income" and the dependent variable is "the interest rate. 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 or 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. The liquidity preference function is downward sloping.

Two basic elements determine the quantity of cash balances demanded liquidity preference and therefore the position and slope of the function:. The money supply function for this situation 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. The LM curve shows the combinations of interest rates and levels of real income for which the money supply equals money demand — that is, for which the money market is in equilibrium.

For a given level of income, the intersection point between the liquidity preference and money supply functions implies a single point on the LM curve: specifically, the point giving the level of the interest rate which equilibrates the money market at the given level of income. Recalling that for 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.

Thus the LM function is positively sloped. One hypothesis is that a government's deficit spending " fiscal policy " has an effect similar to that of a lower saving rate or increased private fixed investment, increasing the amount of demand for goods at each individual interest rate. An increased deficit by the national government shifts the IS curve to the right.

This raises the equilibrium interest rate from i 1 to i 2 and national income from Y 1 to Y 2 , as shown in the graph above. The equilibrium level of national income in the IS-LM diagram is referred to as aggregate demand. Keynesians argue spending may actually "crowd in" encourage private fixed investment via the accelerator effect , which helps long-term growth. Further, if government deficits are spent on productive public investment e.

The extent of any crowding out depends on the shape of the LM curve. A shift in the IS curve along a relatively flat LM curve can increase output substantially with little change in the interest rate.

On the other hand, an rightward shift in the IS curve along a vertical LM curve will lead to higher interest rates, but no change in output this case represents the " Treasury view ". Rightward shifts of the IS curve also result from exogenous increases in investment spending i.

Thus these too raise both equilibrium income and the equilibrium interest rate. Of course, changes in these variables in the opposite direction shift the IS curve in the opposite direction. The IS—LM model also allows for the role of monetary policy. If the money supply is increased, that shifts the LM curve downward or to the right, lowering interest rates and raising equilibrium national income.

Further, exogenous decreases in liquidity preference, perhaps due to improved transactions technologies, lead to downward shifts of the LM curve and thus increases in income and decreases in interest rates.

Changes in these variables in the opposite direction shift the LM curve in the opposite direction. By itself, the IS—LM model is used to study the short run when prices are fixed or sticky and no inflation is taken into consideration. But in practice the main role of the model is as a sub-model of larger models especially the Aggregate Demand-Aggregate Supply model — the AD—AS model which allow for a flexible price level. In the aggregate demand-aggregate supply model, each point on the aggregate demand curve is an outcome of the IS—LM model for aggregate demand Y based on a particular price level.

From Wikipedia, the free encyclopedia. Basic concepts. Fiscal Monetary Commercial Central bank. Related fields. Econometrics Economic statistics Monetary economics Development economics International economics. Edward C. Sargent Paul Krugman N. Gregory Mankiw. See also. Macroeconomic model Publications in macroeconomics Economics Applied Microeconomics Political economy Mathematical economics.

Macroeconomics Eleventh ed. Boston: Pearson Addison Wesley. Gregory Macroeconomics Eighth ed. New York: Worth Publishers. Economics Seventh ed. Prentice Hall. Keynes and the 'Classics': A Suggested Interpretation".

A Guide to Keynes. New York: McGraw Hill. Edward Elgar. History of Political Economy. Keynes' System". Review of Economic Studies. Journal of Post Keynesian Economics. Gregory May Retrieved February 8, Economic theory Political economy Applied economics. Economic model Economic systems Microfoundations Mathematical economics Econometrics Computational economics Experimental economics Publications. Schools history of economic thought. Notable economists and thinkers within economics. Categories : Economics curves Economics models General equilibrium theory Keynesian economics in economics.

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Part of a series on. Policies Fiscal Monetary Commercial Central bank. Related fields Econometrics Economic statistics Monetary economics Development economics International economics.

This raises the equilibrium interest rate from i 1 to i 2 and national income from Y 1 to Y 2 , as shown in the graph above. There is an imperfectly competitive market which consists of a number of monopolistic competitive firms. The rising interest rates are represented by the upward pointing arrow. Menu costs are incurred each time prices are changed periodically rather than continuously. However, under gradually increasing wage rates, workers who stick to their jobs for a long time in the same firm get less than the value of their marginal product as they approach retirement. The LM curve tells what the various rates of interest will be given the quantity of money and the family of demand curves for money at different levels of income.

Characteristics of islm model

Characteristics of islm model

Characteristics of islm model

Characteristics of islm model

Characteristics of islm model

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The classical and new classical microeconomic theories are based on the assumption of flexibility of prices where prices clear markets by adjusting demand and supply quickly. New Keynesian economists, on the other hand, believe in the stickiness of prices in the short-run. Markets do not clear quickly because adjusting prices is costly. Frequently adjusting prices of their goods involve costs to firms. A large sector of the economy is made up of price-makers who sell goods in monopolistic or imperfectly competitive markets.

For them, adjusting prices is costly. The costs of adjusting prices are called the menu costs. Changing prices requires the use of resources by a firm. It has to print new price lists menus , catalogues, and other printed material. A super market has to reliable all products and shelves with the new prices. A hotel and a restaurant have to reprint its menu with new prices. In the menu costs approach to sticky prices, it is profitable for firms to react to small changes in demand by keeping prices constant over a short period and responding with changes in output.

Because of menu costs, firms do not change their prices every time with a change in demand conditions. Menu costs are incurred each time prices are changed periodically rather than continuously. Thus menu costs explain the short-run stickiness of prices. In the menu cost hypothesis, prices adjust slowly because changes in prices have externalities.

When one firm reduces the price of a product, it benefits other firms in the economy. When it reduces the prices it charges, it lowers the average price level slightly and thereby raises real income. The increase in real income, in turn, raises the demand for the products of all firms. With aggregate demand externality, small menu costs can make prices sticky. There is an imperfectly competitive market which consists of a number of monopolistic competitive firms.

Similarly its marginal cost has also declined. It has been shown as MC 1 which remains fixed. The original marginal cost curve MC 0 has not been shown to simplify the figure. Consequently, profit declines to KFCP 1. The firm will not, therefore, reduce the price and there will be nominal price rigidity at OP 0. The menu costs approach is defective in that it considers only costs of price adjustment and not costs of output adjustment.

This approach assumes that marginal cost moves in proportion with demand. As demand rises or falls, marginal cost also increases or declines in the same proportion. In fact, no firm can assume that its marginal cost will be perfectly correlated with its aggregate demand. This hypothesis tries to explain nominal rigidities in adjustments of the level of prices. But it fails to explain rigidities in adjustments of the rate of change of prices. Critics point out that menu costs are small and have become smaller as computers allow the printing of menus at a small marginal cost.

Economists do not agree that menu costs can explain price stickiness in the short run because they are very small. Small menu costs cannot explain recession in the economy.

Another flaw is that small menu costs may be important for an individual firm but they are unlikely to affect the economy as a whole.

In the new classical labour theory, labour market is cleared continuously at the market-clearing real wage rate but it does not explain involuntary unemployment. On the other hand, the new Keynesian theories focus on the real wage rigidity where workers are not paid market-clearing wage and involuntary unemployment exists even in the long run.

This idea that each person has asymmetrical information relative to others was used to develop a labour market model by Grossman and Hart. Given this better knowledge, it is possible and profitable for managers to deceive the workers about the real position of the firm. They enter into contracts with workers for employment commitments whereby the firm pays them rigid real wages.

However, there is an employment commitment in this model that tends to increase the amount of employment in the firm. Two American economists, Baily and Azariades, have developed the implicit contract theory. Usually employment contracts between workers and firms are explicit agreements.

But often there are other dimensions that are not written in the actual contracts. These dimensions are called implicit contracts. Workers and firms enter into implicit contracts concerning job insurance and income because workers are risk-averse with respect to income. Consequently, firms offer workers an implicit contract that is partially an income and job insurance contract and partially an employment contract.

According to Baily and Azariades, such contracts lead to rigidity in real wages that are not affected by fluctuations in business conditions and employment levels during a recession. The insider and outsider theory of labour market was developed by A. Lindback and D. This theory assumes that there are frictions and imperfections in the labour market that act to divide it in terms of employment opportunities.

Insiders are those workers who already have jobs and outsiders are those who are unemployed in the labour market. Unions negotiate the real wage with firms and set it higher than the market-clearing level so that the outsiders are excluded from jobs leading to involuntary unemployment in the presence of fall in aggregate demand.

Unions use their bargaining power to negotiate wages through turnover costs. Turnover costs relate to the costs of firing, hiring and retaining of new workers.

These costs prevent the firms to employ outsiders in place of insiders. Unions can also prevent the entry of outsiders for jobs threatening strikes and work-to-rule.

Insiders can also use these costs against outsiders to achieve a higher negotiated wage than the wage at which the outsiders are prepared to work. However, unions can raise the real wage only up to a certain level because if the real wage is higher than the capacity of the firms to pay, less insiders will be employed, if the aggregate demand falls in the economy. This theory also explains the persistence of involuntary unemployment if the real wage is set very high above the market-clearing level.

This is called hysteresis. In times of high involuntary unemployment in a recession, the insiders may use their bargaining power to prevent outsiders form entering into the labour force. Those who become outsiders may lose their influence on wage bargaining contracts because they are no longer union members. Under the circumstances, a long- period of high involuntary unemployment will tend to become locked-in. This is the hysteresis effect. When outsiders cannot enter the labour market, the hysteresis effect leads to wage stickiness.

In new Keynesian economics, payment of efficiency wages leads to real wage rigidity and the failure of market-clearing mechanism. High wages increase efficiency and productivity of workers. Despite an excess supply of labour, firms do not cut wages even though such a move would increase their profits. Firms also do not cut wages because it would lower productivity and raise costs. So it is in the interest of firms to set the real wage above the market-clearing level.

Such a wage is called the efficiency wage. According to this theory, the real wage is set to minimise turnover costs of firms. Turnover costs include the costs of firing and hiring workers, and training of new workers. It is profitable for firms of reduce such costs. By paying high real wages above the market-clearing wage, firms can prevent experienced and efficient workers from leaving the firm to join other firms.

It can also reduce recruiting costs to replace such workers and costs of training new workers. Firms do not know the quality of workers at the time of selection. Firms have imperfect information about potential workers at the time of hiring them. Selection procedures being costly, firms always try to select higher quality workers. Good quality workers have a higher reservation minimum wage than low quality workers.

If a firm pays below the reservation wage, it will not attract good quality workers. By paying a wage higher than the reservation wage, the firm will attract better quality workers. By paying a higher wage, the firm avoids adverse selection i. Another efficiency wage theory is that a real wage above the market-clearing wage improves on-the-job efficiency of workers. It shows the planned level of investment spending at each rate of interest. At an interest rate, r 1 equilibrium in the goods market is at point E in the upper part of the figure, with an income level of Y 1.

Now a fall in the interest rate to r 2 raises aggregate demand, increasing the level of spending at each income level. The new equilibrium income is Y 2. In the lower part, point F shows the new equilibrium in the goods market corresponding to an interest rate r 2. The IS curve is a locus of points showing alternative combinations of interest rates and income output at which the commodity market clears. That is why the IS curve is called the commodity market equilibrium schedule. We can gain further insight into the IS curve by raising and answering the following questions:.

What determines the position of the IS curve, given its slope, and what causes the curve to shift? What happens when the interest rate and income are at levels such that we are off the IS curve? The steepness of the curve depends on the interest elasticity of investment i. The position of the IS curve depends on the level of autonomous spending. If autonomous spending increases, the IS curve will shift to the right with or without a change in slope, depending on interest elasticity of investment.

At point G national income is the same as at E, but the rate of interest is lower r 2. Consequently the demand for investment is higher than that at E, and the demand for commodities is higher than that of E. Likewise, at point H, the rate of interest is higher than at F.

Thus Fig. At a point like G, for instance, the interest rate is too low and aggregate demand is too high relative to output. The IS curve is the schedule of combinations of the interest rate and the level of income such that the goods market is in equilibrium. The smaller the multiplier and the less sensitive investment spending is to changes in the interest rate, the steeper the IS curve.

At points to the right of the IS curve, there is excess supply in the goods market: at points to the left of the curve, there is excess demand for goods. The financial 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—the supply side and the demand side. So we assume it to be given at the level M. The higher the rate of interest, the lower the quantity of money demanded, at a fixed level of income.

An increase in income raises the demand for money. This is shown by a rightward shift of the money demand schedule. The right hand diagram [part b ] shows the money market. The supply of money is the vertical line M, since it is fixed by the Central Bank. When the income level is Y 1 , the demand curve for money is L 1 and the equilibrium rate of interest is n. In other words, the LM schedule curve , or the money market equilibrium schedule, shows all combinations of interest rates and levels of income such that the demand for money is equal to its supply.

The LM schedule is positively sloped. This means that an increase in the interest rate reduces the demand for money.

To maintain the demand for money equal to the fixed supply, the level of income has to rise. The greater the responsiveness of the demand for money to income, as measured by k, and the lower the responsiveness of the demand for money to the interest rate, as measured by h.

If the demand for money is fairly elastic i. In that case, a small change in the interest rate must be accompanied by a large change in the level of income in order to maintain money market equilibrium. The money supply is held constant along the LM curve. This point is illustrated in Fig.

An increase in the quantity of money in circulation shifts the supply curve of money to the right in part b —from M 1 to M 2. To restore money market equilibrium at the initial level of income Y 1 , the equilibrium rate of interest in the money market has to fall to r 2.

IS–LM model - Wikipedia

You can plot a consumption function A mathematical equation thought to express the level of consumer spending. Investment is composed of so-called fixed investment on equipment and structures and planned inventory investment in raw materials, parts, or finished goods.

For the present, we will ignore G and NX and, following Keynes, changes in the price level. Remember, we are talking about the short term here. Remember, too, that Keynes wrote in the context of the gold standard, not an inflationary free floating regime, so he was not concerned with price level changes. The other line, the aggregate demand function, is the consumption function line plus planned investment spending I.

Equilibrium is reached via inventories part of I. We can now predict changes in aggregate output given changes in the level of I and C and the marginal propensity to consume the slope of the C component of Y ad.

Suppose I increases. This is called the expenditure multiplier and it is summed up by the following equation :. So if a is billion, I is billion, and mpc is. If the marginal propensity to consume were to increase to. A decline in mpc to. Practice calculating aggregate output in Exercise 2. What happened to aggregate output?

How do you know? An increase in exports over imports will increase aggregate output Y by the increase in NX times the expenditure multiplier. Likewise, an increase in imports over exports a decrease in NX will decrease Y by the decrease in NX times the multiplier. Government spending G also increases Y. We must realize, however, that some government spending comes from taxes, which consumers view as a reduction in income. With taxation, the consumption function becomes the following:.

T means taxes. So increasing G, even if it is totally funded by T, will increase Y. Remember, this is a short-run analysis. Nevertheless, Keynes argued that, to help a country out of recession, government should cut taxes because that will cause Y d to rise, ceteris paribus. Many governments, including that of the United States, responded to the Great Depression by increasing tariffs in what was called a beggar-thy-neighbor policy.

Today we know that such policies beggared everyone. What were policymakers thinking? They were thinking that tariffs would decrease imports and thereby increase NX exports minus imports and Y. It was a simple idea on paper, but in reality it was dead wrong.

For starters, other countries retaliated with tariffs of their own. But even if they did not, it was a losing strategy because by making neighbors trading partners poorer, the policy limited their ability to import i. Figure The Keynesian cross diagram framework is great, as far as it goes. Note that it has nothing to say about interest rates or money, a major shortcoming for us students of money, banking, and monetary policy! Interest rates are negatively related to I and to NX.

The reasoning here is straightforward. When interest rates i are high, companies would rather invest in bonds than in physical plant because fewer projects are positive net present value A project likely to be profitable at a given interest rate after comparing the present values of both expenditures and revenues.

Similarly, when i is low the domestic currency will be weak, all else equal. Exports will be facilitated and imports will decline because foreign goods will look expensive. When i is high, by contrast, the domestic currency will be in demand and hence strong. Now think of Y ad on a Keynesian cross diagram.

As we saw above, aggregate output will rise as I and NX do. So we know that as i increases, Y ad decreases, ceteris paribus. Plotting the interest rate on the vertical axis against aggregate output on the horizontal axis, as below, gives us a downward sloping curve.

For each interest rate, it tells us at what point the market for goods I and NX, get it? For all points to the right of the curve, there is an excess supply of goods for that interest rate, which causes firms to decrease inventories, leading to a fall in output toward the curve.

For all points to the left of the IS curve, an excess demand for goods persists, which induces firms to increase inventories, leading to increased output toward the curve. Obviously, the IS curve alone is as insufficient to determine i or Y as demand alone is to determine prices or quantities in the standard supply and demand microeconomic price model.

We need another curve, one that slopes the other way, which is to say, upward. That curve is called the LM curve and it represents equilibrium points in the market for money. So we can immediately plot an upward sloping LM curve, a curve that holds the money supply constant. To the left of the LM curve there is an excess supply of money given the interest rate and the amount of output.

To the right of the LM curve, there is an excess demand for money, inducing people to sell bonds for cash, which drives bond prices down and hence i up to the LM curve. Both the interest rate and aggregate output are determined by that intersection.

Does Figure Why or why not? What does Figure Why is Figure Note that NX improved became less negative during the crisis and resulting recession but dipped downward again during the recovery. Young, Warren, and Ben-Zion Zilbefarb. New York: Springer, Previous Chapter. Table of Contents. Next Chapter. Provide the equation for C and explain its importance. Describe the Keynesian cross diagram and explain its use. Describe the investment-savings IS curve and its characteristics. Describe the liquidity preference—money LM curve and its characteristics.

Explain why equilibrium is achieved in the markets for goods and money. Why is this equation important? What is the equation for C and why is it important? What is the Keynesian cross diagram and what does it help us to do? Stop and Think Box Many governments, including that of the United States, responded to the Great Depression by increasing tariffs in what was called a beggar-thy-neighbor policy. It is important because it allows economists to model aggregate output to discern why, for example, GDP changes.

In a taxless Eden, like the Gulf Cooperation Council countries, consumer expenditure equals autonomous consumer expenditure spending on necessaries a plus the marginal propensity to consume mpc times disposable income Y d , income above a.

C, particularly the marginal propensity to consume variable, is important because it gives the aggregate demand curve in a Keynesian cross diagram its upward slope. A Keynesian cross diagram is a graph with aggregate demand Y ad on the vertical axis and aggregate output Y on the horizontal.

The diagram helps us to see that aggregate output is directly related to a, I, exports, G, and mpc and indirectly related to T and imports. What are their characteristics? What do we learn when we combine the IS and the LM curves on one graph?

Why is equilibrium achieved? Stop and Think Box Does Figure Department of Commerce, Bureua of Economic Analysis. Key Takeaways The IS curve shows the points at which the quantity of goods supplied equals those demanded. On a graph with interest i on the vertical axis and aggregate output Y on the horizontal axis, the IS curve slopes downward because, as the interest rate increases, key components of Y, I and NX, decrease.

Also, high i means a strong domestic currency, all else constant, which is bad news for exports and good news for imports, which means NX also falls. The LM curve traces the equilibrium points for different interest rates where the quantity of money demanded equals the quantity of money supplied.

At all points to the left of the LM curve, an excess supply of money exists, inducing people to give up money for bonds to buy bonds , thus driving bond prices up and interest rates down toward equilibrium. At all points to the right of the LM curve, an excess demand for money exists, inducing people to give up bonds for money to sell bonds , thus driving bond prices down and interest rates up toward equilibrium. At all points to the left of the IS curve, there is an excess demand for goods, causing inventory levels to fall and inducing companies to increase production, thus leading to an increase in output.

At all points to the right of the IS curve, there is an excess supply of goods, creating an inventory glut that induces firms to cut back on production, thus decreasing Y toward the equilibrium.

Characteristics of islm model