Essay on IS LM

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IS/LM Schedule

It consists of two parts the goods market and the money market
In short run equilibrium the goods and money market are in equilibrium
In the goods market equilibrium planned investments equal planned savings
In the money market, money demand equals money supply
But in IS/LM the level of output and interest rate are constant

This model shows the effect on output and interest rate when there is a change in aggregate demand and government policies
IS shows shifts in consumption and investment and changes in fiscal policy (government expenditure or taxation)
LM shows the shifts in money demand and changes in monetary policy (money supply)

The goods market: IS curve
IS curve shows interest rate and output level at equilibrium where aggregate demand equal aggregate supply
Downward sloping because a low interest rates generate higher investments leading to higher output vice versa
Supply output will adjust to any change in demand as wages and prices are fixed
Aggregate demand is made up of planned expenditure on consumption and investment and government spending
1. Any change in the size of the multiplier will change the slope of IS curve
Rise in propensity to consume will increase the multiplier so IS flatter
2. Any change in the interest sensitivity of investment, leading to consequential change in the slope of the IS curve
3. Any change in autonomous consumption or government expenditure will cause the IS curve to shift by the change in autonomous spending times the multiplier

The money market: the LM curve (p.33)
LM curves represents the combination of the interest rate and output at which the money market is in equilibrium

Demand for money versus bonds (p.35)
Money is needed in order to carry out the transactions in a money market
Transactions and money demand vary with income
The interest income is the opportunity cost of holding money form
Rise in interest rate increase opportunity cost for holding money

= L (y, i)
L is liquidity and I is nominal interest rate
A rise in level of income, holding the interest rate unchanged, raising the demand for money (dL/dy > 0)
A rise in interest rate, holding the income unchanged, lowering the demand for money (dL/di < 0)

Assets and speculative motives
If bondholders suddenly believe that the interest rate will be higher in the future that they had previously believed, they will expect capital loss, leading them to selling their bonds which drive the price of the bonds down and interest rates up
The expectation of a rise in the interest rate is fulfilled

Money market equilibrium (p.36)
Money market equilibrium =
Money demand equals to money supply
Demand for money depends on the nominal interest rate and the level of output
Whereas the supply of money is assumed to be fixed by monetary authorities
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