4198 WordsJan 11, 201317 Pages

Understanding Equilibrium in the IS/LM Model
1995 version
Prof. Humberto Barreto1 Introduction: This brief work is designed to provide additional ammunition for the student in the ongoing war against IS/LM confusion and ignorance. The author has claimed in his Notes on Macroeconomic Theory (1995) that, There should be no mystery or uncertainty surrounding the IS/LM analysis at this point. IS/LM curves are simply a short-cut to finding the equilibrium values for income and interest rate. There are two equations and two unknownsÑwhat simpler strategy than to put them on one graph could be devised? (p. 52) The author still worries, however, that the student is memorizing the equilibrium condition, IS=LM generates Ye, without really*…show more content…*

The student should see that the existing values of i and Y will have a tendency to change. The interest rate will fall because there is a shortage of bonds and as the price of bonds rises to drive the bond market to equilibrium, the interest rate will fall. The equilibrium interest rate, of course, will be found at the intersection of the Ms and Md schedules. Output will increase because a falling interest rate will trigger higher investment expenditures by firms. The increased I will increase AD and, therefore, Ye will increase. But then the higher income will shift money demand up, which will increase the equilibrium interest rate, and the same chain will be triggered leading to a decrease in the equilibrium level of output. The student undoubtedly knows that, eventually, after running through a series of converging loops, the system will settle into a mutually compatible, or general equilibrium, combination of i and Y. If you think the iteration process is a messy and cumbersome means of calculating the general equilibrium, or final, resting place of i and Y, you should applaud the use of the IS/LM graph. In one quick graph, we can immediately and easily see the system's general equilibrium solution. From our initial i0, Y0 combination, the IS/LM graph allows us to instantly see the final solution and to predict a decrease in interest rates and increase in output. However, a drawback is that it does not show how or why

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