What is IS-LM?
The IS (Investment Saving), LM (Liquidity Preference- Money Supply), and PC (Philips Curve) is the model that looks at the dynamics of output and inflation. It takes into account the central bank policy decision to adjust the inflation and real interest rate in the economy. It enables the economist to weather to priorities between employment and inflation rate analyzing the model. It is a practice-driven approach adopted by economists worldwide.
According to Keynes, national income is determined at the level where aggregate demand equals aggregate supply.
Aggregate supply is the amount of output produced by firms in the economy, With the objective of profit maximization. The total output produced depends on the level of inputs and technology. The input prices determine the demand for the firm’s inputs. We assume that there are two primary factors, i.e., labor and capital used in the production process. capital means an addition to the existing stock of physical assets to increase productivity. Example: Machinery, building, and vehicles. Labor depends on population growth and prevailing wage rate
In macroeconomics, aggregate demand (AD) is the total demand for goods and services produced in the economy. It is viewed in terms of spending on goods and services. Comprising of four major components i.e., consumption expenditure, investment, government expenditure, and net exports (exports minus imports).
What is IS-LM Curve?
The IS curve describes the goods market. The IS curve slopes down and to the right, representing the fact that as interest rates fall, people and businesses try to invest more in long-lasting goods like houses, cars, and equipment. Families tend to spend more on consumer goods and put less away to save when the interest rates fall. When interest rates fall, families also tend to put less away for savings and spend more on consumer goods. Thus, the effect of a falling interest rate is an increase in GDP through greater investment and less personal savings.
The LM curve describes the money market. The LM curve slopes right upwards. In the expanding economy, extra funds are needed to support more investments by the banks and financial institutions. To get those funds, they encourage consumers to deposit more of their cash into longer-term deposits like certificates of deposit or bonds.
The model determines the GDP of the economy in the short run. The IS and LM relationship creates opposing forces. While a falling interest rate tends to cause the economy to expand, on the other side an expanding economy causes interest rates to rise. Where the two curves meet, the forces are balanced and the economy is in equilibrium.
Equilibrium in Real Sector – IS Curve
An economy is in equilibrium when AD equals AS. AD (consumption and investment) and AS (consumption and savings). Therefore, at the equilibrium level of output, savings is an equal investment. we assume investment as autonomous represented by a horizontal line parallel to income axis, economy is in equilibrium at point E as shown in the fig2. On the right side of point E, the unplanned investment will be positive and on the left-hand side, unplanned investment is negative.
Equilibrium in Monetary Sector – LM Curve
According to Keynes, the LM curve is based on the concept of transaction demand for money and speculative demand for money. Transaction demand for money has a positive relationship with income i.e. at a higher level of income the transaction demand for money is more and vice-versa. Simply put when earning of individual increases, it increases the expenditure thus encouraging the circulation of money in the economy. Speculative demand for money has an inverse relation with the rate of interest. At a higher rate of interest, the speculative demand for money is less, thus people are less enthusiastic to borrow money from the bank at a higher rate of interest and vice-versa. This creates an opportunity cost of holding money in the form of cash.
Saving is a positive relationship with income and Investment has an inverse relation with the rate of interest. Both savings and investment intersect at the equilibrium level of income and interest rate. This represents IS curve in the real sector of the economy.
In the first quadrant, the rate of interest is shown on the y-axis and income on the x-axis.
In the second quadrant, we have taken the rate of interest on the y-axis and investment on the x-axis, showing an inverse relationship between investment and the rate of interest.
In the third quadrant, saving is taken on the y-axis and investment on the x-axis. In the fourth quadrant, we have taken savings on the y-axis and income on the x-axis. shows a 45° line showing saving is equal to investment.
In the fourth quadrant positive relation between savings and investment has been shown. It is showing the different levels of savings at different levels of income.
This implies that saving is directly related to income and investment is inversely related to the rate of interest and saving is equal to investment at an equilibrium level, it is clear that there is an inverse relationship between the rate of interest and income. IS curve is I quadrant which is the locus of equilibrium levels of income. It is implied in IS curve that the real sector can be in equilibrium in any combination of a lower rate of interest and higher income or higher rate of interest and lower-income.
What is the Philip Curve?
The relationship between the rate of unemployment and the rate of inflation is described by A.W. Philips through the Phillips Curve. It proves that the lower the initial rate of unemployment; the greater would be the rise in the money wage rate corresponding to a given rise in the rate of unemployment, assuming that the ratio between prices and nominal wage rates is constant in the short run. Phillip's curve shows an inverse relationship between the rate of unemployment and the rate of inflation.
linear equation form: c = a–bu
c is the rate of wage increase, a and b are constant and u is the rate of unemployment.
It implied that with a lower rate of inflation, the unemployment rate would be high and vice versa.
The Long-Run Phillips Curve
Inflation and unemployment are unconnected in the long term because the long-term Phillips curve is a vertical line at the natural rate of unemployment. Increases in inflation can occur when unemployment falls, but only in the short term. In terms of graphs, this indicates that at the natural rate of unemployment, the Phillips curve is vertical. Attempts to lower unemployment rates simply move the economy up and down this vertical line. Assume the economy starts at point A and has an initial rate of unemployment and inflation rate. If the government decides to pursue expansionary economic policies, inflation will increase as aggregate demand shifts to the right.
This shows movement in the short-run Phillip curve, to point B, which is an unstable equilibrium. As AD increases, more workers are hired to produce more output meeting the rising demand, and unemployment will decrease. Due to the higher inflation, workers’ expectations of future inflation change, which in turn shifts the short-run Phillips curve to the right, from unstable equilibrium point B to the stable equilibrium point C. At point C, the rate of unemployment increases to its natural rate, but inflation remains higher than the initial level. The short-run Phillips curve shows the inverse relationship between inflation and unemployment. As unemployment rates increase, inflation decreases and vice versa
Equilibrium in goods and financial markets and how the output is determined by demand in the short run, equilibrium in the labor market, and derived how unemployment affects inflation. We now combine them and understand the behavior of output unemployment and inflation both in the short and long run. IS-LM-PC model helps to understand the relation between output and inflation.
Now, IS Curve between output and real policy rate, shown in the top half of the figure, IS curve is downward sloping which means the lower is the real policy rate given by flat LM curve higher is level of equilibrium output. Lower policy rate increases investment leads to higher output. An increase in output further increases to increase in consumption and investment increases the demand. In the Philips curve, we saw the relation between change in inflation and output gap is positive. This positive relationship is drawn as the output sloping Philips curve in the bottom half of the fig6. output is measured on the horizontal axis and the change in rate is measured on the vertical axis. When the output is equal to the potential level, the change in inflation is equal to zero. Thus, the Philips curve crosses the horizontal point where the output is equal to the potential or natural level. There the unemployment rate is less than the natural rate of unemployment. Therefore, there is an upward movement in wages which leads to further movement in prices. If the central bank keeps the rate at this low rate, this will lead to greater inflation.
Government expenditure is assumed as exogenous. There is a time lag when the central bank changes the interest rate and its implementation effect on the economy. Resource available in the economy is limited.
Context and Applications
This topic is significant in the professional exams for both graduate and undergraduate courses –
- BA Economics
- BA Economics Honors
- MA Economics
- Master of Finance
- Master of Business Analytics
- Master of Business Administration
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