IS curve and LM curve
The IS curve (income – savings) represents the negative relationship between real interest rates and real income in the goods market. When interest rates are high the cost of capital is high and therefore the income is low. The IS curve is therefore a downward sloping curve and every point on the curve represents the equilibrium level of real interest rates and real income in the goods market.
Lower interest rates decrease savings and increase investment thus reducing S-I and throwing the equation (S-I) = (G-T) + (X-M) out of balance. For equilibrium to be reduced, income should increase thus increasing savings, tax receipts and imports.
The LM curve represents the positive relationship between real interest rates and real income in the money markets. When interest rates are high people do not want to hold money with them but invest it to earn higher income. Therefore equilibrium in the money market is met when high interest rates are accompanied by high income. The increase in the demand for money for high income offsets the decrease in the demand for money for investment due to high interest rates and equilibrium is maintained.
Read here below how interest rates are administered through the monetary policy;
The LM curve is therefore an upward sloping curve and every point on the curve represents a combination of real interest rates and real income that provides equilibrium in the money markets.
For overall equilibrium, the combination of real interest rates and real income should be consistent with the equilibrium in goods market and money market. This condition is sufficed at the combination at which the IS curve and LM curve intersect.
LM curve represents the level of real money supply. Real money supply is the nominal money supply divided by the price. A decrease (increase) in prices will increase (decrease) the real money supply and therefore cause the LM curve to shift downwards (upwards). A downward shift in the LM curve represents new points of equilibrium on the curve at which same real income as on the original curve can be earned at lower real interest rates. Similarly, an upward shift of the LM curve represents new equilibrium points where the interest rates have to be higher to earn the same level of real income as on the original curve. Therefore it shows that greater supply of real money reduces the level of real interest rates and the converse is true for a decrease in supply of real money.
Deriving the Aggregate demand curve
In the above diagram, points A, B and C present the points of overall equilibrium in the goods and money markets. At point C, the real money supply is higher (price level is lower) than point B and at point A, the real money supply is lower (price level is higher) than at point B. Therefore you can see that the relationship between the price level and the real income (which is equal to the real output demanded) is a downward sloping curve. From this we can derive the aggregate demand curve.
The curve is downward sloping because at higher price levels the interest rates are high which makes cost of capital high, which makes the goods produced expensive and which in turn reduces the demand for domestically produced output.
That’s all in this post …..Thanks for reading….in the next post we will read about reasons for shift in the demand and supply curves…
p.s. If you liked what you read don’t forget to use the social sharing buttons on the page :-)…..
p.s. You can also share your views with me via comments…they would be much appreciated…
p.s. To get my posts in your inbox use the SUBSCRIBE button in the sidebar and at the bottom of the page…
For solved examples please refer to the CFA Institute Books or any other study notes that provide them and you may want to use. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.