-
- In the simple Keynesian model of income determination, we have determined the level of income assuming that the investment being autonomous. And therefore we completely avoided the role of interest rates (and money supply) in determining the level of income. But,we know that interest rates and money supply have a major role to play in the economy.
- IS-LM model is constructed by introducing interest rate as an additional determinant of aggregate demand. This model illustrates how goods market (IS curve) and assets market (LM curve) interact and determine income jointly.
- The IS curve shows the combinations of interest rates and level of output such that planned spending equals income. As interest rates and planned investment spending are inversely related, the IS curve slopes downward. At equilibrium, (in goods market) Y= AD. But, investment is a component of aggregate demand. Thus, the equilibrium output decreases (increases) as interest rate rises (decreases), due to inverse relationship between interest rates and planned investment expenditure. If the interest rate increases, ceteris paribus, interest sensitive private investors reduce their investment spending, known as crowding out.
- Asset market is a market in which money, bonds, stocks, houses and other forms of wealth are traded. The demand for money is influenced by the level of real income and the interest rate. It depends on the level of real income because individuals hold money to pay for their consumptions, which in turn, depend on income. The demand for money depends also on the cost of holding money. The cost of holding money is the interest that is forgone by holding money rather than other assets. LM curve shows the combinations of income and interest rate that produce equilibrium in the money market. The LM curve slopes upward. Because, if there is an increase in income, the demand for money rises and this excess demand push the market interest rates up. The real money supply is held constant along the LM curve, and therefore, a change in the real money supply should shift the LM curve that an increase in real money supply shift the LM curve down and to the right whereas a decrease in the real money supply shift the LM curve up and to the right.
- Points on the IS curve indicate equilibrium in the goods market and points on the LM curve indicate equilibrium in the money market. For simultaneous equilibrium in both the goods market and the money market ,point indicating such equilibrium will have to lie on both the IS and the LM curves. Such a point exists only at the intersection of the IS and LM curves.
- Crowding out happens due to increase in interest rates, and therefore, can be reduced by increasing the money supply.
- Money is one of the most crucial elements of economic science. It acts as a medium ofexchange, unit of account, a standard of deferred payment and a store of value. Classical economists viewed that money is demanded only for spending purposes. However, latter Keynes recognized that money was held for other reasons too. In this view money would be held as an asset, a non-interest-paying asset, whereby velocity is affected and tends to change. According to him, the three motives for holding money are transactions, precaution and liquidity or speculation.