IS-LM model

In June 1936, an article on IS-LM model was published by David

Champernowne and W. Briam Reddaway.
On 26 September 1936 by Roy F. Harrod, James E. Meade and J. R. Hicks
that gave birth to the IS-LM model.
While all five articles reduced the aggregate demand analysis of John
Maynard Keynes General Theory of Employment, Interest, and Money to
small systems of simultaneous equations.
It was proposed by John Hicks in 1937 in a paper called Mr Keynes and
the "Classics.
Economics teaching was shaped by the diagram that Hicks labelled SI-LL
which later Alvin Hanses relabelled as showing IS and LM curves in 1949
(hence it is also called the Hicks-Hansen model).
Although Hicks is credited with the invention of the IS-LM, it is also worth
knowing that he was privy to Harrods paper for the system of equations
and Meades paper for notation before writing his own.
IS-LM model is the core of short-run macroeconomics.

The model examines the combined equilibrium of two markets:

The goods market, which is at equilibrium when investments equal
savings, hence IS.
The money market, which is at equilibrium when the demand for
liquidity equals money supply, hence LM.
Examining the joint equilibrium in these two markets allows us to
determine two variables: output Y and the interest rate i.
The model rests on two fundamental assumptions
All prices (including wages) are fixed.
There exists excess production capacity in the economy.
This is a complete change in perspective compared to classical economics:
The level of demand determines the level of output and
employment.
There can be an equilibrium level of involuntary unemployment.
Derivation of IS curve:
Investment spending function:
I = bi b>0
The interest rate and aggregate demand: IS curve
AD = C + I + G + NX
AD = [ + cTR + c(1 - t)Y] + ( bi) + + NX
AD = + c(1 - t)Y bi
Where = + cTR + + + NX
Y = AD = + c(1 - t)Y bi
Which can we simplified to:
Y = + c(1 - t)Y bi
Y - c(1 - t)Y = bi
Y [1 - c(1 - t)] = bi

1
Y= bi)
1c (1t )

1 1
Y= G =
G bi) = 1c (1t ) [ 1b ]

1
Y= ( bi )
1b

where = a + (i.e. the sum of autonomous consumption (a)

and investment expenditure () , b is marginal propensity to
 consume, b is sensitivity of investment to change in rate of
interest)
Y and i are level of income and rate of interest respectively.

The derivation is based on the following propositions:

An increase in rate of Interest leads to a decrease in the level of
Investment.
An decrease in the level of investment leads to a decrease in the level of
income.
Therefore, an increase in the rate of interest leads to a decrease in the
rate of interest.
Demand for real balance (L)
L = kY hi k,h > 0

The derivation is based on the following propositions:

An increase in the level of income leads to an increase in the demand for
money.
An increase in the demand for money leads to an increase in the rate of
interest.
Therefore, an increase in the level of income leads to an increase in the
rate of interest.

Equilibrium in IS-LM model

By mapping out the relationship between Y and i when the goods market
is in equilibrium we get the IS curve.
By mapping out the relationship between Y and i when the money market
is in equilibrium we get the LM curve.
When we set IS=LM we can solve for the equilibrium levels of i and Y. This
represents simultaneous equilibrium in the goods market and the money
market.
At point E, interest rates and income levels are such that the public holds
the existing money stock and planned spending equals output.

Assumption and meaning of Equilibrium:

The price level is constant and that firms are willing to supply whatever
amount of output is demanded at that price level.
The level of output Y0 will be supplied by the firms at the price level P.
This assumption is one that is temporarily needed for the development of
the analysis; it corresponds to the assumption of a flat, short-run
aggregate supply curve.