Telling about Money market and product market

1. Equilibrium of Product and Money Market : The
IS-LM Model or Analysis
EQUILIBRUIM- POLICY EFFECTIVENESS

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The General
Equilibrium of the
Economy
The Product Market
Or
The Real Sector
The Money Market
Or
The Monetary Sector

3. Product Market
The product Market is the marketplace
where final goods or services are sold
to businesses and the public sector.
For Example : the market for airline
travel, smart-phones, new cars, etc.
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• Equilibrium of the product market is achieved when the product market is cleared, i.e.,
according to Keynes, planned saving is equal to planned investment.
S=I
or
Y=C+I
• Is developing the IS model, investment is considered as a function of rate of interest,
consumption and saving as functions of income.
Investment Function : I= I (r)
Consumption Function : C= C (Y)
Saving Function : S= S (Y)
Equilibrium in the Product Market

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• Equilibrium in the product market is achieved when :-
S (Y)= I (r)
• However, this relationship may be shown graphically as
follows.

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• Re-translation of Simple Keynesian model at equilibrium
(Investment = Saving).
• A plot of equilibrium output for various interest rates within the
market for goods and services.
IS Curve

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• Because it’s assumed that the consumption
and investment relations are linear,
ZZ is, in general, a curve rather than a
line.
• ZZ is drawn flatter than a 45 degree
line because it’s assumed that an
increase in output leads to a less than
one for one increase in demand.
Determining Output
NOTE : Two characteristics of ZZ
ZZ
DEMAND
45
o
Demand
Z
Output Y
Y
Z

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DERIVING THE IS CURVE :
(a) An increase in the interest rate decrease the
demand for goods at any level of output,
leading to a decrease in the equilibrium level of
output.
(b) Equilibrium in the goods market implies that
an increase in the interest rate leads to
a decrease in output.
Deriving the IS Curve
ZZ
ZZ
A
A 1
A 1
A
IS
Curve
45
o
Demand
Z
Output Y
Y
1
Y

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 Downward sloping
I increases = C decreases, I decreases = Y decreases
 Increase/Decrease in autonomous expenditure will shift the IS
Curve Rightward/Leftward.
 The steepness or flatness of the IS Curve describes the
elasticity or responsiveness of C and I to the nominal interest
rate.
 Steep IS Curve : inelastic.
 Flat IS Curve : elastic
Properties of IS Curve

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• Money Market Equilibrium is achieved when the supply of
money and demand for money are equal.
Ms=Md
• Money Demand is made of two parts :-
Msp : Speculative Demand for Money
Mt : Transactionary Demand for Money
Md= Msp+Mt
Equilibrium in the Money Market

11. Money Market
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Money market basically refers to a
section of the financial market where
financial instruments with high liquidity
and short-term maturities are traded.
IS is used by many participants,
including companies, to raise funds by
selling commercial papers in the
market.

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• Depicts equilibrium in the Money Market (L=M), as well as the
Bond Market (by Walras Law).
• A plot of the equilibrium interest rate for various levels of output
or income, within the money market for a given level of the
nominal money supply.
LM Curve

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• An increase in income leads, at a given interest rate, to an
increase in the demand for money. Given the money supply,
this increase in the demand for money leads to an increase in
the equilibrium interest rate.
• Equilibrium in the financial markets implies that an increase in
income leads to an increase in the interest rate. The LM Curve
is therefore upward sloping.
Deriving the LM Curve

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Deriving the LM Curve
LM Curve
A 1
A
Md 1
(Y1>Y)
Md (for Y)
A
i
Y
Y1
M/P
(Real) Money,
MP
Income Y
Interest
Rate
i
Interest
Rate
i
A1 i 1
i

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• Upward sloping
Y increases = L increases = I increases
• Increase/Decrease in the real money supply shift the LM Curve
Rightward/Leftward.
• The steepness or flatness of the LM Curve describes the
elasticity or responsiveness of money demand (L) to the
nominal interest rate.
 Steep LM Curve : inelastic.
 Flat LM Curve : elastic.
Properties of LM Curve

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The Equilibrium Curve
Equilibrium in Financial Market (LM)
Equilibrium in Product Market (IS)
A
i
Y
Interest
Rate
i
Output Y

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• Fiscal contraction, refers to fiscal policy that reduces the
budget deficit.
• An increase in the deficit is called a fiscal expansion.
• Taxes affect the IS Curve, not the LM Curve.
• Monetary contraction, refers to a decrease in the money
supply.
• An increase in the money supply is called monetary expansion.
• Monetary policy does not affect the IS Curve, only the LM
Curve.
• For Example : An increase in the money supply shifts the LM
Curve down.
Fiscal and Monetary Policies

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Shift of IS Shift of LM Movement in output Movement in
Interest Rate
Increase in taxes Left None Down Down
Decrease in taxes Right None Up Up
Increase in spending Right None Up Up
Decrease in spending Left None Down Down
Increase in money None Down Up Down
Decrease in money None Up Down Up
Effects of Fiscal and Monetary
Policy

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