Model Answer
0 min readIntroduction
The Keynesian model, developed by John Maynard Keynes in response to the Great Depression, provides a framework for understanding fluctuations in national income and employment. At its heart lies the interaction between the goods market and the money market, represented by the IS-LM model. This model assumes that aggregate demand is the primary driver of output in the short run, and that prices are sticky, preventing markets from clearing instantaneously. Understanding the determination of equilibrium income and interest rate within this framework is crucial for analyzing macroeconomic policies and their impact on the economy. This answer will explain this determination with appropriate assumptions and diagrams.
Key Assumptions of the IS-LM Model
The IS-LM model operates on several key assumptions:
- Closed Economy: The model assumes a closed economy, meaning no international trade or capital flows.
- Fixed Prices: Prices are assumed to be fixed in the short run. This is a crucial departure from classical economics.
- Two Sectors: The economy is simplified to consist of only two sectors: households and firms.
- Government Intervention: The model allows for government intervention through fiscal and monetary policy.
The IS Curve: Goods Market Equilibrium
The IS (Investment-Saving) curve represents the locus of all combinations of income (Y) and interest rate (r) at which the goods market is in equilibrium. Goods market equilibrium occurs when aggregate expenditure (AE) equals aggregate output (Y).
AE = C + I + G, where:
- C = Consumption (dependent on disposable income)
- I = Investment (inversely related to the interest rate)
- G = Government Expenditure (assumed to be exogenous)
A higher interest rate reduces investment, leading to lower aggregate expenditure and thus lower equilibrium income. This inverse relationship is depicted by the downward-sloping IS curve.
Figure 1: The IS Curve
The LM Curve: Money Market Equilibrium
The LM (Liquidity Preference-Money Supply) curve represents the locus of all combinations of income (Y) and interest rate (r) at which the money market is in equilibrium. Money market equilibrium occurs when the demand for money equals the supply of money.
Money Demand (L) is positively related to income (Y) and negatively related to the interest rate (r).
Money Supply (M) is assumed to be fixed by the central bank.
A higher income increases the demand for money, leading to a higher equilibrium interest rate. This positive relationship is depicted by the upward-sloping LM curve.
Figure 2: The LM Curve
Determination of Equilibrium Income and Interest Rate
The equilibrium income and interest rate are determined at the intersection of the IS and LM curves. At this point, both the goods market and the money market are simultaneously in equilibrium.
Figure 3: IS-LM Equilibrium
In Figure 3, the intersection of the IS and LM curves determines the equilibrium income level Y* and the equilibrium interest rate r*.
Fiscal Policy Impact: An increase in government spending (G) shifts the IS curve to the right, leading to higher equilibrium income and a higher equilibrium interest rate.
Monetary Policy Impact: An increase in the money supply (M) shifts the LM curve to the right, leading to higher equilibrium income and a lower equilibrium interest rate.
Limitations of the IS-LM Model
While a powerful tool, the IS-LM model has limitations:
- It assumes fixed prices, which is not always realistic.
- It is a short-run model and does not address long-run growth.
- It simplifies the economy by assuming only two sectors.
Conclusion
The IS-LM model provides a valuable framework for understanding the interaction between the goods and money markets and the determination of equilibrium income and interest rates. By analyzing the shifts in the IS and LM curves, policymakers can assess the impact of fiscal and monetary policies on the economy. While the model has limitations, it remains a fundamental tool in macroeconomic analysis, offering insights into short-run economic fluctuations and policy interventions. Further refinements, such as incorporating expectations and open economy considerations, have led to more sophisticated macroeconomic models.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.