Chapter 5 Macroeconomic Policy Analysis

(IS-LM Model)
5.1.Equilibrium in the Product Market and Money Market
5.1.1.Equilibrium in the Product Market

Equilibrium in the product market is reached when aggregate demand for output, i.e., C + i + G,
becomes equal to aggregate supply of output (K) i.e., Y = C + ir + G.

At a given price level the consumers, businessmen and government are the demanders for output
and the business sector is its supplier.

It is to be noted that every equilibrium level of output is related to a particular rate of interest.
Because, change in interest rate brings about a change in the level of output or income through
changing the level of investment.

Output to be in equilibrium, therefore, the rate of interest must also be in equilibrium at the same
time. Rate of interest is an exogenous factor in the product market as it is determined in the
money market. Product market therefore seeks to find the equilibrium values of the levels of
output related to different interest rates.

One interest rate is related or associated with one equilibrium level of output and the other
interest rate is related to another level of output. Thus, goods market equilibrium establishes
various combinations of interest rate and output. A schedule of such combinations which show
equilibrium points in the goods market is known as IS schedule.

The important condition for equilibrium in the goods market is that the total expenditure must be
equal to output in the economy as shown in the equation given below.

Y = E = C + i + G …… (i)

or

Y = C[Y – T(Y)] + i + G …… (ii)

As the variables here are in real terms. Y = GNP, C is real consumer expenditure as a function of
disposable income and T is real tax revenue as a function of real GNP, i is real intended
investment and G is government purchases of goods and services. E stands for total expenditure.

Once GNP (Y) is produced generates equal amount of income (K) and is distributed amidst
consumer expenditure, saving and taxes as shown by the following equation.
Y = C + S + T …… (iii)

or

Y – C = S[Y – T(Y)] + T (Y) ….. (iv)

where saving is a rising function of disposable income and tax revenue is a rising function of
GNP (Y) On the basis of equation (i) and (iii) we can write:

C + i +G – C + S + T …… (v)

i + G = S + T …… (vi)

where i is the total investment showing intended investment plus change in inventories (∆inv). i
+ G is independent of income, whereas, S + T is a rising function of Y.

Equilibrium level of income will settle down only when S + T = i + G as shown by the
following diagram.

Producers keep a certain amount of output in stock for business purposes, known as inventories.
Inventories are kept of a size considered ideal by the businessman or producers in the business
sector. At Y1, in Fig. 12.1 (S + T) > (i + G), showing excess supply over demand. Because of the
fall in APC at higher levels of income, Y1d is that part of output which was not purchased by the
consumers. Out of Y1d only a part i.e. Y1c was purchased by the investors and government.
Therefore, cd is unsold output which adds to the inventories which was not intended or desired
by the businessman. There would be involuntary accumulation of inventories and the
businessmen will cut down their orders for fresh production.
Through reverse action of multiplier income will be reduced to Y0. When the economy is at Kn
the APC is higher than it was at Y11, resulting into low level of (S + T), where demand for output
is greater than its supply. Excess demand will be met out of inventories. This will cause
involuntary drop in inventories. In order to maintain a normal or an ideal level of inventories the
sellers would issue fresh orders to the producers. This leads to the expansion of output or income
up to Y0 where (S + T) = (I + G), establishing equilibrium level of income. In the above analysis
i, investment has been treated as fixed; whereas it does not remain fixed. It varies with the
changes in interest rate. Investment, actually, depends upon two factors:

Firstly, it depends upon market rate of interest, because, it is a cost to the investors in either case
whether the funds are borrowed or owned. Secondly, it depends upon the stream of future net
returns from the project to be undertaken or the present discounted value (PDV) of the future net
income from the investment to be made.

The PDV is computed by discounting the stream of future net returns at the market
interest rate after deducting the cost (C) of the project, shown by the following equation:

Rt + 1 + Rt + 2 etc. are net returns estimated at the time t i.e. t is time of taking decision regarding
investment, r is the market rate of interest and C is the total cost of the project. If PDV is positive
then it is beneficial to make investment otherwise not. In a project with positive PDV the
investment will continue to flow in until it reaches zero. In the Fig. 12.2 projects have been
arranged in order to their PDV counted on the basis of a fixed interest rate, say, r0 or r1.

When rate of interest is r0 then investment will be made in six projects as all are having positive
PDVt raising the total investment up to i0. When rate of interest falls to r1 then the PDVt curve
shifts upward shown by dotted line in Fig. 12.2 This will make PDVt of two more projects (7th
and 8th) positive which will attract the investors, consequently, investment will rise up to i1.
Hence, there is functional relationship between interest, etc. and investment. Investment is an
inverse function or r.

i = f(r) … (vii)

Thus investment is dependent on r, as r rises i falls and as r falls i rises.

Now, merging equation (vii) in equation (ii) we have

Y = C (Y – T (Y)) + i (r) + G …(viii)

Equation (viii) is a departure from Keynesian Model as it treats investment as variable and
dependent on r. In the aggregate demand C and i depend on y and r respectively. At equilibrium
level of output where AD = AS, there must be a pair of y and r. If either of the two undergoes a
change the pair will be broken and a new equilibrium level of income will be achieved with a
different pair of y and r. Equation (viii) therefore, establishes pairs of y and r that will maintain
equilibrium in the product market.

5.1.2. Derivation of Is Curve:

By now we have come to know that there is opposite relationship between r and y. As r falls
investment rises hence income (y) rises and vice versa. Fig. 12.3 shows the relationship between
r and investment.

In Fig. 12.4 Equilibrium level of income is established by the intersection of (S + T) and (i (r0) +
G) functions at Y0. As r0 falls to r1 the (i (r1) + G) curve shifts upward due to rise in investment
which intersects the (S + T) function at E1 raising the equilibrium level of income to Y1.

Thus, there is inverse relationship between y and r and the line or curve showing this relationship
between the two must be negatively sloped. At a particular rate of interest there is a certain
equilibrium level of y and that level of y will remain stable so long as that particular r does not
change. This pair of r and y shows equilibrium in the product market. There can be several such
pairs showing equilibrium in the product or goods market which can be shown by a curve known
as IS curve. This can be shown by the Fig. 12.5.

In Fig. 12.5 r0 is related with y0 which shows equilibrium in the product market. As r falls to r1
the equilibrium gets disturbed and new equilibrium is found at y1, bringing (S + T) = [I(r1) + G]
and establishing equilibrium in the product market. IS curve comprises several such pairs of r
and y.

All the relationships imbibed by IS curve and discussed so far can be shown together in a four
quadrant (Fig. 12.6).There must be some equilibrium level of interest rate (r) in an economy at
any point of time. From the equilibrium level of r we can trace the values of other variables in
the diagram. Similarly, from other levels of r also we can find the values of these other variables.

In this four quadrant (Fig. 12.6) all the variables are rising from the origin and have positive
values. Suppose r0 is the equilibrium rate of interest and is given, measured on the vertical axis.
At r0 investment and government expenditure is (1 + G)0 which through multiplier determines Y0
equilibrium income. Y0 is equilibrium income because here (S + T)0 = (1 + G)0. Note that (S + T)
is a raising function of income, G is the amount of government expenditure which is fixed as it is
independent of r.

At r0 and y0, (S + T)1 = (1 + G)0, the product market is in equilibrium as the equilibrium
condition of income is satisfied here. The pair r0 y0 is shown by point A, a point on the IS curve.
Similarly, at r1 and Y1 level of income (S + T)1 =(1 + G)1. Hence, r1, v1 is a combination which
establishes equilibrium in the product market and shown by B. If we join AB points a curve
comes into being known as IS curve, showing various combinations of r and y at which the
product market is in equilibrium.
5.1.3 Shift In Is Curve:

An upward or downward shift in IS curve can take place if the factors like investment function,
propensity to save, tax rate, interest rate etc. undergo a change. Effect of each can be seen
separately. Shift due to increase in investment function: Suppose there is an upward shift in the
investment function due to rise in the business expectations of the entrepreneurs. Its effect on the
IS curve can be seen with the help of the Fig. 12.7.

IS is the original IS curve with pair r0 y0 where i’0 = S0 i. e- (i + G)0 = (S + T)0. The other pair is
r1 y1 where i1= s1 (i + G)1 = (S + T)1 showing equilibrium in the product market. With an upward
shift in the investment function to (i + G)1 = ƒ(r) the level of investment goes up to i11 i.e. (i +
G)11raising the level of income through multiplier to a level at which savings can be raised equal
to i11.
Income rises to y11 at which i11n or (i + G)11 = (S + T)11 at r0 interest rate, making a new pair of r0
y11 which establish equilibrium in the product market. Another such pair results from the upward
shift in the investment function is r1 y111 where i111 = s111 or (i + g)111 = (S + T)111. Thus, these
new pairs i.e., r0y11 and r1 y111 in form a new IS curve resulting into upward shift in the IS curve.
This implies that decline in the business expectations will shift the investment function
downward and consequently the IS curve will also shift downward. Similarly increase and
decrease in G will shift IS curve upward and downward respectively.

Shift due to Increase in Tax Rate:

Under the contractionary fiscal policy increase in tax rate (f) will shift the S + T function
leftward or upward where every level of income will yield more S + T than before. For income
to remain in equilibrium i + G must increase to match increased S+T.

This is possible only at lower rate of interest shifting the IS curve downwards as shown in Fig.
12.8. IS0 is the original IS curve with combinations like r0y0 and r1y1 bringing equality between
S+T and i + G and thus establishing equilibrium in the product market at various pairs of r and y
lying on the IS0 curve. Increase in tax rate shifts the (S + T) function to (S + T)1 shown by dotted
line.

Now at y0 more S + T takes place and therefore, for y to remain in equilibrium i + G must rise to
match increased S + T which is possible only at r11. New pair for equilibrium in product market
is r11 y0 shown by A point. Similarly at y1 the interest rate must fall to r111 to bring equity
between new S + T and i + G combination of y1 r111 is shown by B in Fig. 12.8. If we join A and
B a new IS1 curve is shaped by shifting the IS0 downward. Decrease in tax rate, therefore, will
shift the IS curve upward.

Effect of change in other variables like G, savings etc. can be worked out by the students
themselves.