Contd.

r
0
Interest rate
Quantity of money
r
M
M
s
0
r
1
Interest rate
Income
r
Y
LM
0
M
d
(Y
0
)
A
B
C
r
1
r
0
A
B
Y
0
Y
1
M
s
1
LM
1
Figure 6.9 – Shifts in the LM Schedule with an Increase in the
Quantity of Money
Money Market
The LM Schedule
s
M
c
c
c
0
2
2
0
1
s
M
c
c
c
1
2
2
0
1

When M
d
increases for a given level of Y and r (Figure 6.10):
Initial equilibrium is A in the money market corresponding to income
level
Y
0.
Money demand
M
d
0
(Y
0
).
Equilibrium r is at
r
0
and LM
0.
Assume M
d
function shifts to
M
d
1
(Y
0
)
, an increase in M
d
for a given level of
Y.
At the unchanged level of income,
Y
0
, equilibrium in the money market
requires r of
r
1.
Contd.

The new LM function, LM
1
for a given level of
Y
0
will be above the
initial LM curve.
Shown by point B in panel (b):
Similarly maintaining equilibrium in the money market at
r
0
, after the
shift in the M
d
schedule would require a fall in the Y to a level below Y
0
which would shift the schedule back to original
M
d
0
(Y
0
).
Thus the point on LM
1
at r
0
is to the left of LM
0
as shown by C.
A shift in the M
d
function that increases the demand for money at a given
level of both the r and Y shifts the LM schedule upward and to the left and
vice versa.
Contd.

r
0
Interest rate
Quantity of money
r
M
M
s
0
r
1
Interest rate
Income
r
Y
LM
0
A
B
C
r
1
r
0
Y
0
LM
1
M
d
1
(Y
0
)
M
d
0
(Y
0
)
Figure 6.10 – Shifts in the LM Schedule with a Shift in the
Money Demand Function
Money Market
The LM Schedule

Summary of the LM curve:
LM schedule shows combinations of
Y
and
r
that produce
equilibrium in the money market.
LM slopes upward.
LM is relatively flat if interest elasticity of M
d
is relatively high (LM relatively
steep if interest elasticity of M
d
is relatively low).
Increase in M
s
will shift LM to the right (a decrease in M
s
will cause LM to
shift to the left).
LM will shift upward (left) with a shift in the M
d
function that increases the
amount of money demanded at given levels of Y and r, and
vice versa.
Contd.

Product Market Equilibrium (IS)
Construction of the IS Schedule
The condition for equilibrium in the product market is
Y = C + I + G
(7)
or
I + G = S + T
(8)
IS schedule is constructed from
equation
(8).
Look at a simplified case without government sector (G and T is zero)
Rewrite equation (8) as:
I(r) = S(Y)
(9)
Equation (9) indicates that I depends on r whilst S depends on Y.

We need to find a combination of r and Y that will equate
I
and
S.
Figure 6.11 shows the construction of the IS schedule.
The I function is negatively sloped (panel
a
):
I is negatively related to r.
The S function is positively sloped (panel
a
):
S is positively related to Y.
The slope of the saving function is the marginal propensity to save
(MPS).
Contd.

r
r
Y
S
I
Y
I
2
I
1
I
0
Y
2
Y
1
Y
0
I
2
= S
2
(a) Investment and Savings schedules
(b) The IS Schedule
Figure 6.11:
Construction of the IS Schedule ( T = G = 0)
Interest Rate
Savings
Investment
Income
I(r)
r
2
r
1
r
0
I
1
= S
1
I
0
= S
0
S(Y)
Interest Rate
r
2
r
1
r
0
Y
2
Y
1
Y
0
C
A
B
IS