IS-LM Model

Master Study Notes — Module 6

Based on: Lecture Slides + Your Class Notes + Detailed Explanations + Diagrams
1. What is the IS-LM Model?
As you wrote in your class notes: "It is a tool / a mechanism we study the instruments on how
monetary and fiscal policy play an important role and impact variables in the economy. It is a specific
tool to study the rate of interest also known as macroeconomic tool which successfully establishes
economic equilibrium."

In simple words — The IS-LM model is like a two-lock puzzle. Imagine two rooms:

■ Room 1 (Goods Market): Here, businesses produce goods and people buy them. The puzzle
here is: how much will businesses produce? The answer depends on how much people spend —
which depends on the interest rate.
■ Room 2 (Money Market): Here, people decide how much cash to hold vs bonds. The puzzle
here is: what interest rate balances money demand and supply? The answer depends on income
— which comes from the goods market.
■ The Problem (Indeterminacy): You need the interest rate to find income, but you need income
to find the interest rate. They are circular!
■ The Solution (IS-LM): J.R. Hicks (1937) solved both simultaneously by drawing two curves —
IS and LM — and finding where they intersect. That intersection gives us BOTH income (Y*) and
interest rate (r*) at the same time.

Why is it called Hicks-Hansen Model? Hicks developed the graphical framework in 1937. Alvin
Hansen later extended it with detailed mathematics. Together, it's called the Hicks-Hansen Model.

2. The IS Curve — Goods Market

The IS curve stands for Investment = Savings. It shows every combination of interest rate (r) and
income (Y) where the goods market is in equilibrium.

2.1 The Keynesian Cross — Foundation

Before drawing the IS curve, we need to understand the Keynesian Cross — the simplest picture of
how income is determined in an economy.

PE (Planned Expenditure) = C + I + G — What people, businesses and the government PLAN to

spend
Y (Actual Expenditure) = Real GDP — What is actually produced and spent
Equilibrium condition: Y = PE — When actual output equals planned spending, there are no
unplanned changes in inventories, so the economy is in balance
If Y > PE: Firms are producing more than people want to buy → unsold inventory builds up →
firms cut production → Y falls
If Y < PE: People want to buy more than is being produced → inventories run out → firms
increase production → Y rises

Think of it like a restaurant: if more food is ordered than cooked (PE > Y), the kitchen speeds up. If too
much is cooked and food is wasted (Y > PE), the kitchen slows down. Equilibrium = exactly the right
amount cooked.

2.2 The Investment Function

In the basic Keynesian model, investment was fixed. Hicks and Hansen improved this by making
investment depend on the interest rate:

I = ■ − cr (c > 0)

Symbol Meaning Example

■ Autonomous investment — base level regardless of r ■ = 250

c Interest sensitivity of investment (how much I changes per 1%

c=change
5 in r)

r Rate of interest (in %) r = 10%

I Actual planned investment I = 250 − 5×10 = 200

Why does higher r reduce investment? When interest rates are high, borrowing is expensive. A firm
that wants to build a new factory must pay more in interest on its loan. So fewer projects are profitable
→ firms invest less.

2.3 How IS Curve is Derived — Step by Step

This is the chain reaction that creates the IS curve:

Step What Happens Direction

① Interest rate rises: r↑ r↑

② Investment becomes more expensive → firms invest less: I↓ I↓

③ Less investment = less planned spending: PE↓ PE↓

④ PE < Y, so unsold inventory piles up

⑤ Firms cut production to clear inventory: Y↓ Y↓

⑥ New lower equilibrium income is reached Lower Y

Result: Higher r → Lower Y. Therefore the IS curve slopes DOWNWARD. Every point on the IS
curve = goods market equilibrium at that r.

2.4 IS Curve Diagrams

The three panels below show the full derivation from your notes:

Panel (a): As interest rate rises from r■=6% to r■=10%, investment falls. Panel (b): Less investment
shifts the PE line down in the Keynesian Cross, lowering income. Panel (c): Plotting r vs Y gives the
downward-sloping IS curve.

2.5 Four Quadrant IS Derivation (from your class notes)

Your handwritten notes show the four-quadrant approach. Here is the clean version:

Reading the four quadrant diagram: Quadrant A (bottom right) → Investment function: r
determines I. Quadrant B (top right) → 45° line: Investment must equal Saving (I=S). Quadrant C (top
left) → Saving function: Saving level determines income. Quadrant D (bottom left) → IS Curve:
Combining all three, plots r vs Y.

2.6 IS Curve Algebra

Two-sector model (only households and firms, Y = C + I):

C = C■ + bY | I = ■ − cr → Y = [1/(1−b)] × (C■ + ■ − cr)

Three-sector model (adding government G and taxes T, Y = C + I + G):

Y = [1/(1−b)] × (C■ − bT + ■ − cr + G) [Lump-sum tax]

Y = [1/(1−b(1−t))] × (C■ + ■ − cr + G) [Income tax at rate t]

Solved Numerical — IS Curve (Problem 1 from notes)

Given: C = 100 + 0.75Y, I = 250 − 5r

Step Working

Y=C+I Y = 100 + 0.75Y + 250 − 5r

Collect Y terms Y − 0.75Y = 350 − 5r

Simplify 0.25Y = 350 − 5r

Solve for Y Y = (350−5r)/0.25 → Y = 1400 − 20r ■ IS Curve

 Meaning: When r = 0%, Y = 1400. When r = 10%, Y = 1400 − 200 = 1200. Every 1% rise in interest
rate reduces income by 20 units.

2.7 Shifts in the IS Curve (Fiscal Policy)

The IS curve shifts when anything OTHER than r changes in the goods market — mainly fiscal policy
(government budget decisions):

Change IS Curve Shifts Why Multiplier

G↑ (more govt spending)

RIGHT (outward) Higher PE at every r → higher Y ∆Y = [1/(1−MPC)] × ∆G

G↓ (less govt spending)LEFT (inward) Lower PE at every r → lower Y ∆Y = [1/(1−MPC)] × ∆G

T↑ (higher taxes) LEFT (inward) Higher T → lower disposable income → lower

∆Y = [−MPC/(1−MPC)]
C → lower PE × ∆T

T↓ (lower taxes) RIGHT (outward) Lower T → higher disposable income → ∆Y

higher
= [−MPC/(1−MPC)]
C × ∆T

■ Real-life example: COVID stimulus packages (e.g., India's PMGKP scheme) are examples of G↑ —
the government spent more to shift the IS curve right and boost income.
3. The LM Curve — Money Market
The LM curve stands for Liquidity preference = Money supply. It shows every combination of interest
rate (r) and income (Y) where the money market is in equilibrium — meaning people are happy with
how much cash they hold.

3.1 Keynes' Theory of Liquidity Preference

Keynes asked: Why do people hold money (cash) when they could earn interest by holding bonds?
He identified two reasons:

Type of Demand Symbol Why it Exists What Drives It Formula

Need cash for daily purchasesRises with income (Y)

Transactions Demand m■ m■ = kY
(buying food, paying rent, etc.)More income = more spending = more cash needed

People may hold cash instead Falls

of with interest rate (r)
Speculative Demand msp bonds if they expect bond prices msp = m■sp − f(r)
Higher r = bonds give better return
to fall (interest rates to rise) = less reason to hold cash

Total Money Demand:

(M/P)■ = L(r, Y) = kY + m■sp − f(r)

Money Market Equilibrium:

M■/P■ = L(r, Y)

M/P = Real Money Balances. This is the actual purchasing power of money supply, adjusted for
prices. In the short run, prices (P) are fixed, so changes in nominal money supply (M) directly change
real money balances.

3.2 Why the LM Curve Slopes UPWARD

Here's the chain of logic:

Step What Happens Direction

① Income rises: Y↑ Y↑

② People need more cash for transactions (buy more things): m■↑ Money Demand↑

③ Money supply is FIXED → excess demand for money Shortage of money

④ People try to get cash by selling bonds → bond prices fall

⑤ Falling bond prices = rising interest rates: r↑ r↑

⑥ Higher r reduces speculative demand → new equilibrium Balance restored

Result: Higher Y → Higher r. Therefore the LM curve slopes UPWARD. Every point on the LM
curve = money market equilibrium at that income level.

3.3 LM Curve Diagrams

Left panel: When income rises from Y■ to Y■, the money demand curve shifts RIGHT. With money
supply fixed (vertical line), the equilibrium interest rate rises from r■ to r■. Right panel: Plotting all
such (Y, r) pairs gives the upward-sloping LM curve.

3.4 Four Quadrant LM Derivation (from your class notes)

Reading the four quadrant LM diagram: Quadrant A (bottom right) → Speculative demand curve:
higher r reduces msp. Quadrant B (top right) → Money supply allocation: fixed total ms splits between
mt and msp. Quadrant C (top left) → Transactions demand: higher Y needs more mt. Quadrant D
(bottom left) → LM Curve: combining all, plots r vs Y.

3.5 LM Curve Algebra

At equilibrium: Ms = kY + m■sp − f(r)

Solving for Y: Y = (1/k) × [Ms − m■sp + f(r)]

Monetary Policy Multiplier: ∆Y/∆Ms = 1/k

Solved Numerical — LM Curve (Problem 2 from notes)

Given: Ms = 400, m■ = 0.25Y, msp = 100 − 4r

Step Working

Equilibrium: md = ms0.25Y + 100 − 4r = 400

Collect terms 0.25Y = 300 + 4r

Solve for Y Y = (300 + 4r)/0.25 → Y = 1200 + 16r ■ LM Curve

Meaning: When r = 0%, Y = 1200. When r = 10%, Y = 1200 + 160 = 1360. Every 1% rise in interest
rate corresponds to 16 units more income. (LM slopes upward — confirmed!)

3.6 Shifts in the LM Curve (Monetary Policy)

Change LM Curve Shifts Why

Money Supply↑ (RBI prints more money)

RIGHT / DOWN Excess supply → r falls at each Y level → lower LM
Money Supply↓ (RBI contracts money)
LEFT / UP Excess demand → r rises at each Y level → higher LM

Transactions demand↑
LEFT / UP More money needed for transactions → r must rise
(e.g., credit card fraud → use more cash)

Transactions demand↓ RIGHT / DOWN Less cash needed → r can fall

■ Your class exercise: Credit card fraud → people use more cash → transactions demand rises → at
same income Y, demand for money > supply → interest rate rises → LM curve shifts LEFT/UPWARD.
4. IS-LM Equilibrium — Both Markets Together
The economy reaches simultaneous equilibrium when both goods market AND money market are
in balance at the same time. This happens at the intersection of the IS and LM curves, giving us the
unique equilibrium pair (Y*, r*).

Understanding the Four Zones around Equilibrium:

Zone (location relative to curves)
Goods Market Money Market What happens next

Right of IS, Right of LM Excess Supply: Y > C+I+G

Excess Demand: md > ms
Income falls, Interest rate rises
(like Space 1) → S > I+G

Right of IS, Left of LM

Excess Supply: Y > C+I+GExcess Supply: ms > md
Income falls, Interest rate falls
(like Space 2)

Left of IS, Left of LM

Excess Demand: Y < C+I+G
Excess Demand: md > ms
Income rises, Interest rate rises
(like Space 3)

Left of IS, Right of LM

Excess Demand: Y < C+I+G
Excess Supply: ms > md
Income rises, Interest rate falls
(like Space 4)

■ Key insight: No matter which zone the economy starts in, forces in both markets automatically
push it toward the equilibrium point E*. This is called the self-correcting mechanism of the
IS-LM model.

Solved Numerical — Simultaneous Equilibrium (Problem 3)

Given: C = 100+0.75Y, I = 250−5r, Ms = 280, md = 0.25Y − 2r

Working

Y = 1400 − 20r
IS Curve (from earlier)
LM Curve 0.25Y − 2r = 280 → Y = 1120 + 8r

Set IS = LM 1400 − 20r = 1120 + 8r

Solve for r 280 = 28r → r* = 10%

Substitute r* into IS Y* = 1400 − 20(10) = 1400 − 200 = 1200

Answer Equilibrium: Y* = 1200, r* = 10% ■

What this means: At income = 1200 and interest rate = 10%, both the goods market (businesses
produce what people want to buy) AND the money market (people hold exactly as much cash as is
available) are in balance at the same time.
5. Fiscal Policy & the Crowding Out Effect
Fiscal policy = government decisions on spending (G) and taxes (T). It works through the goods
market and shifts the IS curve.

5.1 How Government Spending (∆G) Works

Step What Happens Effect

① Government increases spending by ∆G IS curve shifts RIGHT by [1/(1−b)] × ∆G

② At old r, income would rise by full multiplier to Y' (point E') Expected ∆Y = multiplier × ∆G

③ But higher income → more transactions demand for money md↑

④ Money market excess demand → interest rate rises: r↑ r: r■ → r■

⑤ Higher r → private investment falls (crowding out) I↓

⑥ Income rises less than expected — only to Y■ (not Y') Actual ∆Y < expected ∆Y

5.2 Crowding Out Effect

Crowding out occurs when government spending pushes up the interest rate, which then reduces
private investment — partially cancelling out the effect of the fiscal expansion.

Crowding Out = Y' − Y■ (the income we expected to reach but didn't, because r rose)

Full Multiplier Effect would give: income rises from Y■ to Y' (if r stayed constant)
Actual Effect gives: income only rises from Y■ to Y■ (because r rose and killed some I)
Crowding Out Amount: Y' − Y■ (the difference = private investment that was 'crowded out' by
the higher r)
 ■■ Real-world example: During India's infrastructure push, if the government heavily borrows to fund
highways (G↑), it competes with private firms for loans → interest rates rise → some private firms
cancel their own investment plans. That's crowding out.

5.3 How Tax Changes (∆T) Work

An increase in taxes works differently — it affects consumption (C) first:

T↑ → Disposable income (Y−T) falls → Consumption C falls

Lower C → lower PE → IS curve shifts LEFT by [−MPC/(1−MPC)] × ∆T
Income falls from Y■ to Y■, interest rate falls from r■ to r■
Lower r → some investment recovery → actual fall in Y is LESS than the tax multiplier alone
This is the reverse of crowding out — falling r partially offsets the income fall

Tax Multiplier = −MPC/(1−MPC). The negative sign means income moves OPPOSITE to taxes: taxes
up → income down. The absolute value is smaller than the govt spending multiplier [1/(1−MPC)]
because part of a tax cut is saved, not spent.
6. Monetary Policy & the LM Shift
Monetary policy = central bank (RBI in India) decisions on money supply. It works through the
money market and shifts the LM curve.

How an Increase in Money Supply Works (Monetary Transmission Process):

Step What Happens Effect

① RBI increases money supply: Ms↑ LM curve shifts RIGHT/DOWN

② At old income Y■, people now hold excess cash (more than they
ms >want)
md

③ People try to get rid of excess cash by buying bonds → bondBond

pricesdemand↑
rise

④ Rising bond prices = falling interest rates: r↓ r: r■ → r■ (falls)

⑤ Lower r makes borrowing cheaper → firms invest more: I↑ I↑

⑥ More investment → higher planned spending → income rises:Y:Y↑

Y■ → Y■

This chain — ∆Ms → ∆r → ∆I → ∆Y — is called the Monetary Transmission Process. It is the

mechanism by which monetary policy affects the real economy.
 7. Effectiveness of Fiscal & Monetary Policy
How effective each policy is depends on the shape (elasticity) of the LM curve. The LM curve has
three distinct regions:

Range LM Shape Elasticity What it Means Fiscal Policy Monetary Policy

Keynesian Range ■ Fully Effective ■ Completely Ineffective

Horizontal (flat) Infinite (∞) Speculative demand is infinite. Everyone holds cash, expecting r to rise. No bond b
(Liquidity Trap) (Zero crowding out) (Liquidity trap)

■ Partially effective
Intermediate Range Upward sloping Positive (>0) ■ Partially
Normal realistic situation. Both transactions and speculative demandeffective
exist.
(Some crowding out)

■ Completely Ineffective
Classical Range Vertical Zero (0) Speculative demand is zero. Everyone holds bonds only. ■
Money
Fully is
Effective
only used for tra
(Full crowding out)

Detailed Explanation of Each Range:

■ Keynesian Range (Liquidity Trap)
Interest rate is at a very LOW level (floor). Nobody expects it to fall further.
Everyone expects r to RISE in future → everyone holds only cash, nobody buys bonds
Speculative demand for money = INFINITE → LM is horizontal
Fiscal Policy: Government spends more → IS shifts right → income rises by FULL multiplier.
Why? Because r cannot fall (already at floor), so there is ZERO crowding out. Private investment
is NOT reduced. Fiscal policy is 100% effective.
 Monetary Policy: RBI prints money → extra money enters economy → but everyone is already
willing to hold unlimited cash → r does NOT fall → no effect on investment → no effect on Y. The
extra money is 'trapped in liquidity.' Monetary policy FAILS completely.

■ Historical example: Japan in the 1990s and the US in 2008 experienced near-zero interest rates
where monetary policy lost effectiveness. This is the real-world liquidity trap.

■ Classical Range
Interest rate is at a very HIGH level. Speculative demand = 0 (everyone holds bonds).
Money is demanded ONLY for transactions: md = kY
LM is VERTICAL → money supply directly determines income
Fiscal Policy: G↑ → IS shifts right → r rises sharply (because LM is vertical) → private
investment falls by EXACTLY the amount G rose. Net effect on Y = ZERO. Full crowding out.
Fiscal policy is completely INEFFECTIVE.
Monetary Policy: Ms↑ → excess money → people buy bonds → r falls → I rises → Y rises.
Works perfectly. Monetary policy is 100% effective.

■ Intermediate Range (Most Realistic)

This is the normal everyday situation in real economies.
Both transactions and speculative demand exist.
Fiscal policy is partially effective — income does rise, but less than the full multiplier because r
rises somewhat (partial crowding out).
Monetary policy is partially effective — Ms↑ → r falls → I rises → Y rises, but not to the full
possible extent.
Policy makers typically operate in this range — both fiscal and monetary policy matter, and a
combination (policy mix) often works best.

Effect of IS Curve Elasticity on Monetary Policy:

IS Curve Type Effect of Monetary Expansion Why

Elastic IS curve
a lot) r falls, investment jumps up sharply → big rise in PE → big r
Large increase in income (Y rises When
(investment responds strongly to r)

Inelastic IS curve
Small increase in income (Y rises Even though r falls, investment doesn't respond much → smaller r
a little)
(investment barely responds to r)

8. Full Worked Example — Three Sector (Problem 4)

This problem from the slides combines everything. Work through it carefully.

Given Value

Consumption function C = 100 + 0.8Yd (where Yd = Y−T = disposable income)

Investment function I = 120 − 5r

Government spending G = 50

Taxes T = 50
Money demand md = 0.2Y − 25r

Money supply Ms = 240

Price level P=2

Part A — Derive IS and LM Curves:

Part Working

IS: Y = C+I+G Y = 100+0.8(Y−50)+120−5r+50

Expand Y = 100+0.8Y−40+120−5r+50

Collect Y Y−0.8Y = 230−5r → 0.2Y = 230−5r

IS Curve ■ Y = 1150 − 25r

Real Ms = Nominal Ms / P Real Ms = 240/2 = 120

LM: md = ms 0.2Y − 25r = 120

LM Curve ■ Y = 600 + 125r

Part B — Find Equilibrium (Y* and r*):

Step Working

Set IS = LM 1150 − 25r = 600 + 125r

Solve for r 550 = 150r → r* = 550/150 ≈ 3.67%

Find Y* Y* = 1150 − 25(3.67) ≈ 1150 − 91.7 ≈ 1058

Equilibrium ■ r* ≈ 3.67%, Y* ≈ 1058

Part C — New Equilibrium after ∆G = +50:

New G = 100. Rederive IS:

Step Working

New IS: Y = C+I+G Y = 100+0.8(Y−50)+120−5r+100

New IS Curve ■ Y = 1250 − 25r (shifted right by 100 units = [1/(1−0.8)]×50)

Set new IS = LM 1250 − 25r = 600 + 125r → 650 = 150r → r* = 4.33%

New Y* Y* = 1250 − 25(4.33) ≈ 1250 − 108.3 ≈ 1142

New Equilibrium ■ r* ≈ 4.33%, Y* ≈ 1142

Part D — Crowding Out:

Calculation Value

Full multiplier shift of IS (no LM[1/(1−0.8)]

effect) × 50 = 5 × 50 250
Actual increase in Y Y*_new − Y*_old = 1142 − 1058 84

Crowding Out Amount 250 − 84 166

Rise in interest rate r*_new − r*_old = 4.33 − 3.67 0.67%

Interpretation: The government spent ■50 more. This should have boosted income by 250 (via
multiplier). But the interest rate rose from 3.67% to 4.33%, which reduced private investment. So actual
income only rose by 84. The 'lost' 166 = crowding out.
 9. Quick Reference & Memory Tables
IS vs LM — Side by Side Comparison:
Feature IS Curve LM Curve

Represents Goods Market Money Market

Equilibrium condition I = S (or Y = C+I+G) md = ms (or M/P = L(r,Y))

Slope Downward (negative) Upward (positive)

Reason for slope ↑r → ↓I → ↓Y ↑Y → ↑md → ↑r

Shifts Right when G↑, T↓, autonomous I↑, C↑ Ms↑, md↓

Shifts Left when G↓, T↑, autonomous I↓, C↓ Ms↓, md↑

Policy that shifts it Fiscal Policy Monetary Policy

All Key Formulas:

Formula What it is Notes

I = ■ − cr Investment function c = interest sensitivity; r↑ → I↓

Y = [1/(1−b)](C■+■−cr) IS Curve (2-sector) b = MPC

Y = [1/(1−b)](C■−bT+■−cr+G) IS Curve (3-sector, lump-sum T) Includes government

Y = [1/(1−b(1−t))](C■+■−cr+G) IS Curve (3-sector, income tax t) t = tax rate

(M/P)■ = L(r,Y) = kY−f(r) Money demand function k = transaction sensitivity

Y = (1/k)(Ms−m■sp+f(r)) LM Curve Monetary policy multiplier = 1/k

∆Y = [1/(1−MPC)]×∆G Govt spending multiplier How much Y rises per ∆G

∆Y = [−MPC/(1−MPC)]×∆T Tax multiplier Negative: T↑ → Y↓

Crowding Out = Y'−Y■ Crowding out amount Y' = expected Y, Y■ = actual Y

Policy Effectiveness Cheat Sheet:

Scenario Fiscal Policy Works? Monetary Policy Works?

Liquidity Trap (LM horizontal) ■ YES — fully effective, no crowding out ■ NO — money trapped

Classical Range (LM vertical) ■ NO — full crowding out ■ YES — fully effective

Intermediate Range (normal) ■ Partially effective ■ Partially effective

Elastic IS curve Less affected by interest rate changes Very effective

Inelastic IS curve (I unresponsive to r)More effective (less crowding out) Very limited effect

IS-LM Master Notes | Module 6 | Compiled from Lecture Slides + Handwritten Class Notes