University of the People
Bus 2203- Principles of Finance
Name: Jeremy Greaves
Instructor: Ms. Liuyi Pan
Date: 22nd October, 2025
IS-LM Functions
We are going to assess the IS-LM for a given economy. And analyze impact of an increase
investment , and then we will examine market behavior in each of the four quadrants stated by the four
quadrant defined by the IS-LM (Wright & Quadrani, 2009, pp. 435-452).
Providing Information:
a) We are now going to build the IS-LM function:
- First we have to find the IS Curve. The IS curve represents equilibrium in the goods market. It is
derived by equating aggregate demand (AD) with aggregate supply (AS), by presuming that
aggregate supply is determined by income (Y) (Wright & Quadrini, 2009, Chap: 21, pp. 435-452).
Now, in this scenario:
AD = C + 1 = 1p = 100 + 0.4Y + 100 – 20r = 200 + 0.5Y -20r. If a simple Keynesian model is,
AS = Y, then AS equation would be:
Y = 200 + 0.5Y – 20 r => 0.5Y = 0.5Y = 200 – 20r => Y = 400 – 40r
- Finding the derivation of the LM Curve: The LM curve represents the equilibrium in the money
market. It equates money demand (MD) with money (MS) (Wright & Quadrini, 2009, chap: 21).
Also, we are given two measures M1 an M5, which implies different levels of liquidity preference.
Assuming that MD = M1 = 0.10Y, the money supply will be MS = 80. Therefore, the LM equation
is:
0.10Y = 80 =Y = 800
- Giving the IS-LM System: The IS-LM system is defined by the simultaneous solution of the IS and
LM equation (
IS: Y = 400 – 40r
LM: Y = 800
Moreover, this model shows a vertical LM curve due to the assumption of a fixed money supply and
money demand function, independent of the interest rate. In a more realistic model, the LM curve
would be upward sloping.
b. We will now look at the Impact of an Investment Increase (Terim & Vines, 2014, pp. 53-64):
- Assessing IS Curve: An increase in investment by 100 units shifts the IS curve to the
right, and the investment function becomes IP = 200 – 20r. Therefore the new Ad IS 300 + 0.5y –
20R. Equating this to AS (Y), and we will attain the new IS equation:
- Y = 300 + 0.5Y – 20r => 0.5Y =Y = 300 – 20r => Y = 600 – 40r
- The LM curve Remains Unchanged: The LM curve remains unchanged at Y = 800, because the
money supply and money demand are unaffected by the investment increase.
- The New IS-LM System: The new IS-LM system is:
. IS: Y = 600 – 40r
. LM: Y = 800
c. The Analysis of the Four Quadrants:
The Analysis of the IS and LM curve divides the Y-r plane into four quadrants (Findlay, 1999, 30(4).
Therefore, the simplified model which has a vertical LM, only two quadrants have economic value.
1. For Quadrant 1 (Y > 800, r > the interest at the intersection): In this Area, the money market is in
excess demand (MD > MS, thus pushing interest rates upwards. Concurrently, the goods market is in
excess supply (Y > AD), which lead to a decrease in output. Such pressures will push the economy
towards equilibrium towards.
2. For Quadrant 2 (Y < 800, r > the interest at the intersection): In this area, it represents excess money
supply (MS > MD), and the excess demand for goods (AD > Y). As a result, excess money supply
will push interest rates down.
3. For Quadrant 3 and 4 (Y < 800, r < the interest at the intersection); Y > 800, r < the interest rate at
the intersection): These quadrants are not economically meaningful in this simplified model having a
vertical LM curve, but they would be more relevant in a model with a positive slope at LM.
To summarize, the IS LM model provides a framework to understand the interaction between the goods
and the money market. Also the equilibrium point is where both markets clear, and any deviation from
this equilibrium can trigger adjustment mechanisms in output and interest rates, which push the
economy back towards the intersection of the IS and LM curves (Wright & Quadrini, 2009, pp.435-
452).
References: Wright, R E., & Quadrini, V. (2009). Money Banking, pp. 435-452. Saylor Foundation.
[Link] site/textbooks/Money%20and%[Link]
Temin, P., Vines, D. (2014). Keynes Useful Economics for the World Economy. The Mit Press, pp. 53-
64. [Link] /stable/jctt9qfb39.9.
Findlay, D W. (1999) Is there a Connection between Slopes and the Effectiveness of Fiscal and
Monetary Policy. The Journal of economic Education, 30(4), pp. 373-382.