The paper "Theoretical Review of IS-LM Model" is a perfect example of a micro and macroeconomic case study. The report covers the theoretical review of the IS-LM model. It covers the introduction, the equilibrium in the money and commodity markets. The impact of the monetary policy instruments such as an increase in money supply on the IS-LM model. Finally, the limitations and conclusion of IS-LM are made. Theoretical review: IS-LM Model Introduction The IS-LM model requires the interaction of the commodity and money markets. The equilibrium in the money market LM is equated to the equilibrium in the goods market to obtain the general equilibrium of the IS-LM model. Equilibrium in the commodity market Investment [I(r) = γ − δ r] depends negatively on interest rates due to present value explanations.
A decrease in interest rates results to a rise in investment which in turn causes a multiple expansion in income. In the commodity market, the Keynesian consumption function is utilized as depicted in equation 1; C(Y, T) = α + β (Y − T) 0 < β < 1, α > 0 (1) T (Y) = ξ + Τ y 0 < τ < 1 (2) I(r) = γ – δ r (3 G=GO (4) The direct government expenditure is treated as an exogenous variable.
The equilibrium in the goods market is obtained by summing up equations 1, 3 and 4 into as shown in equation 5: Y = C(Y, T) + G + I(r) (5) But, C(Y, T) = α + β (Y − T) = α + β (Y - ξ – Τ y) And I(r) = γ – δ r Therefore, Y = α + β (Y - ξ – Τ y) + G + γ − δ r Making Y the subject; Y = α / (1− β ) - β ξ /(1− β ) – β Τ y/(1− β ) + G/(1− β ) + γ /(1− β ) − δ r/(1− β ) (6) Where; Y, C, T, G, r and I are income, consumption, tax, government expenditure, official interest rate and investment, respectively.
γ , α , δ and β parameters representing the autonomous investment, autonomous consumption, induced investment and marginal propensity to consume, respectively. Graphical depiction of the IS Curve Figure 1.4 IS curve graphical depiction. The slope of the IS curve depicts the impact of the rate of interest on an investment that results in a multiplier effect which increases income.
The location of the IS curve changes depending on the components of the aggregate demand such as autonomous investment, marginal propensity to consume or fiscal policy.
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