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Modern Theory of Interest (or) IS-LM Model in Closed Economy

This theory integrates Money, Interest and income into a general equilibrium model. Hicks and Hanson diagrammaticframe work known as IS-LM model. The term IS is the equality of I and S which represents product market equilibrium. On the other hand the term LM of the equality of Money Demand (L) and Money Supply (M) represents money market equilibrium. In order to analyse the general equilibrium of product and money markets the study of IS-LM functions is an important one. Derivation of IS Curve: The derivation of the IS Curve shown in Fig in Panel (A) of this fig, the saving curve S in relation to Income is drawn in a fixed position on the Keynesian assumption that the rate of interest has a little effect on Saving. The saving curve shows that saving increases as Income Increases, so S = f (Y): I = f (Y, R) so if R remain constant Y increases and I also increases.

Derivation LM Curve: The LM curve shows all combinations of interest rate and levels of income at which the DM and SM are equal. In other words, the LM schedule shows the combinations of interest rates and levels of income. Where the DM (L) and SM (M) are equal such that the money market equilibrium.

Schedule in part C of the diagram represents Td for Money, assuming demand to be proportional to Y. the schedule B is simply an identity line that mechanically divides the total MS into Td & Sd components. Schedule D is the LM curve. Beganing A with a known interest r, the volume of Sd is L2. Given the total MS, that potion not held as speculative balances must be held in transaction balances (T1) as shown in B. the schedule C shows that level of real income (Y1) must prevail in order to get the public to willingly absorb the money available for TD in that form. Thus, as we see in D for interest rate r, the only possible money market equilibrium volume of Y is Y1. Now we study how these markets are brought into simulateneous equilibrium. It is only when the equilibrium pairs of interest rates and income of the IS Curve equal the pairs of interest rate & Income levels of the LM curve that the general equilibrium is established. If there is any deviation from equilibrium certain forces will act and react in such a manner that the equilibrium will be restored.

If at A point on the LM Curve, where money market is in equilibrium but product market is not in equilibrium. Product market will be at equilibrium at point B. so at point A rate of interest is R2 so there is excess of investment over savings since point A lies to the left of IS Curve. So the excess investment over savings indicates excess demand for goods which raises the Y. As the level of income raises, the need for TM people sell bonds. This tend to raise interest rate. This moves the LM equilibrium from point A to point E.

Derivation of LM Curve: The LM Curve is the locus of all those various combinations of the aggregate money income and the rate of interest at which the money market is in equilibrium (MS=MD). Each point located on the LM Curve shows a particular money income and the rate of interest against his income as which the total demand for money equals to total supply of money. Given a family of demand curves for money and the money supply, the LM Curve can be easily derived.

L1 (Y,R), L2 (Y,R) etc curves shows total amount of money demand at different money incomes and rates of interest. Assumption is money supply is insensitive to changes in rate of interest.

At corresponding to each such pair of money income and rate of interest the demand for money and supply of money are in equilibrium. Plotting these different equilibrium money income and interest rate pairs on the graph paper gives the LM Curve. The LM Curve positively sloping showing that with the fixed money supply and the increase in income, equilibrium in the money market is possible only through an increase in the rate of interest. Y Y1=100 Y2=200 Y3=300 Y4=400 r% 2 3 6 8 DM(M1+M2) 200 200 200 200 M 200 200 200 200