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📈 The IS-LM Framework & Goods-Money Balance ​

Developed by John Hicks (1937) to formalize Keynes' General Theory, the IS-LM model determines simultaneous short-run equilibrium output (Y) and interest rates (i) by integrating the Goods Market (IS: Investment-Saving) with the Money/Financial Assets Market (LM: Liquidity Preference-Money Supply).


1. 📦 The IS Curve (Goods Market Equilibrium) ​

The IS curve represents combinations of (Y,i) where goods market demand equals aggregate supply:

Y=C(Y−T)+I(i)+G

Assuming linear specifications:

C=C0+c1(Y−T),I=I0−d1iY=C0+c1Y−c1T+I0−d1i+GY(1−c1)=A0−d1i⟹Y=A01−c1−d11−c1iwhere A0=C0−c1T+I0+G

1.1 Properties of the IS Curve ​

  • Slope: Downward-sloping (didY=−1−c1d1<0). A higher interest rate raises the cost of borrowing, depressing business investment I(i) and aggregate demand.
  • Shifts: Autonomous increases in government spending (ΔG>0), tax cuts (ΔT<0), or consumer/business confidence shift the IS curve rightward by ΔY=11−c1ΔG.

2. 💵 The LM Curve (Money Market Equilibrium) ​

The LM curve represents combinations of (Y,i) where real money supply equals real money demand (Liquidity Preference):

MsP=L(Y,i)=kY−hi(k>0,h>0)

Solving for interest rate i:

i=khY−1hMsP

2.1 Properties of the LM Curve ​

  • Slope: Upward-sloping (didY=kh>0). Higher income Y increases transaction demand for money; with fixed money supply M/P, the interest rate must rise to clear the money market.
  • Shifts: An increase in real money supply (ΔM>0) shifts the LM curve rightward/downward by ΔY=1kΔ(M/P).

3. ⚡ General Equilibrium & Policy Interventions ​

  Interest Rate (i)
    ▲                                    LM
    │                                   /
    │                   IS             /
 i* │────────────────────•────────────/
    │                   / \          /
    │                  /   \        /
    │                 /     \      /
    │                /       \    /
    └───────────────┴─────────┴──┴────────► Real Output (Y)
                   Y*

3.1 Fiscal Expansion & Crowding Out ​

When government increases expenditure (ΔG>0), IS shifts right. Output expands to Y1, which raises money demand, driving up interest rates from i0 to i1. The higher interest rate crowds out private investment:

Crowding-Out Effect=I(i0)−I(i1)>0
Policy Regime              LM Slope            Fiscal Multiplier          Crowding Out %
────────────────────────────────────────────────────────────────────────────────────────
Classical Case             Vertical (h → 0)    k_G = 0                    100% (Complete)
Intermediate Normal Case   Upward-sloping      0 < k_G < 1/(1-c_1)        Partial
Liquidity Trap / ZLB       Horizontal (h → ∞)  k_G = 1/(1-c_1)            0% (Zero!)

4. 🎯 Olympiad-Level Worked Master Problem ​

Master Problem: IS-LM Mathematical Equilibrium

Problem: An economy is described by the following structural equations:

  • Goods Market: C=200+0.8(Y−T), I=400−2000i, G=300, T=250.
  • Money Market: MP=800, L(Y,i)=0.4Y−4000i.
  1. Derive the mathematical equations for the IS and LM curves.
  2. Calculate the general equilibrium output Y∗ and interest rate i∗.
  3. Calculate the degree of investment crowding out if government spending rises to G′=400.

Step-by-Step Rigorous Solution: ​

  1. Derive the IS Equation:

    Y=200+0.8(Y−250)+400−2000i+300=700+0.8Y−2000i0.2Y=700−2000i⟹Y=3500−10000i(IS Curve)
  2. Derive the LM Equation:

    800=0.4Y−4000i⟹0.4Y=800+4000i⟹Y=2000+10000i(LM Curve)
  3. Solve for Equilibrium (Y∗,i∗):

    3500−10000i=2000+10000i⟹20000i=1500⟹i∗=0.075=7.5%Y∗=2000+10000(0.075)=2000+750=$2750

    Baseline Investment: I0=400−2000(0.075)=400−150=$250.

  4. Fiscal Expansion (ΔG=100⟹G′=400): New IS Curve: 0.2Y=800−2000i⟹Y=4000−10000i. Equating with LM:

    4000−10000i=2000+10000i⟹20000i=2000⟹i′=0.10=10.0%Y′=2000+10000(0.10)=$3000

    New Investment: I′=400−2000(0.10)=400−200=$200.

    Private Investment Crowded Out=I0−I′=250−200=$50