Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

8.2 THE IS 
– LM MODEL 
The IS 
– LM model emphasizes the interaction between the 
goods and assets markets. The IS 
–LM model is at the core of 
modern macro economics. It is an extension of Keynesian analysis 
on equilibrium income and output. The interaction between goods 
market and assets market is given by the following chart. 
 
 
 
 
 
 
 
 
 
 
 
FIGURE 8.1: STRUCTURE OF THE IS-LM MODEL 
Fiscal policy affects the goods market and the monetary 
policy affects the assets market. The assets market consists of 
money market and the bond market. Money represent non-income 
earning financial assets with 100 % liquidity, bond market represent 
income yielding financial assets. 
The increase in income and output in goods market affects 
the assets market through demand for money (liquidity preference 
is directly related to level of income). This leads to an increase in 
the rate of interest with given supply of money. Increase in interest 
rate lead to fall in the investment demand in goods market. 
Thus the link from goods market to money market is 
through the change in income and from the assets market to the 
goods market is through the change in interest rate.
Assets markets 
Money market Bond market 
Demand 
Supply 
Demand
Supply 
Goods markets 
Aggregate demand 
Output 
Interest rates 
Income 
Monetary 
Policy 
Fiscal Policy 

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Therefore, the aggregate demand, interest rates and income 
jointly determined by the equilibrium in the goods and assets 
markets.