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

 
8.0 OBJECTIVES 
 
The model of aggregate demand developed in this unit, called 
the IS 
– LM model, is the leading interpretation of Keynes‘s 
theory. The objective of the model is to show what determines 
national income for a given price level. 
To find the values of the interest rate and income with 
simultaneous equilibrium in both the goods market and the 
money market. Initially we identify combinations of income and 
the interest rate that are equilibrium values for the goods 
market. Next we identify combinations of income and the 
interest rate that equilibrate the money market. These two sets 
of equilibrium combinations of interest rate and income levels 
are then shown to obtain one combination that equilibrate both 
markets. 
To study two markets 
– the goods market and the money 
market 
– and their linkage through two macroeconomic 
variables namely interest rate and income.
8.1 INTRODUCTION 

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The first things we do in this unit is to introduce the interest 
rate into the goods market (via investment demand), leaving us with 
one market and two macroeconomic variables, GDP (Y) and the 
interest rate (i). We will call the goods market equation the IS curve. 
Next we introduce the money market, where equilibrium is 
determined when the demand for money equals the supply of 
money. The demand for money depends on income and interest 
rates. The supply of money is determined by the central bank (RBI). 
Solving for equilibrium in the money market again gives us one 
market and two macroeconomic variables, GDP (Y) and the interest 
rate (i). We will call the money market equation the LM curve. 
Finally, we put the goods and money markets together, 
giving us two markets (goods and money) and two variables (GDP 
and the interest rate). The IS 
– LM model finds the values of GDP 
and the interest rate which simultaneously clear the goods and 
money markets. 
We use figure 8.1 to explain the structure of this unit. We 
begin in section 8.2.1 with a discussion of goods market equilibrium 
where we derive a key relationship 
– the IS curve – that shows 
combinations of interest rates and levels of income for which the 
goods market clear. In section 8.2.2, we turn to the assets markets 
and in particular to the money market. We show that the demand 
for money depends on interest rates and income and that there are 
combinations of interest rates and income levels 
– the LM curve – 
for which the money market clears. In section 8.2.3, we combine 
the two schedules to study the joint determination of interest rates 
and income.
In section 8.3 we show how monetary and fiscal policy work. 
These are the two main macroeconomic policy tools that the 
government can use to keep the economy at a reasonable rate, 
with low inflation. In sections 8.3.1 and 8.3.2 we use the IS 
– LM 
model to analyse the effects of policy actions on income and the 
interest rate. Equilibrium levels of income and the interest rate are 
given by the intersection of the IS and LM curves. The factors that 
change these equilibrium levels are those that shift either the IS or 
the LM curve. In section 8.3.3, we see how such shifts affect 
income and the interest rate when we consider the two schedules 
jointly i.e. Fiscal Policy and Crowding out Effect. In section 8.3.4, 
we wee how the magnitude of the effects of different policies 
depends on the slopes of the IS and LM curves i.e. Monetary 
Accommodation and Policy Mix. 

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