Islm Curve Essay

4213 Words Jan 25th, 2013 17 Pages
Understanding Equilibrium in the IS/LM Model
1995 version

Prof. Humberto Barreto1 Introduction: This brief work is designed to provide additional ammunition for the student in the ongoing war against IS/LM confusion and ignorance. The author has claimed in his Notes on Macroeconomic Theory (1995) that, There should be no mystery or uncertainty surrounding the IS/LM analysis at this point. IS/LM curves are simply a short-cut to finding the equilibrium values for income and interest rate. There are two equations and two unknownsÑwhat simpler strategy than to put them on one graph could be devised? (p. 52) The author still worries, however, that the student is memorizing the equilibrium condition, IS=LM generates Ye, without really
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In economics, most endogenous variables, such as output in a macro model, are usually constrained to be positive; but they can still take on any value from zero to positive infinity. The equilibrium value is one particular valueÑthe one value where the variable has no tendency to change. Any other value is not a state of rest for there are forces within the model that will generate movement to a new value. Step (2): Pick a value and see if it has a tendency to change Figure 1 shows an initial value of i0 and Y0 that's on the IS curve, but not on the LM curve:

i (%) LM i0

IS Y0 Y ($)

Figure 1: An Initial Disequilibrium

3

The student no doubt knows that the i, Y combination depicted in Figure 1 is not the equilibrium combination, but the crucial question is "Why?" To apply the "equilibration process" explanation to this question, we must show how and why the i0, Y0 pair has a tendency to change. In order to do this, we will bring to the front the set of graphs that underlies the IS/LM graph:

i (%) LM i0

IS Y0 Ms i (%) Y ($)

i (%)

$

i0

i0 AD=C+I 0 +G M d 0) (Y M I0 I d I Y0 Y ($)

Figure 2: An Initial Disequilibrium -- The Whole Story

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Look closely at the relationship between the IS/LM graph and the three graphs that compose the IS/LM graph. Being on the IS curve means that we are in equilibrium in the goods market; hence, I was careful to place Y0 on the intersection of the AD and 450 line. However, being

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