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Q1) Define and derive the IS-LM model. More specifically, how we obtain the IS-LM equilibrium? Please...

Q1) Define and derive the IS-LM model. More specifically, how we obtain the IS-LM equilibrium? Please explain every step-in detail

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Answer #1

IS-LM model focuses on goods and money market equilibrium which shows relationship between rate of interest and output level.

Derivation of IS curve: In an closed economy, production of goods is equal to demand in an economy.

Output = Consumption + Investment + Government Spending

Investment is dependent on interest rate and have negative relationship with each other. Rise in rate of interest reduces the level of output production which dervies Investment - Saving (IS) curve which is downward sloping.

Derivation of LM curve: It shows relationship between liquidity and money. As there is equilibrium in money market occurs when money demand equals money supply where money supply is fixed and money demand rises when output rises. Money market shows a positive relationship between rate of interest and output level.  

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