Outline the joint determination of the level of income and the rate of interest by the demand side o

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Outline the joint determination of the level of income and the rate of interest by the demand side o

 

One way to explain the determination of the level of income and the rate of interest is IS/LM analysis.  IS/LM analysis is designed to show the relationship between output and income, the rate of interest, the goods market, and the money market.  The IS curve represents all the points at which investment is equal to saving, i.e. all the points at which the goods market is in equilibrium.  The LM curve likewise represents all the points where money supply is equal to money demand, i.e. all the points at which the money market is in equilibrium.  When these two curves are plotted together on a graph of output/income and rates of interest, it can be seen that there is an equilibrium point of both goods and money markets together, and that there is therefore a relationship between income and rates of interest, determined by the point of equilibrium between the goods and money markets.

 

The IS schedule is derived by first drawing a normal graph of aggregate demand, as shown below.  We know that a change in interest rates will affect the height of the aggregate demand curve, since interest rates affect investment.  With a lower rate of interest, the aggregate demand schedule will be higher, and with a higher rate of interest the aggregate demand schedule will be lower.  Knowing this, it is possible to plot an aggregate demand curve for any given rate of interest, and show the different equilibrium points.  Several aggregate demand curves are shown on the graph below.

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Since we know the rate of interest which produced the aggregate demands curves AD0, AD1 and AD2, we also know the rates of interest which produced the incomes E0, E1 and E2.  We can therefore plot rates of interest against income, which will give us the IS schedule shown below.

 


 

The LM curve is similarly derived, beginning from a graph of the money demand schedule.  We know that for any given level of income there will be a certain amount of money demand, which will depend on the interest rate.  A change in the ...

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