Internal and External Equilibrium in the IS-LM-BP Model, Equilibrium in the Commodity Market: IS Curve - International Economics

The internal and external equilibrium in the IS-LM-BP model

In the Keynesian model discussed above, the "earnings - expenses" money played virtually no role, in particular the banking interest rate, established on the money market, regardless of the equilibrium in the market of goods and services, was for this model an exogenous variable. At the same time, the interaction between the markets of goods and money is obvious: changes in the volumes of national production directly affect the demand for monetary assets, while the fluctuations in the banking interest rate - for the volume of aggregate expenditures and, first of all, for their investment component.

The interrelation and interdependence of the commodity and money markets can be analyzed within the framework of the IS-LM double equilibrium model, proposed in 1937 by the English economist, Nobel Prize winner Sir John Hicks, the most prominent representative of the Keynesian economic school. In particular, the IS curve simulates the situation in the commodity market, and LM - in the money market.

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Since the interest rate affects both the volume of investment and the demand for money, this variable allows you to link the markets of goods and money. It is very important that it is through this link that the supply of money affects the national income and trade balance.

Equilibrium in the commodity market: IS curve

Let's describe the logic of constructing the curve IS, using as a basis the Keynesian model "income-expenses", removing the extremely simplifying assumption of a fixed level of planned investments, since in reality the planned investments depend on the interest rate i : I = I ( i ). This function is shown in Fig. 6.8, a. Since the interest rate is the cost of obtaining a loan to finance investment projects, the growth of the interest rate reduces the amount of planned investments.

In turn, the reduction in planned investments shifts the function of aggregate spending downward (Figure 6.8, b). The shift in the function of total expenditure leads to a lower level of income. The increase in the interest rate reduces the income from the value of Y1 to the level of Y2, and the IS curve specifies the important relationship between the interest rate and the equilibrium level of income. The IS curve is the locus of points of all combinations of the interest rate i and the national income Y that hold the market of goods and services in equilibrium, i.e. those combinations i and y that satisfy the identity

I + X = S + M.

Model IS - equilibrium in the commodity market: a - the function of investment; 6 - the model

Fig. 6.8. Model IS - equilibrium in the commodity market: a - the function of investment; 6 is the revenue-expense model; in is the curve IS

The concept of IS function plays a special role in macroeconomic analysis, since the output volume always tends to correspond to any point on the curve, since only at such points the equilibrium condition in the commodity market is observed.

To better understand the meaning of the IS function, consider points that do not lie on its graph (see Figure 6.9).

Obviously, point A3 is characterized by an excess of the level of expenditure (demand) over the corresponding level of output (supply) of the national product. The same A4 corresponds to another kind of disequilibrium state of the economic system - the excessive supply of goods and services. Consequently, for points below (to the left) of IS curve, excessive demand for goods and services is characteristic, and for points lying higher (to the right), their excessive supply.

If the state of the economic system is determined by the point A4, excessive demand in the commodity market leads to an unplanned decrease in stocks, which implies an increase in output and a shift in the point corresponding to the current state of the economy towards the IS line.

Excess supply and excess demand in the commodity market

Fig. 6.9. Excessive supply and excess demand in the commodity market

In the state of the economy corresponding to point A4, the excess supply leads to an unplanned accumulation of commodity stocks. As a result, output is reduced, and the economic system in Fig. 6.9 is also shifted towards the IS curve.

It is also easy to see that IS curve is less elastic than, firstly, investment costs are less sensitive to interest rate changes and, secondly, the less the multiplier of expenses of a specific economic system.

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A shift in the IS curve can occur when all factors other than the interest rate change:

- the level of autonomous consumer spending;

- the level of public procurement;

- net taxes;

- change in investment volumes (at an existing interest rate).

Let's analyze, for example, the effect of changing investment plans of entrepreneurs: the growth of optimism at a fixed rate of interest. This will lead to a shift in the investment demand curve Id, and hence to the shift in the aggregate expenditure line, followed by the shift of the IS curve (Figure 6.10).

Shift of the IS curve with changing investment demand

Fig. 6.10. Shifting the curve IS with a change in investment demand

Considering the problem of macroeconomic equilibrium, it should be noted that the IS function, modeling the equilibrium in the commodity market, does not allow to uniquely determine the only equilibrium level of national production. Although the IS function indicates to which value the aggregate output volume should strive at each level of interest rates, it can not be determined until the value of the interest rate itself is known. To justify the equilibrium interest rate, it is also necessary to consider the money market model, and then combine both models.

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