Equilibrium in The Commodity Market:
The IS curve shows the equilibrium in the commodity market. and for this it requires that savings (S) and investment (I) must be equal. Now, savings is a function of income [S=¦(Y)], and investment is a function of interest rate [I=¦(r)].
So equilibrium condition: S=I
Now in graph A, an investment demand curve is drawn that shows that investment varies inversely with interest rate. In graph B, as I & S will be equal for equilibrium, a 45° line is drawn to show the relationship. And graph C brings in the savings function, showing that savings vary directly with income.
Now, at r= 8, I=20=S and S=20 when Y=40. So the commodity market will be in equilibrium when r=8 and Y=40. Again, when r=10, I=10=S and =10 when Y=30. So, the commodity market will be in equilibrium at r=10 and Y=30 as I=S. Thus such other combinations can also be formed and by joining all these combinations we can derive the IS curve that shows equilibrium in commodity market at various interest rate and income level.
Equilibrium In The Money Market:
The LM curve shows equilibrium in the money market. For this, it requires that total money demand equals money supply in a economy. Now, according to Keynes, money demand consists of two types of demand; transaction demand, & speculative demand. Now, the transaction demand for money (including precautionary demand) is a direct function of income level and the speculative demand for money is an inverse function of interest rate. That is, m1=¦(Y) and m2=¦(r), where m1=transaction demand and m2=speculative demand.
So, the equilibrium condition for money market is:
L = M;
L=money demand, M=money supply
Now in graph A, the speculative demand for money is shown as a function of interest rate (r). Graph B shows that a total money supply of $30, all of which must be held either in transaction demand or in speculative demand. Thus, m1 & m2 has an inverse relationship. And as transaction demand is a function of income level, their relation is shown in graph C.
Now, at an interest rate of 8%, the total speculative demand for money is $15. And at a given money supply of $30, the transaction demand for money is $15, which shows an income level of $30. Thus the money market is in equilibrium when r=8% & Y=30. Again, when r=10%, m2=$10; so m1=$30-$10=$20 and m1 is $20 when Y=$40. So, the money market will also be in equilibrium when r=10% and Y=$40. Such other combinations can also be formed and by joining these combinations, we can derive the LM curve that shows the money market equilibrium in various interest rate and income level.
Equilibrium Of Commodity & Money Market:
From the derivations of IS and LM curve, we know that equilibrium between S & I is possible at various combinations of r and Y. Similarly, equilibrium between L and M is possible at various combinations of r and Y. However, there is only one combination of Y and r at which both S=I and L=M. This combination is defined by intersection of IS and LM curve.
So, both the commodity market and money market is in equilibrium at the point where IS & LM curves intersects. This situation is called the general equilibrium of goods and money market, as illustrated in the following graph.
Here, general equilibrium occurs when r=5% and Y=100. Every other combination of Y and r is a disequilibria combination. For example, at r=4%, the commodity market is in equilibrium when Y=120. But at Y=120, money market is in disequilibrium, as L>M. So, the excess money demand will drive r down until IS=LM. Thus, the economy will return to equilibrium. Again, let’s say, at r=6%, the money market is in equilibrium when Y=120. But at Y=120, commodity market is in disequilibrium since S>I. This excess of S over I indicates a deficiency in demand and Y falls (S also falls). This reduces m1 and increase m2, thus reducing r and increasing I. So, the L=M equilibrium moves along the LM schedule until IS=LM. Thus, the economy is again in equilibrium.
Changes In Equilibrium Of Commodity And Money Market:
The general equilibrium condition of income and interest rate is identified by the intersection of the IS and LM function will change due to any shift in the IS or LM functions. Shifts in the IS function are caused by shifts in the investment or saving function; shifts in the LM curve are caused by shifts in money supply, speculative demand or transactions demand. Also a shift in any of the factors that determine the position of IS and LM curve may result in a change in general equilibrium, for example, fiscal policies, money suuply, change in investment etc. Changes caused by such factors are described below-
INCREASE IN INVESTMENT:
Lets say for example that innovations shift the MEC curve to the right by $20 at each rate of interest. If MPS=0.50 then income will rise by $40, which in turn raises the interest rate. So the IS curve will shift to the right and there will be a movement in LM curve as r and Y changes. So the equilibrium will change.
Here, in the graph, the general equilibrium is at r=3% & Y=120. Now, due to innovations, investment curve will shift by $20 at every level. With an MPS of 0.5, it will increase income by 20×2=40. But actually income does not rise by that much because interest rate rises to 4% and thus makes the actual rise in investment $10, which gives an increase of 10×2=20 in income. Thus the new general equilibrium is at r=4% AND Y=140.
INCREASE IN MONEY SUPPLY:
An increase in money supply will shift the LM curve. With no change in speculative demand and transaction demand, the increase in money supply will shift the LM curve rightward. The increased money supply
will reduce r and so there will be a movement in the IS curve. Thus equilibrium will change. For example, let IS and LM equilibrium is at r=4% and Y=$120. Now if there is an increase of $20 in total money supply, then it will raise equilibrium income from Y=$120 to Y=$140 and will lower equilibrium interest rate from r=4% to r=3%. As a result, there will be a movement along IS curve and a rightward shift in LM curve as real money supply increases.
INCREASE IN BOTH INVESTMENT AND MONEY SUPPLY:
If there is a simultaneous increase in both investment and money supply, then both IS and LM curve will shift. Here the increase in investment
spending will shift the IS curve as income will increase. But due to equal increase in monmey supply, real income will rise and thus LM curve will also shift. So, interest rate will not rise. So the new equilibrium will be at a higher income level at the previous interest level. And thus general equilibrium will change.