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Where the IS and LM curves come from, and how to draw them

Derive the LM curve by one of the standard methods used in Macroeconomics. Be sure to label all axis and curves on your graph. Explain in writing to what your derivation brings equilibrium and how it accomplishes this.

Derive the IS curve by one of the standard methods used in Macroeconomics. Explain in writing to what market your derivation brings equilibrium and how it accomplishes this.

Solution Preview

Both the LM and IS curves show a relationship between the interest rate, r, and real output, Y. When you graph the LM and IS curves, real output Y goes on the x-axis (kind of confusing) while the interest rate r goes on the Y axis. The LM curve slopes up, and the IS curve slopes down.

The LM curve is related to the money market. The IS curve is related to the goods market.

To derive the LM curve:

The LM curve shows combinations of real output and the interest rate that occur when the money market is in a variety of possible equilibria.

The theory of liquidity preference underlies the LM curve. The theory of liquidity of preference can be viewed as a supply and demand model of the market for real money balances. Real money balances, represented by 'M/P' are defined as money divided by the price level. The name 'liquidity preference' comes from the fact that money is the economy's most liquid asset.

In the market for liquidity preference, there is supply, demand, a price, and a quantity of real money balances. The price is the interest rate r. The quantity is the quantity of real money balances. So the graph of the market for liquidity preference has real money balances, represented by 'M/P' on the x-axis and the interest rate r on the y-axis.

The supply of real money balances is fixed by the central bank. So on the graph, supply is a veritical line at the supply set by the central bank.

Demand for real money ...

Solution Summary

Verbally describes why the IS and LM curves are shaped the way they are, and how to draw them on a graph.

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