When you graph the IS curve, it is a downward sloping curve built from where the intersections occurred.
X axis is real aggregate income and Y axis is interest rate
But when I look at the LM curve, it is an upward sloping curve using the same axises. For the LM curve, the X axis is real GDP (which is the same as real aggregate income?) and the Y axis is interest rate
For two graphs having the same axis labels, why are they sloping in opposite directions?
The IS curve describes fiscal equilibrium. The LM curve describes financial equilibrium.
I wrote a series of articles that may be of some helpm starting here: http://financialexamhelp123.com/islm-deriving-aggregate-demand-synopsis/.
that was seriously amazing. after reading through this curriculum, i’m convinced that for me anyway, this topic has been the most difficult to wrap my head around. you broke it down much better imo than CFAI. i cannot thank you enough!
bahh. i’ve tried to analyze it more and i’m coming up lame…
one thing that really frustrates me is the creation of IS. i get how we go from the expenditure and income approach to arrive at: (S-I) = (G-T) + (X-M)
what i don’t get is, how can one side of this equation be a decreasing function of Y (I understand that taxes and imports increase as Y increases) when the left side, that is mathematically equal, be an increasing function of the exact same variable??
also speaks to how I don’t understand that the right side of the equation can be reduced (taxes and imports increase) and yet somehow on the left side of the equation, savings increases at a higher rate than investment?? does that = sign not mean both sides are equal? any clarity here would be awesome!
anyone?
This is really frustrating me; I understand the final concepts, but the derivation is where I struggle.
So the above post, is one thing that I don’t get (where left side S-I is increasting function of Y, but right side G-T + X-M is decreasing function.
The other, very similar, concept I don’t get is the LM curve and being upward sloping. In the text, it mentions how M/P (demand for money) is an increasing function of Y and decreasing function of r (interest rate) (Pg. 234 CFAI). So basically to me, the IS curve has the same characteristics relative to Y. IS curve (Investment-Savings) is an increasing function of Y and a decreasing function of r. So why then are these curves the opposite (ie. one downward sloping, and the other upward sloping)? If they have the same properties in relation to Y and r (the 2 axis).
I’m sure I’m missing something quite simple here, but hasn’t come to light yet
wow, after more thought, think it’s breaking through a bit now. i know i’m just talking to myself here, but i still want to share my developments for my own sake, and to maybe save anyone’s time who later reads and tries to explain. i’m not 100% that i’m correct, but it seems to make sense to me at the moment…
IS Curve: the equation (S-I) = (G-T) + (X-M) must always be kept in balance. We need to figure out the relationship between real GDP (Y) and interest rate ®, while keeping that equation in balance. If Y increases, the right side of that equation might decrease (taxes will increase compared to government spending, and imports will increase compared to exports). So in order to keep that equation in balance, the left side must also decrease as well. For the left side to decrease, we need to decrease interest rates so that I (investment) increases in proportion to savings. So interest rates will come down as real GDP increases (inverse relationship). Likewise, when Y falls, interest rates must go up, so that Investment increases in proportion to savings, to balance out the equation. (sidenote: I suppose this would mean that investment is more sensitive to interest rates than savings?? ie. it impacts the equation more when there are increases/decreases in Y)
LM Curve: here the equation that must always be held in balance is the supply of money = the demand of money (M/P). We know that M/P has inverse relationship with r (when interest rates go up, ppl demand less money supply), and positive relationship with Y (we know that from the equation M/P = kY…real income has a positive effect on money demand). SO, if Y goes up, in order to hold the demand for money constant, ie. usually it goes up too, but that would throw the balance of supply = demand of money off) we need to increase interest rates, to offset things. And if Y comes down, we need to decrease interest rates so the demand for money doesn’t change and stays = to the supply of money).
I think I’m on the right track now, but I’ve thought this before, so who knows. Either way, the IS and LM derivation seem to make more sense now.
What you’re missing is that the equation:
S – I = (G – T) + (X – M)
is true only for a specific value of GDP (i.e., when GDP = C + I + G + (X – M), or GDP = C + S + T). When they say that S – I is an increasing function of Y (= real GDP), they mean that it’s an increasing function if everything else (other than GDP) remains constant, and when they say that (G – T) + (X – M) is a decreasing function of Y, they mean that it’s a decreasing function if everything else (other than GDP) remains constant. In fact, as is pointed out later in the construction of the IS curve, when interest rates change (which, in the construction of the LM curve, we see happens whenever Y changes), S – I changes as well.
Yes, you’re on the right track. The key is that as real GDP changes, interest rates will also change.