Does anyone have a clear explanation of what IS and LM curves are all about? I didn’t get it on the first pass of the material and now that I’m going through the second time I still don’t get it.
The IS curve I kinda get, I think, it’s basically the level of Saving and Investment at different interest rates (so higher rates, greater savings and lower investments).
But then the LM curve… I understand nothing of what this curve is meant to represent.
A plain english explanation of what these curves are about and how they work together would be greatly appreciated.
btw - I’ve searched the net and youtube but all the explanation I’ve have just confused me more.
I think the confusion comes as the axes for the LM curve (output and interest rate) isn’t the full picture. The money supply is an important factor when discussing the LM curve as it determines the relationship between interest rate and output. The fact that it’s externally determined makes it confusing.
I look at it this way: Money supply is set by the Federal bank. if money supplies are held constant, prices must adjust to maintain equilibrium should demand for money rise. As output increases (i.e. demand for funds to fund production and the like), the higher the interest rates must become in order to maintain money supply at the same level. Therefore, higher output means higher interest rates for a set level of money supply. If money supply were to increase, it causes the LM curve to move to the right.
I found this concept difficult as well, and it’s important as a foundation for understanding LRAS, SRAS etc. I like this summary which also contains a capsular view on the concept from Dr Krugman.
S2000, that is really really good. Question: I find the concept of “price” confusing–price of what exactly? Just the general price level of an economy?
Sorry to be so stupid but Krugman mentions that the two curves can seem contradictory and they do to me and I am still confused. How can you say on the IS curve that as real aggregate income gets larger, interest rates fall, i.e. there is a lot of money out there and so interest rates are low while, at the same time, you say as real aggregate income gets larger, more and more people want money so you have to pay more in interest to get that money, i.e. the price of money increases. I really don’t get this and would appreciate someone’s explanation. Thanks!
Thanks Bill, that was quite helpful but I fear it still doesn’t answer my question. I’m just not seeing it and am confused. Can’t understand why the two graphs say opposite things, i.e. GDP up , interest rates down. GDP up, interest rates up. Don’t get it:(
Schweser explains IS is the negative relationship between interest rates and income (i.e. less investment demand at lower rates increases money supply). LM is the positive relationship between interest rates and income (i.e. greater returns at higher interest rates increases money supply. Where these two factors intersect is your equilibrium.
Perhaps it’s an incorrect over-generalization, but I tried to view LRAS, SRAS simply as singlular goods (instead of the output of an economey, a single product from a single manufacturer) and had a much easier time understanding the concepts. Obviously, it’s not quite as general as that, but perhaps it would be a good starting off point for you?