Using the IS-LM framework Essay Example | Topics and Well Written Essays - 1750 words

Using the IS-LM framework - Essay Example The model is represented in the form of a graph. The horizontal axis represents the national income or Gross Domestic Product (GDP) of an economy. The vertical axis represents the variable â€Å"i† which denotes the prevailing interest rates in the economy. The model achieves equilibrium at a point where â€Å"IS† curve intersects the LM curve. Inflation is considered as an exogenous factor in this model in the short run. This means that in the short-run real and nominal interest rates are same and any changes in the nominal interest rates affect the demand for money in the economy. (Lipsey & Chrystal 2003) IS curve is drawn just like a conventional demand curve. The independent variable of this curve is the interest rate and the dependent variable is the national income of the economy which is denoted by â€Å"Y†. The curve is a downward sloping line. The reason for the downward or negative slop of the curve is the fact that at lower interest rates demand for mo ney â€Å"Y† is high. At higher interest rate levels, the demand drops down. This is in line with the rational behavior of consumers, institutions, businesses and governments. Since interest rate is a cost of money, many people would demand more money when it is being offered at cheaper rates. Similarly businesses will demand more money when the interest rates are low which lowers down their cost of doing business. Governments and other institutions will also borrow when the interest rate is low because of the fact that they will have to give lower amount to the party lending the fund, for the use of funds. In other words opportunity cost of borrowing is low when interest rates are low and high when interest rates are higher. All the parties needing money borrow more at lower interest rates unless the demand for money is inelastic. (Brue & McConnell 2006) IS Curve can be mathematically explained by the following equation: In the above equation, C(Y-T(Y)) represents the consum er spending part of the function. I(r) represent the investment function which is affected by the interest rates. It must be remembered that the relationship between investment and interest rate is negatively proportional at all times. G represents the government spending part which is exogenous or given. No factor affects the government spending and since it is solely determined by the government’s own policy hence it is considered as an exogenous factor. The last part of the function is related to international trade. NX(Y) represents the net import minus exports and denotes the net international trade as a function of real income. It must be remembered that the relationship between the international trade and disposable income is positive all the times. This makes sense as it tells the readers that the more income the people have, more they will be willing to spend. (Anabtwi & Smith 1994) In the diagram â€Å"Figure 1†, it can be seen that the IS curve is downward s loping. In other words, the relationship between national income (GDP) and interest rate is negatively correlated. Any fall in interest rate increases the national income and any rise in interest rate decreases the national income (GDP). The relationship is more explicitly point out in numerical figures. The rise in interest rates from 4 percent to 5 percent has resulted in the fall in national income from $700 to $600. The relationship between these two variables is negative. The relationship makes sense because of the opportunity cost