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Q. Simultaneous determination of Y in the IS-LM model?
Simultaneous determination of Y and R in the IS-LM model
By combining IS curve and LM curve, we can graphically explain what interest rate and what level of GDP which will satisfy both equations: YD(Y, R) = Y and MD(Y, R) = MS. For all points on IS-curve, we have equilibrium in the goods market and for all points on LM-curve, we have equilibrium in the money market. There is just one point where both markets are in equilibrium, Y* and R*.
Figure: IS-LM model
According to IS-LM model, economy will move to Y* and R*. Argument is as below.
1. Imagine that R > R*. It's the not possible to be on both IS and LM-curve.
2. Assume that we are on IS-curve but to the left of LM curve. The interest rate is higher than equilibrium interest rate and R will fall.
3. Suppose that we are on LM-curve but to right of the IS-curve. Y is then higher than equilibrium value and Y will fall. We will then move away from LM-curve and interest rates will fall.
4. If we are neither on IS- nor on LM-curve then Y will fall as long as we are to right of the IS-curve and R will fall as long as we are to left of the LM-curve.
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