The IS-LM model combines the IS and LM curves to determine output and interest rates. In this exercise, you work with the variables that determine the position of each curve. the exercise has two parts: one showing how the IS curve is derived and one showing how the LM curve is derived. To switch between IS and LM, click on the main tabs in the upper left corner.

The IS curve is derived from the Keynesian Cross model. This model consists of two basic equations:

E = C (Y - T) + I(r) + G

Planned Expenditure (E) equals the sum of consumption (C), investment (I) and government spending (G).

Y = E

Actual expenditure (Y) equals planned expenditure.

Figures in the textbook illustrates the Keynesian Cross model. The equilibrium values of Y and E are at the intersection of the two curves.

By varying the interest rate (r):

In summary, the Keynesian Cross model implies that Y and r and negatively related.

In the IS curve part of the exercise, you will be able to change G and T. A change in G or T causes the planned expenditure schedule to shift at every r, resulting in a shift of the IS curve.

The LM curve is derived from the Liquidity Prefernce theory. This theory consists of three basic equations:

The supply of real balances is fixed.

The demand for real balances is related to the interest rate.

The supply of real balances equals the demand for real balances.

The equilibrium r is determined by the intersection of the two curves.

The LM curve is derived from the theory of Liquidity Preference by varying income (Y).

This implies that r and Y are positively related.

A change in M or P shifts the supply of (M/P) at every level of Y, resulting in a shift of the LM curve.