Chapter 2. Deriving the IS and LM Curves

An increase in the interest rate will reduce investment spending because it is more expensive to borrow. Therefore planned expenditure E = C + I + G will fall. The decline in planned expenditure will cause firms to reduce output as inventories increase.

An increase in government spending will increase planned aggregate expenditure as given by E = C + I + G. This shifts the planned aggregate expenditure schedule upwards, leading to an increase in equilibrium output for any given level of the interest rate. This increase in equilibrium output will shift the IS curve to the right.

An increase in income will increase consumption spending, and this will give people an incentive to hold and therefore demand more money. This shifts the money demand curve to the right, leading to an increase in the interest rate. When money demand increases relative to money supply, people sell bonds in an attempt to hold more money. This pushes bond prices down and causes the interest rate to rise.

An increase in the money supply will cause the quantity of money balances supplied to exceed the quantity of money balances demanded. As people attempt to convert money to bonds (interest-bearing assets) this will increase the demand for bonds, and hence the price of bonds. The increase in the price of bonds will reduce the interest rate. When the interest rate falls for any given level of income (Y) this will shift the LM curve down and to the right.