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11.3 Conclusion: The Short-Run Equilibrium

We now have all the pieces of the *IS*–*LM* model. The two equations of this model are

The model takes fiscal policy *G* and *T*, monetary policy *M*, and the price level *P* as exogenous. Given these exogenous variables, the *IS* curve provides the combinations of *r* and *Y* that satisfy the equation representing the goods market, and the *LM* curve provides the combinations of *r* and *Y* that satisfy the equation representing the money market. These two curves are shown together in Figure 11-13.

Figure 11.13: FIGURE 11-13: **Equilibrium in the ***IS* – *LM* Model The intersection of the *IS* and *LM* curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.

The equilibrium of the economy is the point at which the *IS* curve and the *LM* curve cross. This point gives the interest rate *r* and the level of income *Y* that satisfy conditions for equilibrium in both the goods market and the money market. In other words, at this intersection, actual expenditure equals planned expenditure, and the demand for real money balances equals the supply.

As we conclude this chapter, let’s recall that our ultimate goal in developing the *IS*–*LM* model is to analyze short-run fluctuations in economic activity. Figure 11-14 illustrates how the different pieces of our theory fit together. In this chapter we developed the Keynesian cross and the theory of liquidity preference as building blocks for the *IS*–*LM* model. As we see more fully in the next chapter, the *IS*–*LM* model helps explain the position and slope of the aggregate demand curve. The aggregate demand curve, in turn, is a piece of the model of aggregate supply and aggregate demand, which economists use to explain the short-run effects of policy changes and other events on national income.

Figure 11.14: FIGURE 11-14: **The Theory of Short-Run Fluctuations** This schematic diagram shows how the different pieces of the theory of short-run fluctuations fit together. The Keynesian cross explains the *IS* curve, and the theory of liquidity preference explains the *LM* curve. The *IS* and *LM* curves together yield the *IS*–*LM* model, which explains the aggregate demand curve. The aggregate demand curve is part of the model of aggregate supply and aggregate demand, which economists use to explain short-run fluctuations in economic activity.