Unit 1: Determination of National Income

1. Aggregate Demand Schedule: IS-LM Approach

The IS-LM model represents the general equilibrium of the economy where both the goods market and the money market are in balance.

The IS Curve (Goods Market)

The IS curve represents the combinations of interest rates (r) and income levels (Y) where investment equals savings (I=S). It shows equilibrium in the goods market.

The LM Curve (Money Market)

The LM curve represents the combinations of interest rates (r) and income levels (Y) where money demand (L) equals money supply (M). It shows equilibrium in the money market.

2. Factors Determining IS Curve (Slope & Position)

The IS curve slopes downward because a lower interest rate stimulates investment, which increases national income.

Slope of the IS Curve

• Interest Sensitivity of Investment: If investment is highly sensitive to interest rates, the IS curve will be flatter.
• The Multiplier: A larger multiplier (higher marginal propensity to consume) results in a flatter IS curve.

Position (Shifts) of the IS Curve

The IS curve shifts due to changes in autonomous spending:

• An increase in government spending (G) or autonomous investment (I) shifts the IS curve to the right.
• An increase in taxes (T) shifts the IS curve to the left.

3. Factors Determining LM Curve (Slope & Position)

The LM curve slopes upward because higher income increases money demand, requiring higher interest rates to maintain equilibrium with a fixed money supply.

Slope of the LM Curve

• Interest Sensitivity of Money Demand: If the demand for money is very sensitive to interest rates, the LM curve is flatter.
• Income Sensitivity of Money Demand: If money demand increases significantly with income, the LM curve is steeper.

Position (Shifts) of the LM Curve

The LM curve shifts primarily due to changes in Monetary Policy:

• An increase in the Money Supply (M) shifts the LM curve to the right.
• A decrease in the Money Supply shifts the LM curve to the left.

4. Derivation of Aggregate Demand (AD) at Variable Price

The AD curve shows the relationship between the price level (P) and the level of national income (Y) at which both goods and money markets are in equilibrium.

Derivation Logic:

1. Suppose the Price Level (P) increases.
2. Real Money Supply (M/P) decreases, causing the LM curve to shift to the left.
3. This leads to a higher interest rate and a lower level of national income (Y).
4. Plotting the inverse relationship between P and Y yields the downward-sloping AD curve.

5. Derivation of Aggregate Supply (AS) at Variable Price

The Aggregate Supply curve shows the total quantity of goods and services that firms are willing to produce and sell at different price levels.

Classical vs. Keynesian AS:

• Classical AS: Vertical at the full-employment level of output, assuming perfectly flexible wages and prices.
• Keynesian AS: Upward sloping in the short run because wages and prices are "sticky".

6. National Income Determination via AD-AS Model

The overall equilibrium of the economy is found where the Aggregate Demand curve intersects the Aggregate Supply curve.

Equilibrium Point: AD(P, G, M, T) = AS(P, W, Technology)

This intersection determines the Equilibrium Price Level and the Equilibrium Real GDP.