Question

Explain why disequilibrium in the goods and money markets will move the economy to point equilibrium at the intersection of IS-LM.

Answer 1

Answer: We know that the IS curve represents the the level of real output and real interest rate that brings the goods market in equilibrium. Similarly, the LM curve shows the the level of real output and real interest rate that brings the money market in equilibrium. Now if the real interest rate is higher than the equilibrium rate of interest, then the money market will be in disequilibrium, and as bond price and real interest rates are inversely related, a higher interest rate will give incentive to people to get rid of money and to buy bonds. As a result of which, the real interest rate will start to decline and will eventually reach the equilibrium real rate of interest where the IS and LM curve intersects.

On the other hand if the real output is lower than the equilibrium level, then the rate of interest will be higher than the equilibrium level, and as equation of the IS curve is= consumption+investment+government spending, then rate of investment will be lower.. Thus at that point there will be an excess supply of goods and services which will raise the inventory level and by the law of supply and demand, eventually the equilibrium point will be reached.