I never understood why governments switched from John Hicks IS/LM Model which lasted from 1937 -1997 to its present GDP calculations
(b) The rate of interest.
Income and the rate of interest are therefore determined together at the point of intersection of these two curves, i.e., E in Fig. 20.3. The equilibrium rate of interest thus determined is Or2 and the level of income determined is OY2.
At this point income and the rate of interest stand in relation to each other such that (1) the goods market is in equilibrium, that is, the aggregate demand equals the level of aggregate output, and (2) the demand for money is in equilibrium with the supply of money (i.e., the desired amount of money is equal to the actual supply of money). It should be noted that LM curve has been drawn by keeping the supply of money fixed.
Effect of Changes in Supply of Money on the Rate of Interest and Income Level:
Let us first consider what will happen if the supply of money is increased by the action of the Central Bank. Given the liquidity preference schedule, with the increase in the supply of money, more money will be available for speculative motive at a given level of income which will cause the interest rate to fall.
As a result, the LM curve will shift to the right. With this rightward shift in the LM curve, in the new equilibrium position, rate of interest will be lower and the level of income greater than at point E. With the increase in the supply of money, LM curve shifts to the right to the position LM’, and with IS schedule remaining unchanged, new equilibrium is at point G corresponding to which rate of interest is lower and level of income greater than at E.
Now, suppose that instead of increasing the supply of money, Central Bank of the country takes steps to reduce the supply of money. With the reduction in the supply of money, less money will be available for speculative motive at each level of income and, as a result, the LM curve will shift to the left of E, and the is curve remaining unchanged, in the new equilibrium position (as shown by point T in Fig. 20.4) the rate of interest will be higher and the level of income smaller than before.
Changes in the Desire to Save or Propensity to Consume:
Let us consider what happens to the rate of interest when desire to save or, in other words, propensity to consume changes. When people’s desire to save falls, that is, when propensity to consume rises, the aggregate demand curve will shift upward and, therefore, level of national income will rise at each rate of interest.
As a result, the IS curve will shift outward to the right. In Fig. 20.5 suppose with a certain given fall in the desire to save (or increase in the propensity to consume), the IS curve shifts rightward to the dotted position IS”. With LM curve remaining unchanged, the new equilibrium position will be established at H corresponding to which rate of interest as well as level of income will be greater than at E.
Thus, a fall in the desire to save has led to the increase in both rate of interest and level of income. On the other hand, if the desire to save rises, that is, if the propensity to consume falls, aggregate demand curve will shift downward which will cause the level of national income to fall for each rate of interest and as a result the IS curve will shift to the left.
With this, and LM curve remaining unchanged, the new equilibrium position will be reached to the left of E, say at point L (as shown in Fig. 20.5) corresponding to which both rate of interest and level of national income will be smaller than at E.