Macro Economic General equilibrium is an integration of money, interest and income through the product and money markets. The integration is realized through the Hicks-Hansen diagrammatic framework known as IS-LM Model.

Hicks & Hansen add the effects of interest rates on spending, and thus income and the dependence of the financial markets on income. Interest rates & income are determined jointly by equilibrium in the goods & financial markets.

The IS–LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output, in the goods and services market and the money market. The intersection of the IS and LM curves is the "general equilibrium" where there is simultaneous equilibrium in both markets.

IS curve represents the equality of investment & saving to show the product market equilibrium. LM curve on the other hand is the expression of the equality of money demand (L) & money supply (M) & represents the money market equilibrium. The product market equilibrium is also known as “real sector equilibrium” & the money market equilibrium is also known as “monetary sector equilibrium”.

Product Market Equilibrium

Product market is in equilibrium when desired saving & investment are equal or aggregate supply (Y) is equal to aggregate demand (C+I).

Assumption

  1. Closed economy
  2. No government spending or taxes
  3. Consumption & saving are the function of income
  4. Investment is a function of rate of interest

I) Y=C+I

   C= C(Y)............... (1)

   I= I (r).................. (2)

   Y=C(Y) + I(r)……(3)

II) Y=C+S, so, I=S

   S=S(Y)

   I=I(r)

   S(Y) = I(r)

This IS curve is also a locus of points showing alternate combinations of interest rate & income at which the commodity market clears. That is why the IS curve is called the commodity market equilibrium schedule. The IS curve is a graphical representation of the product market equilibrium condition that planned investment be equal to saving and it shows the level of income that will yield equality of planned investment & saving at different possible interest rates.

IS curve thus shows various combinations of interest rates & income at which there is equally between S & I.

Properties of IS curve

  1. Slope of IS curve is negatively sloped because a higher level of interest rate reduces investment spending, thereby reducing aggregates demand & thus the equilibrium level of income.
  2. Shifts in IS curve
    1. If autonomous spending increases, the IS curve will shift to the right.
    2. If saving reduces, the IS curve will shift to the right & vice versa.
    3. If an autonomous investment increases, the IS curve will shift to the right & vice versa.

Money Market Equilibrium

Money market is in equilibrium when demand for money and supply of money are equal.To simplify the analysis we take two sector model.

Assumptions:

  1. Closed Economy
  2. No government spending or taxes
  3. The financial market is confined to only money transactions & other forms of income earning assets.

Equilibrium in the money market exists when the demand for money is equal to the supply of money.

Derivation: