Money and Goods Market Relationship

The theory of liquidity preference on the rate of interest and the goods market remained separate when the General Theory of Employment Interest and Money was published in 1936. Although Keynes indicated the use of making a relationship, it was the later Keynesian economists who developed it.

The IS/LM Curve

You will learn about this at university, it is good to get ahead and know it now. Developed by Keynesian economists John Hicks and Alvin Hansen, also Paul Samuelson and James Tobin.

Given certain conditions, it shows you the equilibrium level of national income and rate of interest, where the IS and LM cross.

What is the IS Curve?

‘Changes in the rate of interest trigger income changes’.

Along with a Keynesian piece of thoery comes a Keynesian Cross Diagram, with the aggregate supply and demand curves crossing at the equilibrium level of output. We will see how this level changes with different rates of interest.

The assumption is that the AD function only slopes upwards with income because consumption increases with income, with investment and other factors constant. The slope is defined hence by the marginal propensity to consume.

What happens with changing RI: Now say we lower the rate of interest, the MPC is higher, hence the AD curve is steeper, and we have an equilibrium at a greater level of income. With a higher rate, the MPC is lower, hence from where consumption equals a minimum, we have a lower equilibrium.

So….in this we can see that the IS curve shows an inverse correlation with the interest rate. Hence slopes downwards with those two the variables.

The LM Curve

‘Changes in income trigger changes in the interest rate’.

Shows you how changes in the level of national income trigger a change in the rate of interest, with a constant money supply. Use liquidity preference theory of interest.

How the Markets are Linked…If we take the money market as given and suddenly a cause such as overseas growth causes the level of national income to rise. The transactions demand for money rises, and the reaction is a rise in the rate of interest.

Likewise, a fall in the income level will cause less demand for money, adn the rate will fall.

So….If higher income causes pressure on the rate of interest and vice versa, we can see the positive correlation between income and the interest rate.


2 Responses to Money and Goods Market Relationship

  1. Pingback: Thinktank « Zahablog's Economic Page

  2. helarudin khanz says:

    its good to see that kind of answer i really learn

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