MODERN THEORY: HICKS — HANSEN SYNTHESIS: IS-LM CURVE MODEL
1. Modern theory was propounded by Hicks and Hensen.
2. According to the theory, the interest depends upon saving, investment, liquidity preference and income.
3. The rate of interest according to the theory is determined by monetary equilibrium and income
equilibrium.
4. This theory is a synthesis between the Classical and Keynes' theories of interest.
5. It has propounded an adequate and determinate theory of interest through the intersection of what are
called IS and LM curves.
6. According to Hicks and Hansen, the classical and loanable funds theories amount to the same thing. The
difference between these two theories, i.e. classical and loanable funds, lies only in the meaning of savings.
7. IS curve is derived from various saving curves at various income levels together with the given
investment demand curve. This IS curve tells us what will be the various rates of interest at different levels of
income, given the investment demand curve and a family of saving curves at different levels of income.
8. LM curve is obtained from Keynes' formulation. The LM curve is obtained from a family of liquidity
preference curves corresponding to various income levels together with the given stock of money supply.
This is because as the level of income increases, people would like to hold more money under the
transactions motive. That is, the higher the level of income, the higher would be the liquidity preference
curve. With the given supply of money, the different levels of liquidity preference curves corresponding to
various levels of income would determine different rates of interest. This yields LM curve, which depicts the
various combinations of interest and income level, at which money market is in equilibrium.
9. Hicks and Hansen show that with the intersection of IS and LM curves, both the interest and income
are simultaneously determined. Thus the classical and Keynes' theories taken together help us in obtaining
as adequate and determinate theory of interest.
DERIVATION OF THE IS CURVE:
1 As the income rises, the savings curve shifts to the right and the rate of interest, which equalizes savings
and investment, falls.
2. Since, as income increases, rate of interest falls, the IS curve slopes downward.
3. IS curve relates the rates of interest with the levels of income at which intended savings and investment
are equal. In other words, the IS curve depicts the various combinations of levels of interest and income at
which, intended savings equal investment; goods-market is in equilibrium.
4. Since with the increase in income the savings curve shifts to the right, its intersection with the
investment demand curve will lower the rate of interest.
5. The level of income and rate of interest are inversely related. That is, the IS curve slopes downward.
6. Further, the steepness of the IS curve depends upon the elasticity or sensitiveness of investment
demand to the changes in rate of interest. A given change in interest will produce a large change in
investment and thereby cause a large change in the level of income.
7. Thus when investment demand is greatly elastic or highly sensitive to the rate of interest, the IS curve
will be flat (i.e. less steep). On the other hand, when investment demand is not very sensitive to the changes
in rate of interest, the IS curve will be relatively steep.
8. The *position of IS curve and changes in its level are determined by the level of autonomous
expenditure
such as government expenditure, transfer payments, autonomous investment. If the government
expenditure or any other type of autonomous expenditure increases, it will increase the equilibrium level of
income at the given rate of interest. This will cause the IS curve to shift to the right. A reduction in
government expenditure or transfer payments will shift the IS curve to the left.
DERIVATION OF THE LM CURVE FROM KEYNES' LIQUIDITY PREFERENCE THEORY
1. The LM curve can be derived from the Keynesian liquidity preference theory of interest.
2. Liquidity preference or demand for money to hold depends upon transaction motive and speculative
motive.
3. It is the money held for transactions motive which is a function of income. The greater the level of
income, the greater the amount of money held for transactions motive and, therefore, the higher the level of
liquidity preference curve.
4. A family of liquidity preference curves can be drawn at various levels of income. The intersection of
these various liquidity preference curves, corresponding to different income levels with the supply curve of
money fixed by the monetary authority, would give the LM curve that relates the rate of interest with the level
of income as determined by money-market equilibrium corresponding to different levels of liquidity
preference curve.
5. The LM curve tells us what the various rates of interest will be (given the quantity of money and the
family of liquidity preference curves) at different levels of income. But the liquidity preference curves alone
cannot tell us what exactly the rate of interest will be.
6. As income increases, liquidity preference curve shifts outward and therefore the rate of interest, which
equates supply of money with demand for money, rises.
THE SLOPE AND POSITION OF THE LM CURVE
1. The LM curve slopes upward to the right. This is because with higher levels of income, demand for
money (that is, the liquidity preference curve) is higher and consequently the money-market equilibrium, that
is, the equality of the given money supply with liquidity preference curve occurs at a higher rate of interest.
This implies that rate of interest varies directly with income
2. Factors that determine the slope of the LM curve include (i) Responsiveness of demand for money (i.e.
Liquidity Preference) to the changes in income and (ii) Elasticity or responsiveness of demand for money
(i.e., liquidity preference for speculative motive) to the changes in rate of interest.
3. As the income increases, demand for money would increase for being for transactions motive. This
extra demand for money would disturb the money-market equilibrium, and in order to restore the equilibrium
the rate of interest will rise to the level where the given money supply curve intersects the new liquidity
preference curve corresponding to the higher income level.
4. In the new equilibrium position, with the given stock of money supply, money held under the
transactions motive will increase whereas the money held for speculative motive will decline. The greater the
extent to which demand for money for transaction motive increases with the increase in income, the greater
the decline in the supply of money available for speculative motive.
5. Given the liquidity preference schedule for speculative motive, the higher the rise in the rate of interest,
the steeper the LM curve consequently.
6. According to Keynes' liquidity preference theory, r = f (M2,L2) where M2 is the stock of money available
for speculative motive and L2 is the money demand or liquidity preference function for speculative motive.
7. The second factor which determines the slope of the LM curve is the elasticity or responsiveness of
demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of interest. The
lower the elasticity of liquidity preference with respect to the changes in interest rate, the steeper will be LM
curve.
8. On the other hand, if the elasticity of liquidity preference (money-demand function) to the changes in
the rate of interest is high, the LM curve will be relatively flat or less steep.
What brings about shifts in the LM curve?:
1. An LM curve is drawn with a given stock of money supply. Therefore, when the money supply
increases, given the liquidity preference function, it will lower the rate of interest at the given level of income.
This will cause the LM curve to shift down and to the right. On the other hand, if money supply is reduced,
given the liquidity preference (money; demand) function, it will raise the rate of interest at the given level of
income and therefore cause the LM curve to shift above and to the left.
2. The other factor that causes a shift in the LM curve is the change in liquidity preference (money
demand function) for a given level of income. If the liquidity preference function for a given level of income
shifts upward, this, given the stock of money, will lead to the rise in the rate of interest. This will bring about
a shift in the LM curve above and to the left. On the contrary, if the liquidity preference function for a given
level of income declines, it will lower the rate of interest and will shift the LM curve down and to the right.
Intersection of the IS and LM curves: Simultaneous determination of interest rate and income
1. The IS curve and the LM curve relate the two variables: (a) income, and (b) the rate of interest.
2. Income and the rate of Interest determined together at the equilibrium rate of interest are, at the point
of intersection of IS and LM curve.
3. At this point, income and the rate interest stand in relation to each other such that (1) investment and
saving are in equilibrium, and (2) the demand for money is in equilibrium with the supply of money (Le., the
desired amount of money is equal to the actual supply of money).
4. Thus, a determinate theory of interest is based on: (1) the investment-demand function, (2) the saving
function (or, conversely, the consumption function), (3) the liquidity preference function, and (4) the quantity
of moneyor, conversely, the consumption function),
5. According to Hicks and Hansen, both monetary and real factors, namely, productivity, thrift, and the
monetary factors, that is, the demand for money (liquidity preference) and supply of money play a part in
determining of the rate of interest. Any change in these factors will cause shift in IS or LM curve and will
therefore change the equilibrium level of the rate of interest and income.
1. Modern theory was propounded by Hicks and Hensen.
2. According to the theory, the interest depends upon saving, investment, liquidity preference and income.
3. The rate of interest according to the theory is determined by monetary equilibrium and income
equilibrium.
4. This theory is a synthesis between the Classical and Keynes' theories of interest.
5. It has propounded an adequate and determinate theory of interest through the intersection of what are
called IS and LM curves.
6. According to Hicks and Hansen, the classical and loanable funds theories amount to the same thing. The
difference between these two theories, i.e. classical and loanable funds, lies only in the meaning of savings.
7. IS curve is derived from various saving curves at various income levels together with the given
investment demand curve. This IS curve tells us what will be the various rates of interest at different levels of
income, given the investment demand curve and a family of saving curves at different levels of income.
8. LM curve is obtained from Keynes' formulation. The LM curve is obtained from a family of liquidity
preference curves corresponding to various income levels together with the given stock of money supply.
This is because as the level of income increases, people would like to hold more money under the
transactions motive. That is, the higher the level of income, the higher would be the liquidity preference
curve. With the given supply of money, the different levels of liquidity preference curves corresponding to
various levels of income would determine different rates of interest. This yields LM curve, which depicts the
various combinations of interest and income level, at which money market is in equilibrium.
9. Hicks and Hansen show that with the intersection of IS and LM curves, both the interest and income
are simultaneously determined. Thus the classical and Keynes' theories taken together help us in obtaining
as adequate and determinate theory of interest.
DERIVATION OF THE IS CURVE:
1 As the income rises, the savings curve shifts to the right and the rate of interest, which equalizes savings
and investment, falls.
2. Since, as income increases, rate of interest falls, the IS curve slopes downward.
3. IS curve relates the rates of interest with the levels of income at which intended savings and investment
are equal. In other words, the IS curve depicts the various combinations of levels of interest and income at
which, intended savings equal investment; goods-market is in equilibrium.
4. Since with the increase in income the savings curve shifts to the right, its intersection with the
investment demand curve will lower the rate of interest.
5. The level of income and rate of interest are inversely related. That is, the IS curve slopes downward.
6. Further, the steepness of the IS curve depends upon the elasticity or sensitiveness of investment
demand to the changes in rate of interest. A given change in interest will produce a large change in
investment and thereby cause a large change in the level of income.
7. Thus when investment demand is greatly elastic or highly sensitive to the rate of interest, the IS curve
will be flat (i.e. less steep). On the other hand, when investment demand is not very sensitive to the changes
in rate of interest, the IS curve will be relatively steep.
8. The *position of IS curve and changes in its level are determined by the level of autonomous
expenditure
such as government expenditure, transfer payments, autonomous investment. If the government
expenditure or any other type of autonomous expenditure increases, it will increase the equilibrium level of
income at the given rate of interest. This will cause the IS curve to shift to the right. A reduction in
government expenditure or transfer payments will shift the IS curve to the left.
DERIVATION OF THE LM CURVE FROM KEYNES' LIQUIDITY PREFERENCE THEORY
1. The LM curve can be derived from the Keynesian liquidity preference theory of interest.
2. Liquidity preference or demand for money to hold depends upon transaction motive and speculative
motive.
3. It is the money held for transactions motive which is a function of income. The greater the level of
income, the greater the amount of money held for transactions motive and, therefore, the higher the level of
liquidity preference curve.
4. A family of liquidity preference curves can be drawn at various levels of income. The intersection of
these various liquidity preference curves, corresponding to different income levels with the supply curve of
money fixed by the monetary authority, would give the LM curve that relates the rate of interest with the level
of income as determined by money-market equilibrium corresponding to different levels of liquidity
preference curve.
5. The LM curve tells us what the various rates of interest will be (given the quantity of money and the
family of liquidity preference curves) at different levels of income. But the liquidity preference curves alone
cannot tell us what exactly the rate of interest will be.
6. As income increases, liquidity preference curve shifts outward and therefore the rate of interest, which
equates supply of money with demand for money, rises.
THE SLOPE AND POSITION OF THE LM CURVE
1. The LM curve slopes upward to the right. This is because with higher levels of income, demand for
money (that is, the liquidity preference curve) is higher and consequently the money-market equilibrium, that
is, the equality of the given money supply with liquidity preference curve occurs at a higher rate of interest.
This implies that rate of interest varies directly with income
2. Factors that determine the slope of the LM curve include (i) Responsiveness of demand for money (i.e.
Liquidity Preference) to the changes in income and (ii) Elasticity or responsiveness of demand for money
(i.e., liquidity preference for speculative motive) to the changes in rate of interest.
3. As the income increases, demand for money would increase for being for transactions motive. This
extra demand for money would disturb the money-market equilibrium, and in order to restore the equilibrium
the rate of interest will rise to the level where the given money supply curve intersects the new liquidity
preference curve corresponding to the higher income level.
4. In the new equilibrium position, with the given stock of money supply, money held under the
transactions motive will increase whereas the money held for speculative motive will decline. The greater the
extent to which demand for money for transaction motive increases with the increase in income, the greater
the decline in the supply of money available for speculative motive.
5. Given the liquidity preference schedule for speculative motive, the higher the rise in the rate of interest,
the steeper the LM curve consequently.
6. According to Keynes' liquidity preference theory, r = f (M2,L2) where M2 is the stock of money available
for speculative motive and L2 is the money demand or liquidity preference function for speculative motive.
7. The second factor which determines the slope of the LM curve is the elasticity or responsiveness of
demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of interest. The
lower the elasticity of liquidity preference with respect to the changes in interest rate, the steeper will be LM
curve.
8. On the other hand, if the elasticity of liquidity preference (money-demand function) to the changes in
the rate of interest is high, the LM curve will be relatively flat or less steep.
What brings about shifts in the LM curve?:
1. An LM curve is drawn with a given stock of money supply. Therefore, when the money supply
increases, given the liquidity preference function, it will lower the rate of interest at the given level of income.
This will cause the LM curve to shift down and to the right. On the other hand, if money supply is reduced,
given the liquidity preference (money; demand) function, it will raise the rate of interest at the given level of
income and therefore cause the LM curve to shift above and to the left.
2. The other factor that causes a shift in the LM curve is the change in liquidity preference (money
demand function) for a given level of income. If the liquidity preference function for a given level of income
shifts upward, this, given the stock of money, will lead to the rise in the rate of interest. This will bring about
a shift in the LM curve above and to the left. On the contrary, if the liquidity preference function for a given
level of income declines, it will lower the rate of interest and will shift the LM curve down and to the right.
Intersection of the IS and LM curves: Simultaneous determination of interest rate and income
1. The IS curve and the LM curve relate the two variables: (a) income, and (b) the rate of interest.
2. Income and the rate of Interest determined together at the equilibrium rate of interest are, at the point
of intersection of IS and LM curve.
3. At this point, income and the rate interest stand in relation to each other such that (1) investment and
saving are in equilibrium, and (2) the demand for money is in equilibrium with the supply of money (Le., the
desired amount of money is equal to the actual supply of money).
4. Thus, a determinate theory of interest is based on: (1) the investment-demand function, (2) the saving
function (or, conversely, the consumption function), (3) the liquidity preference function, and (4) the quantity
of moneyor, conversely, the consumption function),
5. According to Hicks and Hansen, both monetary and real factors, namely, productivity, thrift, and the
monetary factors, that is, the demand for money (liquidity preference) and supply of money play a part in
determining of the rate of interest. Any change in these factors will cause shift in IS or LM curve and will
therefore change the equilibrium level of the rate of interest and income.
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