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In this article, we will take a look at both the IS and LM curve — both how we can understand them mathematically, economically, and intuitively. For this task, we will need to look at a variety of different formulas. Let us get started.
Understanding the IS curve
We can start deriving the IS curve and also try to understand the intuition behind it. For this, we will first need to look at a few different formulas. We can start by considering the following one:
So, what exactly is this formula? This is the formula for the investments, which we will need to take into account when we see the formula for the GDP. We can try to break down what it consists of on the right-hand side:
An example of unavoidable investments could, for example, be when a company needs to replace their computer screens. This investment does not depend on the real interest rate, r. It is an investment that will always need to be done. On the other hand, we also have some investments that depend on the real interest rate, r. Here we need to remember that ‘r’ can basically be seen as the price of money. Hence, when we have a high ‘r’ then we will have a small I_1 since it will discourage investments when we have to pay a lot for the money. We can then also say that when we have a low ‘r’, then it will encourage investments — meaning I_1 will be high.
We can then look at the following formula:
