General Equilibrium

The IS curve shows all combinations of output and interest rates where the goods market is in equilibrium. At every point on this curve, planned spending equals total output. Interest rates influence borrowing and investment decisions, which affect the amount people and businesses spend on goods and services.

The LM curve represents combinations of output and interest rates where the money market is in equilibrium. At every point, the demand for money equals the supply of money. As the economy produces more output, people need more money for transactions, typically requiring interest rates to rise to maintain balance.

The intersection of the IS and LM curves, labeled point E, represents the joint equilibrium of the economy where both goods and money markets are balanced simultaneously. The equilibrium interest rate r* determines borrowing costs, while the equilibrium output level Y* shows total production. This point establishes the short-run economic balance.

General equilibrium occurs when the IS-LM intersection aligns with the full-employment line, meaning goods, money, and labor markets are all simultaneously in balance. IS-LM equilibrium alone only balances two markets. When the IS-LM point falls below or above full employment, policy adjustments are needed to achieve true general equilibrium.

Interest rates influence borrowing costs for consumers and businesses. When rates are too high, people cut back on spending, lowering output. When rates are too low, excessive demand may emerge that the economy cannot immediately meet. This relationship between interest rates and spending is central to the IS curve's downward slope.

The full-employment line shows the level of production when everyone willing to work at the prevailing wage can find employment. Adding this line to the IS-LM diagram reveals whether the economy is utilizing all available labor and resources. If the IS-LM intersection deviates from this line, the economy is either in recession or experiencing inflationary pressure.

Changes in government spending shift the IS curve, while changes in the money supply shift the LM curve. These policy adjustments alter the equilibrium point, leading to new outcomes for both output and interest rates. Understanding these shifts is essential for analyzing how expansionary or contractionary policies influence the overall economy.