by In an open economy, the determination of national income and the interest rate are jointly determined by the interaction of the IS and LM curves. Changes in economic policies and external factors can cause shifts in these curves, leading to changes in the equilibrium level of income and the interest rate.
Shifts in the IS curve can be caused by changes in autonomous consumption, investment, government spending, or net exports. For example, an increase in government spending would shift the IS curve to the right, as shown in Figure 1.
Figure 1: Shift in IS Curve due to Increase in Government Spending
At the initial equilibrium point E0, the interest rate is r0 and output is Y0. An increase in government spending shifts the IS curve from IS0 to IS1, leading to a new equilibrium point E1, where the interest rate is r1 and output is Y1.
Shifts in the LM curve can be caused by changes in the money supply or the demand for money. For example, a decrease in the money supply would shift the LM curve to the left, as shown in Figure 2.
Figure 2: Shift in LM Curve due to Decrease in Money Supply
At the initial equilibrium point E0, the interest rate is r0 and output is Y0. A decrease in the money supply shifts the LM curve from LM0 to LM1, leading to a new equilibrium point E1, where the interest rate is r1 and output is Y1.
In addition to shifts in the IS and LM curves, changes in external factors, such as changes in world interest rates or changes in exchange rates, can also cause shifts in the IS and LM curves, leading to changes in the equilibrium level of income and the interest rate.
The joint determination of national income and the interest rate is illustrated in Figure 3.
Figure 3: Joint Determination of National Income and the Interest Rate
The IS and LM curves intersect at the equilibrium point E, where the interest rate is r* and output is Y*. At this point, the goods market and the money market are both in equilibrium. If the economy is not in equilibrium, adjustments will occur until the IS and LM curves intersect at the equilibrium point.
For example, if the economy is initially at point A, where the interest rate is r1 and output is Y1, the goods market is in surplus, and the money market is in deficit. In the goods market, the surplus of goods leads to a decrease in the price level, which increases the demand for money and leads to an increase in the interest rate. In the money market, the deficit of money leads to an increase in the price level, which decreases the demand for money and leads to a decrease in the interest rate. These adjustments continue until the economy reaches the equilibrium point E.
In summary, the joint determination of national income and the interest rate in an open economy is determined by the interaction of the IS and LM curves. Shifts in these curves due to changes in economic policies, external factors, or changes in the money supply and demand can lead to changes in the equilibrium level of income and the interest rate. The economy will adjust until the IS and LM curves intersect at the equilibrium point where the goods market and money market are both in equilibrium.
