- Classical: I = S ⇒ r* [IS] Real sector
- Keynesian: Md =Ms = r* [LM] Monetary sector
This theory shows that the interest rate is determined jointly by the interaction between the real and monetary sectors. It means interest rate determination is not only by the real sector nor by the monetary sector, but it is determined by the equilibrium ofthe real and monetary sectors simultaneously.
The real sector equilibrium is represented by the IS curve, which is downward sloping, and the money market equilibrium is represented by the LM curve, which is upward sloping. The point of intersection between them determines the equilibrium interest rate at which both the real and monetary sectors are simultaneously in equilibrium.
Here, both the IS and the LM curve are intersecting at E*, implying that both the real and monetary sectors are simultaneously at equilibrium at r* interest rate and OY* output.
This equilibrium is said to be stable because there are internal mechanism that asjusts the economy to the equilibrium sooner or later if there are any disturbances. If there are some disturbances in the equilibrium, then the money market adjusts the interest rate while the real sector adjusts the output and brings the economy back to the equilibrium.
- If Md > Ms ⇒ r*↑
- If Md < Ms ⇒ r*↓
- If I > S ⇒ Y↑
- If I < S ⇒ Y↓
This IS-LM theory of interest rate determination is said to be the classical Keynesian Synthesis of interest rate. In the classical theory, the interest rate is determined by the real sector, where the equilibrium interest rate is determined by the real sector equilibrium (i.e., I = S).
Similarly, in the Keynesian theory, the interest rate is determined by the monetary sector, where the money market equilibrium (i.e., Md = Ms) determines the equilibrium interest rate. However, in the IS-LM theory, the equilibrium interest rate is determined by the simultaneous equilibrium of the real sector and monetary sector (i.e., I = S & Md = Ms).
So, the IS-LM theory synthesizes both the real and monetary sector equibilrium and so this is said to be the classical Keynesian synthesis of interest rate determination.