IS-LM model

From CEOpedia

IS-LM model (Investment-Saving / Liquidity preference-Money supply model) is a macroeconomic framework showing the relationship between interest rates and output in the short run, depicting simultaneous equilibrium in goods and money markets (Hicks J.R. 1937, p.147)[1]. When John Hicks published "Mr. Keynes and the 'Classics'" in 1937, he condensed Keynes's verbose General Theory into two intersecting curves on a graph. That simple diagram—IS curve for goods market, LM curve for money market—became the workhorse model of macroeconomic analysis for four decades.

The model's elegance lies in its ability to trace how monetary and fiscal policy affect economic activity. Expansionary fiscal policy shifts IS rightward; expansionary monetary policy shifts LM downward. The intersection determines both output and interest rates simultaneously. For students encountering macroeconomics, IS-LM provides an accessible entry point. For policymakers during the mid-20th century, it provided intellectual foundation for activist stabilization policy.

Historical development

The IS-LM model emerged from theoretical ferment:

Keynesian revolution. John Maynard Keynes's General Theory of Employment, Interest, and Money (1936) challenged classical economics but was famously difficult to interpret. Different readers drew different conclusions about what Keynes actually meant[2].

Hicks's synthesis. In 1937, Hicks formalized Keynes's ideas mathematically, creating the SI-LL diagram (later renamed IS-LM). He intended to show that Keynesian economics was a special case of a more general framework.

Hansen's elaboration. American economist Alvin Hansen adopted and popularized the model, developing it further and cementing its place in economics curricula. The "Hicks-Hansen synthesis" became standard macroeconomics.

Dominance era. From the 1940s through the 1970s, IS-LM dominated macroeconomic teaching and policy analysis. The Kennedy-Johnson tax cuts of the 1960s reflected IS-LM thinking about fiscal stimulus.

Decline and persistence. The stagflation of the 1970s challenged Keynesian frameworks. New Classical economics and later New Keynesian models supplanted IS-LM in academic research. Yet the model persists in undergraduate teaching as an intuitive introduction to macroeconomic relationships.

The IS curve

The IS curve represents goods market equilibrium:

Derivation

Equilibrium condition. In the goods market, planned expenditure must equal output. Total spending comprises consumption, investment, government purchases, and net exports. Y = C + I + G + NX[3].

Interest rate effect. Higher interest rates reduce investment (borrowing costs rise) and consumption (saving becomes more attractive). Lower spending means lower equilibrium output.

Curve slope. The IS curve slopes downward—higher interest rates correspond to lower output. The slope depends on interest sensitivity of spending and the expenditure multiplier.

Shifts in IS

The IS curve shifts when non-interest-rate factors change spending:

Fiscal policy. Government spending increases shift IS rightward. Tax cuts similarly increase disposable income, boosting consumption and shifting IS rightward.

Confidence changes. Consumer or business confidence affects spending at any interest rate. Optimism shifts IS right; pessimism shifts IS left.

Net exports. Trade partner growth or currency depreciation increases exports, shifting IS rightward.

The LM curve

The LM curve represents money market equilibrium:

Derivation

Money demand. Keynes identified three motives for holding money: transactions (for purchases), precautionary (for emergencies), and speculative (for investment opportunities). Money demand increases with income (more transactions) and decreases with interest rates (higher opportunity cost of holding money)[4].

Money supply. Central banks control money supply, treating it as fixed in the basic model.

Equilibrium. The LM curve shows interest rate-output combinations where money demand equals money supply.

Curve slope. The LM curve slopes upward—higher output increases money demand, requiring higher interest rates to restore equilibrium with fixed money supply.

Shifts in LM

Monetary policy. Money supply increases shift LM rightward (or downward)—more money available means lower interest rates at any output level.

Money demand changes. Financial innovations reducing money demand (like credit cards or money market funds) shift LM rightward.

General equilibrium

The intersection of IS and LM determines simultaneous equilibrium:

Output determination. The intersection specifies equilibrium output (Y*) and interest rate (r*). Both markets clear simultaneously.

Disequilibrium adjustment. Away from intersection, either the goods market or money market is out of equilibrium. Market forces push toward the intersection[5].

Policy analysis

IS-LM illuminates policy effects:

Fiscal policy

Expansionary fiscal policy. Government spending increases or tax cuts shift IS rightward. The new equilibrium shows higher output and higher interest rates.

Crowding out. The interest rate increase partially offsets the fiscal stimulus. Higher rates reduce private investment, "crowding out" some of the government spending's effect. Complete crowding out would make fiscal policy ineffective.

Effectiveness depends on LM slope. Steep LM (interest-insensitive money demand) produces large interest rate increases and significant crowding out. Flat LM allows fiscal policy to increase output with minimal interest rate impact.

Monetary policy

Expansionary monetary policy. Money supply increases shift LM rightward. The new equilibrium shows higher output and lower interest rates[6].

Transmission mechanism. Lower interest rates stimulate investment and consumption, increasing aggregate demand and output.

Effectiveness depends on IS slope. Steep IS (interest-insensitive spending) limits monetary policy effectiveness. Flat IS (interest-sensitive spending) allows monetary expansion to substantially increase output.

Policy mix

Combining policies. Fiscal and monetary policies can be combined to achieve desired output and interest rate targets separately. Expansionary fiscal policy with tight monetary policy raises rates; expansionary monetary policy with contractionary fiscal policy lowers them.

Special cases

Extreme conditions produce notable cases:

Liquidity trap. At very low interest rates, the LM curve becomes horizontal. Money demand is infinitely elastic—additional money simply gets held rather than stimulating spending. Monetary policy becomes ineffective; only fiscal policy can increase output. Japan in the 1990s and post-2008 economies exemplified this scenario[7].

Classical case. If money demand is completely interest-insensitive, LM becomes vertical. Fiscal policy then merely raises interest rates without affecting output—complete crowding out. Only monetary policy affects output. Classical economists believed this approximated reality.

Investment trap. If investment is completely interest-insensitive, IS becomes vertical. Monetary policy cannot affect output regardless of how much it lowers rates.

Criticisms and limitations

The IS-LM model faces substantial criticism:

Static framework. The model captures a single point in time without dynamics. Expectations, adjustment processes, and time paths receive no treatment.

Price level fixed. IS-LM assumes fixed prices, inappropriate for analyzing inflation or long-run equilibrium. The AD-AS model extends IS-LM by allowing prices to vary.

Expectations ignored. Economic agents' expectations about future policy affect current behavior. IS-LM's mechanical relationships miss this channel.

Interest rate targeting. Modern central banks target interest rates, not money supply. The traditional LM curve's money supply focus is outdated. The IS-MP model (replacing LM with a monetary policy rule) better reflects current practice[8].

Microfoundations absent. IS-LM relationships aren't derived from optimizing behavior of households and firms. Modern macroeconomics demands microfoundations that IS-LM lacks.

Empirical limitations. Attempts to estimate IS-LM relationships produce unstable coefficients. The model's predictive performance is limited.

Modern adaptations

Contemporary versions address some limitations:

IS-MP model. David Romer (2000) and others replace LM with a horizontal MP curve representing central bank interest rate targeting. This better reflects modern monetary policy.

Dynamic stochastic general equilibrium (DSGE). New Keynesian DSGE models incorporate IS-LM intuitions within rigorous dynamic frameworks with microfoundations and rational expectations.

Teaching role. Despite limitations, IS-LM remains valuable for building intuition about macro relationships. Most macroeconomics textbooks still present it before moving to more sophisticated models.


IS-LM model — recommended articles
Macroeconomics — Fiscal policy — Monetary policy — Economic equilibrium

References

Footnotes

  1. ↑ Hicks J.R. (1937), Mr. Keynes and the 'Classics', p.147
  2. ↑ Mankiw N.G. (2020), Macroeconomics, pp.326-334
  3. ↑ Blanchard O. (2021), Macroeconomics, pp.89-112
  4. ↑ Hicks J.R. (1937), Mr. Keynes and the 'Classics', pp.150-156
  5. ↑ Mankiw N.G. (2020), Macroeconomics, pp.345-356
  6. ↑ Blanchard O. (2021), Macroeconomics, pp.123-145
  7. ↑ Romer D. (2000), Keynesian Macroeconomics without the LM Curve, pp.157-165
  8. ↑ Romer D. (2000), Keynesian Macroeconomics without the LM Curve, pp.168-176

Author: Sławomir Wawak

Retrieved from "https://ceopedia.org/index.php?title=IS-LM_model&oldid=6608"