IS-LM model

Generally, the birth of the economics we study at university is attributed to John Keynes and his book “The General Theory of Employment, Interest, and Money”. The purpose of this article, therefore, is to give a general definition of one of the best-known economic models. The model refers to an economy closed to foreign trade and is of course inspired by Keynes. According to Rhona C. Free, Keynes' goal was to provide an explanation for the Great Depression of those years. Moreover, another reason why it had to be published was an explanation for the rapid rise of communism in both the working class and the bourgeoisie. The period was characterized by, as already mentioned, a sudden collapse of the economy, resulting in a fall in demand and production.

Keynes opposed the general idea of that period, i.e. the neoclassical theory. According to Togati, in fact, in summary, the model presented by Keynes considers an equilibrium of unemployment, while the most common model of that period, the neoclassical theory, considers the economy of a country with the maximum commitment of its resources . Thus, according to Keynes, state intervention is essential and would lead to a constant reduction in unemployment. Rhona C.Free, in line with Keynes's theory, defines the past as 'an immutable factor' and the future as 'an unknowable factor' therefore investment decisions are made under conditions of total uncertainty. Continuing to quote the book written by Rhona C. Fee, because it explains the theory of the economist Keynes as best as possible, the economist in question believed that a country's economy shifted its equilibrium point due to expectations, and not according to price adjustment. Another contrast with neoclassical theory. Keynes confirms what has already been said by his colleague Hinks, considering the model to be suitable for the correct interpretation of effective demand and unemployment equilibrium. However, Keynes also states that for full employment to be achieved within a country, fiscal policy is essential.

Keynes, in summary, suggests a correlation between two topics: monetary and accurate, which had never been offered until then. A great discovery that smacks of revolution. As Hinks argues, the two markets are to be solved simultaneously in order to counter the Great Depression. Now we come to the explanation of the graph, hence the explanation of the model itself. As we can see in the graph above, the model has two curves and the intersection of these curves. The two curves represent two different markets, LM the money market and IS the goods market. They have different characteristics, specific to the curve, which also allows their slope, in the graph, to be balanced. In order to start explaining the graph, according to the book already mentioned above, it is essential that one knows some formulas, which are available directly in that book.

The formulas expressed in that gives us the possibility of plotting the graph, as already mentioned. The two curves differ, primarily, in their meaning and definition of different markets, but also in their slope: IS sloped negatively, while LM sloped positively. In accordance with Rohana C. Free, IS is negatively inclined because the propensity to save is greater than the propensity to invest. The equilibrium point that is formed by the intersection of the two curves, gives us the possibility of recreating in both axes, a certain level of the interest rate and the optimal level of production and income.

File:IS-LM graph

Draw of IS-LM graph done by my laptop

For the model to be submitted, it must have specific characteristics. First of all, according to the book already mentioned, the curves must be able to intersect and thus be able to create an equilibrium, which can be measured by the two axes. Clearly, the curves must only be able to intersect once, without there being multiple equilibria, but only one. It is supposed be essential to know that the equilibrium condition will be verified when I = S and L = M, this implies Saving = Investment and Money demand = Money supply, according to the book.

Ideally, the goods market has a function that is inversely proportional to the interest rate, which is why a fall in interest will have a large impact on the demand for investment, hence an increase in production. There are certain situations for which the model undergoes 'modifications'. According to Rhona C.Free, the IS curve will be as steep when investment demand is inelastic. Conversely, it will be flat when investment demand is elastic. Now it is important to establish another important difference with the neoclassical model. Thus, we are talking about the level of full employment Y, which in Keynes' model is higher than the level of output. Keynes' theory turns out to be almost always true, because as the book says, in a normal condition, "the economy is always supported by the under-employment equilibrium".

In conclusion, we can consider the IS curve, rather than a curve, an equilibrium locus. Thus, this implies that every point on the IS curve represents an equilibrium. In technical terms, as defined by the book '21st Century Economics: A Reference Handbook', the market 'lifts', and thus neither excess demand nor excess supply occurs. The IS-LM model is a model that explains a specific economy, namely the period of the Great Depression. At the same time, however, it has no analogies with the classical model, which, in turn, demonstrates the workings of an economy under normal conditions. Conditions that do not always occur, however. Proof of this is the behavior of the LM curve with a positive slope. As aggregate demand increases, therefore, output, interest rates, and also employment in the country will increase accordingly.

Author: Samuele Cannistrà