IS–LM model

The IS–LM model, or Hicks–Hansen model, is a two-dimensional

macroeconomic tool that shows the relationship between interest rates
and assets market (also known as real output in goods and services
market plus money market). The intersection of the "investment–
saving" (IS) and "liquidity preference–money supply" (LM) curves
models "general equilibrium" where supposed simultaneous equilibria
occur in both the goods and the asset markets.[1] Yet two equivalent
interpretations are possible: first, the IS–LM model explains changes in
national income when price level is fixed short-run; second, the IS–LM
model shows why an aggregate demand curve can shift.[2] Hence, this
tool is sometimes used not only to analyse economic fluctuations but
also to suggest potential levels for appropriate stabilisation policies.[3]

The model was developed by John Hicks in 1937,[4] and later extended
by Alvin Hansen,[5] as a mathematical representation of Keynesian The IS curve moves to the right, causing
macroeconomic theory. Between the 1940s and mid-1970s, it was the higher interest rates (i) and expansion in the
"real" economy (real GDP, or Y)
leading framework of macroeconomic analysis.[6] While it has been
largely absent from macroeconomic research ever since, it is still a
backbone conceptual introductory tool in many macroeconomics textbooks.[7] By itself, the IS–LM model is used to study the
short run when prices are fixed or sticky and no inflation is taken into consideration. But in practice the main role of the model is
as a path to explain the AD–AS model.[2]

Contents
History
Formation
IS (Investment Saving) curve
LM curve
Shifts
Incorporation into larger models
See also
References
Further reading
External links

History
The IS–LM model was first introduced at a conference of the Econometric Society held in Oxford during September 1936. Roy
Harrod, John R. Hicks, and James Meade all presented papers describing mathematical models attempting to summarize John
Maynard Keynes' General Theory of Employment, Interest, and Money.[4][8] Hicks, who had seen a draft of Harrod's paper,
invented the IS–LM model (originally using the abbreviation "LL", not "LM"). He later presented it in "Mr. Keynes and the
Classics: A Suggested Interpretation".[4]

Hicks later agreed that the model missed important points of Keynesian theory, criticizing it as having very limited use beyond "a
classroom gadget", and criticizing equilibrium methods generally: "When one turns to questions of policy, looking towards the
future instead of the past, the use of equilibrium methods is still more suspect."[9] The first problem was that it presents the real
and monetary sectors as separate, something Keynes attempted to transcend. In addition, an equilibrium model ignores
uncertainty—and that liquidity preference only makes sense in the presence of uncertainty "For there is no sense in liquidity,
unless expectations are uncertain."[9] A shift in one of the IS or LM curves will cause a change in expectations, which shifts the
other curve.

Although generally accepted as being imperfect, the model is seen as a useful pedagogical tool for imparting an understanding of
the questions that macroeconomists today attempt to answer through more nuanced approaches. As such, it is included in most
undergraduate macroeconomics textbooks, but omitted from most graduate texts due to the current dominance of real business
cycle and new Keynesian theories.[10]

Formation
The model is presented as a graph of two intersecting lines in the first quadrant.

The horizontal axis represents national income or real gross domestic product and is labelled Y. The vertical axis represents the
real interest rate, r (or sometimes i). Since this is a non-dynamic model, there is a fixed relationship between the nominal interest
rate and the real interest rate (the former equals the latter plus the expected inflation rate which is exogenous in the short run);
therefore variables such as money demand which actually depend on the nominal interest rate can equivalently be expressed as
depending on the real interest rate.

The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors (though not
necessarily in other sectors, such as labor markets): both the product market and the money market are in equilibrium. This
equilibrium yields a unique combination of the interest rate and real GDP.

IS (Investment Saving) curve

For the investment-saving curve, the independent variable is the interest rate and
the dependent variable is the level of income. (Note that economic graphs often
place the independent variable—interest rate, in this example—on the vertical
axis while the dependent variable is measured with the horizontal axis.)[11] The
IS curve is drawn as downward-sloping with the interest rate r on the vertical
axis and GDP (gross domestic product: Y) on the horizontal axis. The initials IS
stand for "Investment and Saving equilibrium" but since 1937 have been used to
represent the locus of all equilibria where total spending (consumer spending +
planned private investment + government purchases + net exports) equals an
economy's total output (equivalent to real income, Y, or GDP). To keep the link
with the historical meaning, the IS curve can be said to represent the equilibria IS curve represented by equilibrium
where total private investment equals total saving, where the latter equals in the money market and Keynesian
cross diagram.
consumer saving plus government saving (the budget surplus) plus foreign
saving (the trade surplus). In equilibrium, all spending is desired or planned;
there is no unplanned inventory accumulation.[12] The level of real GDP (Y) is determined along this line for each interest rate.
Thus the IS curve is a locus of points of equilibrium in the "real" (non-financial) economy. Each point on the curve represents the
equilibrium between saving broadly defined and investment.

Given expectations about returns on fixed investment, every level of the real interest rate will generate a certain level of planned
fixed investment and other interest-sensitive spending: lower interest rates encourage higher fixed investment and the like.
Income is at the equilibrium level for a given interest rate when the saving that consumers and other economic participants
choose to do out of this income equals investment (or, equivalently, when "leakages" from the circular flow equal "injections").
The multiplier effect of an increase in fixed investment resulting from a lower interest rate raises real GDP. This explains the
downward slope of the IS curve. In summary, this line represents the causation from falling interest rates to rising planned fixed
investment (etc.) to rising national income and output.

The IS curve is defined by the equation

where Y represents income, represents consumer spending as an increasing function of disposable income
(income, Y, minus taxes, T(Y), which themselves depend positively on income), represents physical investment as a
decreasing function of the real interest rate, G represents government spending, and NX(Y) represents net exports (exports minus
imports) as a decreasing function of income (decreasing because imports are an increasing function of income).

LM curve
For the liquidity preference and money supply curve, the independent
variable is "income" and the dependent variable is "the interest rate."
The LM curve shows the combinations of interest rates and levels of
real income for which the money market is in equilibrium. It is an
upward-sloping curve representing the role of finance and money.

The LM function is the set of equilibrium points between the liquidity

preference (or demand for money) function and the money supply
function (as determined by banks and central banks).

Each point on the LM curve reflects a particular equilibrium situation

in the money market equilibrium diagram, based on a particular level
of income. In the money market equilibrium diagram, the liquidity
preference function is simply the willingness to hold cash balances
instead of securities. For this function, the nominal interest rate (on the The money market equilibrium diagram.
vertical axis) is plotted against the quantity of cash balances (or
liquidity), on the horizontal. The liquidity preference function is
downward sloping. Two basic elements determine the quantity of cash balances demanded (liquidity preference) and therefore the
position and slope of the function:

1) Transactions demand for money: this includes both (a) the willingness to hold cash for everyday transactions
and (b) a precautionary measure (money demand in case of emergencies). Transactions demand is positively
related to real GDP (represented by Y, and also referred to as income). This is simply explained – as GDP
increases, so does spending and therefore transactions, and therefore money balances needed to support the
transactions. As GDP is considered exogenous to the liquidity preference function, changes in GDP shift the
curve. For example, an increase in GDP will increase transactions which will increase the demand for money for
given interest rates, and cause the liquidity preference curve to shift to the right.
2) Speculative demand for money: this is the willingness to hold cash instead of securities as an asset for
investment purposes. Speculative demand is inversely related to the interest rate. As the interest rate rises, the
 opportunity cost of holding money rather than investing in securities increases. So, as interest rates rise,
speculative demand for money falls.
The money supply function for this situation is plotted on the same graph as the liquidity preference function. The money supply
is determined by the central bank decisions and willingness of commercial banks to loan money. Though the money supply is
related indirectly to interest rates in the very short run, the money supply in effect is perfectly inelastic with respect to nominal
interest rates (assuming the central bank chooses to control the money supply rather than focusing directly on the interest rate).
Thus the money supply function is represented as a vertical line – money supply is a constant, independent of the interest rate,
GDP, and other factors. Mathematically, the LM curve is defined by the equation , where the supply of money
is represented as the real amount M/P (as opposed to the nominal amount M), with P representing the price level, and L being the
real demand for money, which is some function of the interest rate and the level of real income. The LM curve shows the
combinations of interest rates and levels of real income for which the money supply equals money demand – that is, for which the
money market is in equilibrium.

For a given level of income, the intersection point between the liquidity preference and money supply functions implies a single
point on the LM curve: specifically, the point giving the level of the interest rate which equilibrates the money market at the given
level of income. Recalling that for the LM curve, the interest rate is plotted against real GDP (whereas the liquidity preference
and money supply functions plot interest rates against the quantity of cash balances), an increase in GDP shifts the liquidity
preference function rightward and hence increases the interest rate. Thus the LM function is positively sloped.

Shifts
One hypothesis is that a government's deficit spending ("fiscal policy") has an effect similar to that of a lower saving rate or
increased private fixed investment, increasing the amount of demand for goods at each individual interest rate. An increased
deficit by the national government shifts the IS curve to the right. This raises the equilibrium interest rate (from i1 to i2) and
national income (from Y1 to Y2), as shown in the graph above. The equilibrium level of national income in the IS-LM diagram is
referred to as aggregate demand.

Keynesians argue spending may actually "crowd in" (encourage) private fixed investment via the accelerator effect, which helps
long-term growth. Further, if government deficits are spent on productive public investment (e.g., infrastructure or public health)
that spending directly and eventually raises potential output, although not necessarily more (or less) than the lost private
investment might have. The extent of any crowding out depends on the shape of the LM curve. A shift in the IS curve along a
relatively flat LM curve can increase output substantially with little change in the interest rate. On the other hand, an rightward
shift in the IS curve along a vertical LM curve will lead to higher interest rates, but no change in output (this case represents the
"Treasury view").

Rightward shifts of the IS curve also result from exogenous increases in investment spending (i.e., for reasons other than interest
rates or income), in consumer spending, and in export spending by people outside the economy being modelled, as well as by
exogenous decreases in spending on imports. Thus these too raise both equilibrium income and the equilibrium interest rate. Of
course, changes in these variables in the opposite direction shift the IS curve in the opposite direction.

The IS–LM model also allows for the role of monetary policy. If the money supply is increased, that shifts the LM curve
downward or to the right, lowering interest rates and raising equilibrium national income. Further, exogenous decreases in
liquidity preference, perhaps due to improved transactions technologies, lead to downward shifts of the LM curve and thus
increases in income and decreases in interest rates. Changes in these variables in the opposite direction shift the LM curve in the
opposite direction.

Incorporation into larger models

By itself, the IS–LM model is used to study the short run when prices are fixed or sticky and no inflation is taken into
consideration. But in practice the main role of the model is as a sub-model of larger models (especially the Aggregate Demand-
Aggregate Supply model – the AD–AS model) which allow for a flexible price level. In the aggregate demand-aggregate supply
model, each point on the aggregate demand curve is an outcome of the IS–LM model for aggregate demand Y based on a
particular price level. Starting from one point on the aggregate demand curve, at a particular price level and a quantity of
aggregate demand implied by the IS–LM model for that price level, if one considers a higher potential price level, in the IS–LM
model the real money supply M/P will be lower and hence the LM curve will be shifted higher, leading to lower aggregate
demand as measured by the horizontal location of the IS–LM intersection; hence at the higher price level the level of aggregate
demand is lower, so the aggregate demand curve is negatively sloped.

See also
Keynesian cross
AD-IA model
IS/MP model
Mundell–Fleming model
National savings
Policy mix

References
1. Gordon, Robert J. (2009). Macroeconomics (Eleventh ed.). Boston: Pearson Addison Wesley.
ISBN 9780321552075.
2. Mankiw, N. Gregory (2012). Macroeconomics (Eighth ed.). New York: Worth Publishers. ISBN 9781429240024.
3. Sloman, John; Wride, Alison (2009). Economics (Seventh ed.). Prentice Hall. ISBN 9780273715627.
4. Hicks, J. R. (1937). "Mr. Keynes and the 'Classics': A Suggested Interpretation". Econometrica. 5 (2): 147–159.
doi:10.2307/1907242 (https://doi.org/10.2307%2F1907242). JSTOR 1907242 (https://www.jstor.org/stable/19072
42).
5. Hansen, A. H. (1953). A Guide to Keynes. New York: McGraw Hill.
6. Bentolila, Samuel (2005). "Hicks–Hansen model". An Eponymous Dictionary of Economics: A Guide to Laws and
Theorems Named after Economists. Edward Elgar. ISBN 978-1-84376-029-0.
7. Colander, David (2004). "The Strange Persistence of the IS-LM Model" (http://muse.jhu.edu/journals/history_of_p
olitical_economy/v036/36.5colander.pdf) (PDF). History of Political Economy. 36 (Annual Supplement): 305–322.
CiteSeerX 10.1.1.692.6446 (https://citeseerx.ist.psu.edu/viewdoc/summary?doi=10.1.1.692.6446).
doi:10.1215/00182702-36-suppl_1-305 (https://doi.org/10.1215%2F00182702-36-suppl_1-305).
8. Meade, J. E. (1937). "A Simplified Model of Mr. Keynes' System". Review of Economic Studies. 4 (2): 98–107.
doi:10.2307/2967607 (https://doi.org/10.2307%2F2967607). JSTOR 2967607 (https://www.jstor.org/stable/29676
07).
9. Hicks, John (1981). " 'IS-LM': An Explanation". Journal of Post Keynesian Economics. 3 (2): 139–154.
doi:10.1080/01603477.1980.11489209 (https://doi.org/10.1080%2F01603477.1980.11489209). JSTOR 4537583
(https://www.jstor.org/stable/4537583).
10. Mankiw, N. Gregory (May 2006). "The Macroeconomist as Scientist and Engineer" (http://scholar.harvard.edu/file
s/mankiw/files/macroeconomist_as_scientist.pdf) (PDF). p. 19. Retrieved 2014-11-17.
11. Krugman, Paul Supply and Demand and QWERTY (https://krugman.blogs.nytimes.com/2011/02/08/supply-and-d
emand-and-qwerty/). February 8, 2011.
12. Fonseca, Gonçalo L., The General Glut Controversy (https://web.archive.org/web/20030726214851/http://homep
age.newschool.edu/het/essays/classic/glut.htm), The New School, archived from the original (http://homepage.ne
wschool.edu/het/essays/classic/glut.htm) on 2003-07-26
Further reading
Ackley, Gardner (1978). "The 'IS–LM' Form of the Model". Macroeconomics: Theory and Policy (https://archive.or
g/details/macroeconomicsth00ackl/page/358). New York: Macmillan. pp. 358–383 (https://archive.org/details/mac
roeconomicsth00ackl/page/358). ISBN 978-0-02-300290-8.
Barro, Robert J. (1984). "The Keynesian Theory of Business Fluctuations". Macroeconomics (https://archive.org/
details/macroeconomics00barr/page/487). New York: John Wiley. pp. 487–513 (https://archive.org/details/macroe
conomics00barr/page/487). ISBN 978-0-471-87407-2.
Darby, Michael R. (1976). "The Complete Keynesian Model". Macroeconomics. New York: McGraw-Hill. pp. 285–
304. ISBN 978-0-07-015346-2.
Dernburg, Thomas F.; McDougall, Duncan M. (1980). "Macroeconomic Equilibrium: The Level of Economic
Activity". Macroeconomics (Sixth ed.). New York: McGraw-Hill. pp. 53–229. ISBN 978-0-07-016534-2.
Keiser, Norman F. (1975). "The Real-Goods and Monetary Spheres". Macroeconomics (Second ed.). New York:
Random House. pp. 231–260. ISBN 978-0-394-31922-3.
Leijonhufvud, Axel (1983). "What is Wrong with IS/LM?". In Fitoussi, Jean-Paul (ed.). Modern Macroeconomic
Theory (https://archive.org/details/modernmacroecono0000unse/page/49). Oxford: Blackwell. pp. 49–90 (https://a
rchive.org/details/modernmacroecono0000unse/page/49). ISBN 978-0-631-13158-8.
Mankiw, N. Gregory (2013). "Aggregate Demand I+II". Macroeconomics (Eighth international ed.). London:
Palgrave Macmillan. pp. 301–352. ISBN 978-1-4641-2167-8.
Sawyer, John A. (1989). "A Model from Keynes's General Theory". Macroeconomic Theory. New York: Harvester
Wheatsheaf. pp. 62–95. ISBN 978-0-7450-0555-3.
Smith, Warren L. (1956). "A Graphical Exposition of the Complete Keynesian System". Southern Economic
Journal. 23 (2): 115–125. doi:10.2307/1053551 (https://doi.org/10.2307%2F1053551). JSTOR 1053551 (https://w
ww.jstor.org/stable/1053551).
Vroey, Michel de; Hoover, Kevin D., eds. (2004). The IS-LM model: Its Rise, Fall, and Strange Persistence.
Durham: Duke University Press. ISBN 978-0-8223-6631-7.
Young, Warren; Zilberfarb, Ben-Zion, eds. (2000). IS-LM and Modern Macroeconomics. Recent Economic
Thought. 73. Springer Science & Business Media. ISBN 978-0-7923-7966-9.

External links
Krugman, Paul. There's something about macro (http://web.mit.edu/krugman/www/islm.html) – An explanation of
the model and its role in understanding macroeconomics.
Krugman, Paul. IS-LMentary (https://krugman.blogs.nytimes.com/2011/10/09/is-lmentary/) – A basic explanation
of the model and its uses.
Wiens, Elmer G. IS–LM model (http://www.egwald.ca/macroeconomics/basicislm.php) – An online, interactive
IS–LM model of the Canadian economy.

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