IS-LM Curve Model

Definition of IS-LM curve

The IS-LM model, which stands for "investment-savings" (IS) and "liquidity preference-money
supply" (LM) is a Keynesian macroeconomic model that shows how the market for economic
goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as
a graph in which the IS and LM curves intersect to show the short-run equilibrium between
interest rates and output.

Key Takeaways

 The IS-LM model describes how aggregate markets for real goods and financial markets
interact to balance the rate of interest and total output in the macro economy.
 IS-LM stands for "investment savings-liquidity preference-money supply."
 The model was devised as a formal graphic representation of a principle of Keynesian
economic theory.
 On the IS-LM graph, "IS" represents one curve while "LM" represents another curve.
 IS-LM can be used to describe how changes in market preferences alter the equilibrium
levels of gross domestic product (GDP) and market interest rates.
 The IS-LM model lacks the precision and realism to be a useful prescription tool for
economic policy.

Understanding the IS-LM Model

British economist John Hicks first introduced the IS-LM model in 1936, just a few months
after fellow British economist John Maynard Keynes published "The General Theory of
Employment, Interest, and Money." Hicks's model served as a formalized graphical
representation of Keynes's theories, though it is used mainly as a heuristic device today.

The three critical exogenous, i.e. external, variables in the IS-LM model are liquidity,
investment, and consumption. According to the theory, liquidity is determined by the size and
velocity of the money supply. The levels of investment and consumption are determined by the
marginal decisions of individual actors.

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The IS-LM graph examines the relationship between output, or gross domestic product (GDP),
and interest rates. The entire economy is boiled down to just two markets, output and money;
and their respective supply and demand characteristics push the economy towards
an equilibrium point.

Goods Market Equilibrium: IS Curve

 By Goods Market, we mean all the buying and selling of goods and services. This investment
schedule shows what planned spending would be at various rates of interest.

The IS element of the model is the IS curve, or the goods market equilibrium schedule (in
contrast with the money market in LM). The IS curve shows the combinations of interest rates
and output levels so that planned spending equals income. In short, the IS curve indicates how
much firms would spend depending on various interest rates. The higher the interest rate, the less
they would invest or spend.

To put the investment spending into a formula we have:

Let I = investment spending Let I (with a horizontal line above it) = exogenous or autonomous
investment spending Let i = rate of interest Let b = sensitivity of investment spending. This
equation says the lower the interest rate, the greater the investment. If the sensitivity to
investment spending, or b, is large, a small interest rate increase creates a large decrease in
investment spending.

Derivation of IS Curve
The IS-LM curve model emphasizes the interaction between the goods and money markets. The
goods market is in equilibrium when aggregate demand is equal to income. The aggregate
demand is determined by consumption demand and investment demand. In the Keynesian model
of goods market equilibrium, we also now introduce the rate of interest as an important
determinant of investment. With this introduction of interest as a determinant of investment, the
latter now becomes an endogenous variable in the model. When the rate of interest falls the level
of investment increases and vice versa.

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Thus, changes in the rate of interest affect aggregate demand or aggregate expenditure by
causing changes in the investment demand. When the rate of interest falls, it lowers the cost of
investment projects and thereby raises the profitability of investment. The businessmen will
therefore undertake greater investment at a lower rate of interest.

The increase in investment demand will bring about increase in aggregate demand which in turn
will raise the equilibrium level of income. In the derivation of the IS curve we seek to find out
the equilibrium level of national income as determined by the equilibrium in goods market by a
level of investment determined by a given rate of interest.

Thus IS curve relates different equilibrium levels of national income with various rates of
interest. With a fall in the rate of interest, the planned investment will increase which will cause
an upward shift in aggregate demand function (C + I) resulting in goods market equilibrium at a
higher level of national income.
The lower the rate of interest, the higher will be the equilibrium level of national income. Thus,
the IS curve is the locus of those combinations of rate of interest and the level of national income
at which goods market is in equilibrium. How the IS curve is derived is illustrated in Fig. 20.1. In
panel (a) of Fig. 20.1 the relationship between rate of interest and planned investment is depicted
by the investment demand curve II.

It will be seen from panel (a) that at rate of interest Or 0the planned investment is equal to OI0.
With OI0 as the amount of planned investment, the aggregate demand curve is C + I 0 which, as
will be seen in panel (b) of Fig. 20.1 equals aggregate output at OY 0 level of national income.
Therefore, in the panel (c) at the bottom of the Fig. 20.1, against rate of interest Or 0, level of
income equal to OY0has been plotted. Now, if the rate of interest falls to Or 1, the planned
investment by businessmen increases from OI0 to OI1 [see panel (a)].
With this increase in planned investment, the aggregate demand curve shifts upward to the new
position C + II in panel (b), and the goods market is in equilibrium at OY 1 level of national
income. Thus, in panel (c) at the bottom of Fig. 20.1 the level of national income OY 1 is plotted
against the rate of interest, Or1. With further lowering of the rate of interest to Or2, the planned
investment increases to OI2 [see panel (a)].

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With this further rise in planned investment the aggregate demand curve in panel (b) shifts
upward to the new position C +I2corresponding to which goods market is in equilibrium at
OY2 level of income. Therefore, in panel (c) the equilibrium income OY 2 is shown against the
interest rate Or2.
By joining points, A, B, D representing various interest-income combinations at which goods
market is in equilibrium we obtain the IS curve. It will be observed from Fig. 20.1 that the IS
curve is downward sloping (i.e., has a negative slope) which implies that when rate of interest
declines, the equilibrium level of national income increases.

Why does IS Curve Slope Downward?

What accounts for the downward-sloping nature of the IS curve? As seen above, the decline in
the rate of interest brings about an increase in the planned investment expenditure. The increase
in investment spending causes the aggregate demand curve to shift upward and therefore leads to
the increase in the equilibrium level of national income.

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Thus, a lower rate of interest is associated with a higher level of national income and vice versa.
This makes the IS curve, which relates the level of income with the rate of interest, to slope

downward. The IS curve is negatively sloped because a higher level of the interest rate reduces
investment spending, thereby reducing aggregate demand and thus the equilibrium level of
income. The steepness of the curve depends on how sensitive investment spending is to changes
in the interest rate, and also on the multiplier (K). If investment spending is very sensitive to
interest rate, then a given change in the interest rate produces a large change in aggregate
demand, and thus shifts the aggregate demand curve up by a large distance.

Factors Determining the Slope of the IS Curve

It is not enough to know that the IS curve is negatively sloped. It may be steep or flat. The
steepness of the curve is of considerable interest to us because it is a factor determining the
relative effectiveness of stabilization policies, viz., monetary and fiscal policies.

The steepness of the IS curve depends on two things

 Interest elasticity of investment
 MPS, i.e., the slope of saving curve.

1. Interest elasticity of investment

If the interest elasticity of investment is high, a small drop in r will lead to a large
increase in I and a correspondingly large increase in Y (through the investment multiplier).
When the investment (demand) curve is steep (I), a fall in r will increase I by only a small
amount. Therefore, an increase in saving and, hence, income is needed to restore equilibrium in
the commodity market.

So the IS curve in part c (IS) is steep. If the investment curve is relatively flat, investment will
increase by a much larger in respond to a fall in r. Thus increase is saving and income has to be
much larger than in the first case. In this case the IS curve will be relatively flat (such as IS’).

2. The slope of the saving curve

The slope of the IS curve also depends on the saving function whose slope is MPS. The
higher the MPS, the steeper is the IS curve. For a given fall in the interest rate, the amount by

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which income would have to be increased to restore equilibrium in the product market is smaller
(larger), the higher (lower) the MPS.

If the MPS is relatively high, then a small increase in income is necessary to generate the new
saving (required to support new investment caused by a fall in the rate of interest) than if the
MPS were low.

Shift in IS Curve

It is important to understand what determines the position of the IS curve and what causes shifts
in it. It is the level of autonomous expenditure which determines the position of the IS curve and
changes in the autonomous expenditure cause a shift in it. By autonomous expenditure we mean
the expenditure, be it investment expenditure, the Government spending or consumption
expenditure, which does not depend on the level of income and the rate of interest. The
government expenditure is an important type of autonomous expenditure. Note that the
Government expenditure, which is determined by several factors as well as by the policies of the
Government, does not depend on the level of income and the rate of interest.

Similarly, some consumption expenditure has to be made if individuals have to survive even by
borrowing from others or by spending their savings made in the past year. Such consumption
expenditure is a sort of autonomous expenditure and changes in it do not depend on the changes
in income and rate of interest. Further, autonomous changes in investment can also occur.

In the goods market equilibrium of the simple Keynesian model the investment expenditure is
treated as autonomous or independent of the level of income and therefore does not vary as the
level of income increases. However, in the complete Keynesian model, the investment spending
is thought to be determined by the rate of interest along with marginal efficiency of investment.

Following this complete Keynesian model, in the derivation of the IS curve we consider the level
of investment and changes in it as determined by the rate of interest along with marginal
efficiency of capital. However, there can be changes in investment spending autonomous or
independent of the changes in rate of interest and the level of income.

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For instance, growing population requires more investment in house construction, school
buildings, roads, etc., which does not depend on changes in level of income or rate of interest.
Further, autonomous changes in investment spending can also take place when new innovations
come about, that is, when there is progress in technology and new machines, equipment, tools
etc., have to be built embodying the new technology.

Besides, Government expenditure is also of autonomous type as it does not depend on income
and rate of interest in the economy. As is well known, government increases its expenditure for
the purpose of promoting social welfare and accelerating economic growth. Increase in
Government expenditure will cause a rightward shift in the IS curve.

Money Market Equilibrium: LM Curve

By Money Market, we mean the interaction between demand for money and the supply of
money (the size of the money stock) as set by the Federal Reserve working through the banking
system.

The LM part of the model is the LM curve, or the money market equilibrium schedule (in
contrast with the goods market in IS). The LM curve shows the combinations of interest rates
and output levels so that money demand equals money supply.

LM Slope

 The LM curve is positively sloped.

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  An increase in income (and quantity of money demanded) has to occur with an
increase in the interest rate, which cuts the amount of money demanded and
establishes market equilibrium.
 A steeper LM curve will result from increased responsiveness of the demand for
money to income, and lower responsiveness of the demand for money to the
interest rate.
 A horizontal LM curve creates a liquidity trap as a result of hyper-sensitive
demand for money.
 An increase in the money supply moves the curve to the right (slope remains the
same).

Derivation of the LM Curve

The LM curve can be derived from the Keynesian theory from its analysis of money market
equilibrium. According to Keynes, demand for money to hold depends upon transactions motive
and speculative motive. It is the money held for transactions motive which is a function of
income. The greater the level of income, the greater the amount of money held for transactions
motive and therefore higher the level of money demand curve.

The demand for money depends on the level of income because they have to finance their
expenditure, that is, their transactions of buying goods and services. The demand for money also
depends on the rate of interest which is the cost of holding money. This is because by holding
money rather than lending it and buying other financial assets, one has to forgo interest.

Thus demand for money (Md) can be expressed as

Md = L (Y, r)
where Md stands for demand for money, Y for real income and r for rate of interest. Thus, we can
draw a family of money demand curves at various levels of income. Now, the intersection of
these various money demand curves corresponding to different income levels with the supply
curve of money fixed by the monetary authority would give us the LM curve.
The LM curve relates the level of income with the rate of interest which is determined by
money-market equilibrium corresponding to different levels of demand for money. The LM

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curve tells what the various rates of interest will be (given the quantity of money and the family
of demand curves for money) at different levels of income.

But the money demand curve or what Keynes calls the liquidity preference curve alone rises. In
Fig. 20.2 (b) we measure income on the X-axis and plot the income level corresponding to the
various interest rates determined at those income levels through money market equilibrium by
the equality of demand for and the supply of money in Fig. 20.2 (a).

Slope of LM Curve
It will be noticed from Fig. 20.2 (b) that the LM curve slopes upward to the right. This is because
with higher levels of income, demand curve for money (M d) is higher and consequently the
money- market equilibrium, that is, the equality of the given money supply with money demand
curve occurs at a higher rate of interest. This implies that rate of interest varies directly with
income.
It is important to know the factors on which the slope of the LM curve depends. There are two
factors on which the slope of the LM curve depends. First, the responsiveness of demand for
money (i.e., liquidity preference) to the changes in income. As the income increases, say from
Y0 to Y1, the demand curve for money shifts from M d0 to Md1, that is, with an increase in income,
demand for money would increase for being held for transactions motive, Md or L1 =f(Y).
This extra demand for money would disturb the money market equilibrium and for the
equilibrium to be restored the rate of interest will rise to the level where the given money supply

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curve intersects the new demand curve corresponding to the higher income level. It is worth
noting that in the new equilibrium position, with the given stock of money supply, money held
under the transactions motive will increase whereas the money held for speculative motive will
decline.

The greater the extent to which demand for money for transactions motive increases with the
increase in income, the greater the decline in the supply of money available for speculative
motive and, given the demand for money for speculative motive, the higher the rise in the rate of
interest and consequently the steeper the LM curve, r = f (M 2, L2) where r is the rate of interest,
M2 is the stock of money available for speculative motive and L2 is the money demand or
liquidity preference function for speculative motive.
The second factor which determines the slope of the LM curve is the elasticity or responsiveness
of demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of
interest. The lower the elasticity of liquidity preference for speculative motive with respect to the
changes in the rate of interest, the steeper will be the LM curve. On the other hand, if the
elasticity of liquidity preference (money demand function) to the changes in the rate of interest is
high, the LM curve will be flatter or less steep.

Shifts in the LM Curve

Another important thing to know about the IS-LM curve model is that what brings about shifts in
the LM curve or, in other words, what determines the position of the LM curve. A LM curve is
drawn by keeping the stock or money supply fixed. Therefore, when the money supply increases,
given the money demand function, it will lower the rate of interest at the given level of income.
This is because with income fixed, the rate of interest must fall so that demand for money for
speculative and transactions motive rises to become equal to the greater money supply. This will
cause the LM curve to shift outward to the right.

The other factor which causes a shift in the LM curve is the change in liquidity preference
(money demand function) for a given level of income. If the liquidity preference function for a
given level of income shifts upward, this, given the stock of money, will lead to the rise in the
rate of interest for a given level of income. This will bring about a shift in the LM curve to the
left.

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It therefore follows from above that increase in the money demand function causes the LM curve
to shift to the left. Similarly, on the contrary, if the money demand function for a given level of
income declines, it will lower the rate of interest for a given level of income and will therefore
shift the LM curve to the right.

Essential Features of LM curve

 The LM curve is a schedule that describes the combinations of rate of interest and level
of income at which money market is in equilibrium.
 The LM curve slopes upward to the right.
 The LM curve is flatter if the interest elasticity of demand for money is high. On the
contrary, the LM curve is steep if the interest elasticity demand for money is low.
 The LM curve shifts to the right when the stock of money supply is increased and it shifts
to the left if the stock of money supply is reduced.
 The LM curve shifts to the left if there is an increase in the money demand function
which raises the quantity of money demanded at the given interest rate and income level.
On the other hand, the LM curve shifts to the right if there is a decrease in the money
demand function which lowers the amount of money demanded at given levels of interest
rate and income.

Why LM curve is positively sloped?

LM here stands for Liquidity Preference-Money Supply. Thus, the LM curve depicts equilibrium
in the money market. Now, LM curve gives us combinations of Income and Interest Rates at
which the money market is in equilibrium. When Income increases, Money demand increases
with money supply being constant which leads to an increase in the interest rate. Thus, an
increase in Y is accompanied with an increase in the interest rate.

Hence, LM curve is upward sloping.

Interaction between Goods and Money market:

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  The money market determines the interest rate. The demand for money in the money
market is affected by income (which is determined in the goods market).
 The goods market determines income, which depends on planned investment. Planned
investment in turn depends on the interest rate (which is determined in the money
market). Thus:

If something changes in goods markets and affects Y, this in turn will affect Md and hence
affect r.

If something changes in money markets and affects r, this in turn will affect Ip, and hence
affect Y.

The Interest Rate and Planned Investment

Back when we first set out the goods market, we had to leave Ip as fixed -- exogenously set.
Now, finally, we have a theory about why Ip might change.

 The argument is as follows: interest rates reflect the cost of borrowing in order to finance
investment projects. (Interest rates are not the only thing that determines decisions, but they are
the variable we will focus on since they give us the links between the money market and the
goods market). Other things being equal, as interest rates rise, it becomes more expensive to
finance investment projects. Thus, as r increases, the number of investment projects planned will
decline. This will reduce the level of investment expenditures in the goods market.

 So Ip increases as r decreases, and Ip decreases as r increases.

A more extensive explanation would go like this: a firm may have a number of different capital
investment projects in mind. If we assume that it can consider each one separately, and attach an
expected rate of return to it with confidence, then at an interest rate of ten percent a firm will
undertake all the projects that will generate a ten percent rate of return or better, but it will not
borrow at ten percent to finance a project that will produce only a nine percent return. If the
interest rate falls to eight percent, though, that project that offered a nine percent return now

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looks pretty good. So the lower the interest rate, the larger the amount of capital equipment firms
will acquire, or the higher will be Ip.

Planned Investment and the Equilibrium Level of National Income

 As shown above, as r decreases, Ip increases. Now as Ip increases, aggregate expenditures

increase. And, as aggregate expenditures increase, equilibrium Y increases. This works exactly
like an increase in G: it's additional demand for goods, which will call forth additional output of
goods. As output (Y) rises C rises, which means even more demand for goods, more output,
more C, etcetera. So the multiplier process will produce a larger change in equilibrium Y than
the initial increment in Ip.

So we have the whole picture in place. When the Fed increases the money supply, it lowers the
interest rate. This causes Ip to increase, and thus causes aggregate expenditures to increase. This
in turn will set loose our multiplier and cause income to increase. When the Fed reduces the
money supply, this causes interest rates to rise, this in turn causes Ip to fall, and thus causes
aggregate expenditures to fall. This is turn will let loose our multiplier process and cause income
and employment to decrease. Thus, expansionary monetary policy means that the Fed is either
reducing the required reserve ratio, lowering the discount rate, or buying bonds. Any of these
policies will increase the money supply, which should reduce interest rates and cause investment,
and hence expenditures, and income and employment, to increase.

Contractionary monetary policy is when the Fed practices a policy of "tight money." This
involves either raising the required reserve ratio, raising the discount rate, or selling bonds. Any
of these policies will reduce the money supply (hence "tight money"), which will increase the
interest rate. This causes investment to fall, which in turn will cause expenditures, income and
employment to decrease.

Impact of the Goods Market on the Money Market

We're not quite done yet. We've have looked at how the money markets affect the goods
markets, but not examined the reverse in any detail. The argument is: as Y increases, Md
increases. As Md increases, ceteris paribus, r will increase. Let us say that the government cut

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taxes. This will cause Y to increase. As Y increased in the goods market. Md increases, causing r
to increase. As a result, Ip will fall. Similarly, if Y falls, Md falls. As Md falls, ceteris paribus,  r
will fall. On the other hand, if government spending were cut, the resulting lower Y would
reduce Md, and r would fall. Ip would then rise. (We also noted earlier that if the price level
changed Md would change. We'll get to price-level changes later.)

Interactions Between Fiscal and Monetary Policy

Let us start by assuming that the government undertakes expansionary fiscal policy to
increase Y and hence to increase employment. Let us say the government increased G. When the
government increases G, we already know that aggregate expenditures, and hence aggregate
income, will increase. But, as Y increases, Md will increase. And, as Md increases, r
increases. This in turn causes Ip to decrease. As Ip decreases, this "dampens" the impact of fiscal
policy and income does not rise by as much. The effect of fiscal policy on money markets causes
the interest rate to rise and thus causes investment to fall. This is sometimes called "crowding
out," where the government's expansionary fiscal policy can reduce investment and thus harm
growth. Note that these repercussion effects and crowding out would not happen if the fed had
increased the money supply as Y increased, and thus prevented r from rising when the Fed does
this, the Fed is "accommodating" the expansionary fiscal policy to prevent crowding out and to
thus prevent fiscal policy from harming future growth.

 How the Effects of Monetary Policy Are Modified by the Goods Market? 

As noted above, the Fed can affect the goods markets by changing the money supply and hence
affecting r. This in turn affects Ip, which affects Y. Suppose the Fed bought bonds and increased
the money supply. As we know from our theory, this will cause r to drop as the money market
seeks a new equilibrium. The drop in r raises Ip. As Ip rises, Y rises. But: as Y rises, Md rises,
and as Md rises, that will push r back up just a little. Therefore: r will not fall by as much once
we take the interactions between the two markets into account.

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Investment and the Interest Rate Revisited 

Note that in the story of crowding out under fiscal policy, the key question that we have
to address is exactly how much investment will change as r changes. In other words, the question
of crowding out due to fiscal policy depends on the interest sensitivity of investment. Similarly,
for monetary policy the ability of monetary authorities to affect the goods market via monetary
expansions depends on the extent to which investment responds to the interest rate.

 Thus, in assessing the interactions between goods and money markets, the key factor that will
determine the extent of the repercussions between goods and money markets will be the extent to
which planned investment responds to changes in the interest rate.

 While investment depends on the interest rate, it also depends on many other things. Two key
variables that can determine planned investment are firm’s expectations about the future
prospects for sales in goods markets, and the level of unutilized or underutilized capital they
already have. If firms have a low expectation of future sales because they are nervous about a
recession, or if firms already have a lot of unused production capacity, firms will not increase
planned investment very much even if interest rates drop. Thus, the interest rate sensitivity of
planned investment will depend on the expectations and capital utilization rates that firms have.

The Macroeconomic Policy Mix

  As we have seen above, the government can use both fiscal and monetary policy to affect
income and employment, though this may be easier said than done. In the United States fiscal
policy (taxing and spending) is controlled by Congress, while monetary policy is controlled by
the Federal Reserve, which is largely independent of Congress (or the Presidency).

Let's run through the possible combinations:

 Expansionary fiscal policy with contractionary monetary policy: this would help to boost
demand and employment, but hurt investment and hence long-term growth. The extent of
this impact depends on how sensitive investment is to the interest rate.

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  Contractionary fiscal policy with expansionary monetary policy: this should favor
investment, since the combination of fiscal contraction and monetary expansion will
lower interest rates. However, again, the net effect on income will depend on how
sensitive investment is to the interest rate. If investment increases, but not enough to
compensate for the drop on government expenditures, then income and employment will
decrease.
 Expansionary fiscal policy with expansionary monetary policy: as long as the money
supply is increased by the appropriate amount to ensure that interest rates don't rise, the
fiscal expansion will cause income and employment to increase without hurting
investment and growth: both G and Ip will rise.
 Contractionary fiscal policy with contractionary monetary policy: the reduction in G
Lowers Y and also lowers Md which would normally lower r and boost Ip, but we also
lower Ms at the same time so that r is not as likely to fall, and may even rise, in which
case both G and Ip fall.

 There is no hard and fast rule about the appropriate mix to follow. The correct mix will depend
on how bad the recessionary pressures in an economy are, and how strongly investment responds
to the interest rate.

But we can say this: if Ip is highly sensitive to r, then monetary policy is quite effective, and the
monetary repercussions of fiscal policy will tend to dampen its effects. So if Ip is very sensitive
to r, use monetary policy to change Y. On the other hand, if Ip is not very sensitive to r then
you're better off using fiscal policy: not only will monetary policy be weak, but if you go with
fiscal policy the dampening repercussions through the money market will be insignificant.

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Simultaneous Equilibrium of Goods Market and Money Market

The IS and the LM curves relate the two variables.

(a) Income and

(b)The rate of interest.

 Income and the rate of interest are therefore determined together at the point of
intersection of these two curves, i.e., E in Fig. 20.3. The equilibrium rate of interest thus
determined is Or2 and the level of income determined is OY2.
 At this point income and the rate of interest stand in relation to each other such that (1)
the goods market is in equilibrium, that is, the aggregate demand equals the level of
aggregate output, and (2) the demand for money is in equilibrium with the supply of
money (i.e., the desired amount of money is equal to the actual supply of money). It
should be noted that LM curve has been drawn by keeping the supply of money fixed.

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Thus, the IS-LM curve model is based on
 The investment-demand function, the investment demand function is something that
can change. It is simply the relationship between the interest rate and the amount of
investment that is demanded. This curve can shift far a variety of reasons and that means
that the function can change when those factors can change.
 The consumption function, the consumption function, or Keynesian consumption
function, is an economic formula that represents the functional relationship between
total consumption and gross national income. It was introduced by British
economist John Maynard Keynes, who argued the function could be used to track and
predict total aggregate consumption expenditures.
 The money demand function, a money demand function displays the influence that
some aggregate economic variables will have on the aggregate demand for money.
The above discussion indicates that money demand will depend positively on the level of
real gross domestic product (GDP) and the price level due to the demand for transactions.
 The quantity of money, according to the quantity theory of money, if the amount of
money in an economy doubles, all else equal, price levels will also double. This means
that the consumer will pay twice as much for the same amount of goods and services.
This increase in price levels will eventually result in a rising inflation level; inflation is a
measure of the rate of rising prices of goods and services in an economy.

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  We see, therefore, that according to the IS-LM curve model both the real factors, namely,
saving and investment, productivity of capital and propensity to consume and save, and
the monetary factors, that is, the demand for money (liquidity preference) and supply of
money play a part in the joint determination of the rate of interest and the level of
income.
 Any change in these factors will cause a shift in IS or LM curve and will therefore
change the equilibrium levels of the rate of interest and income. The IS-LM curve model
explained above has succeeded in integrating the theory of money with the theory of
income determination. And by doing so, as we shall see below, it has succeeded in
synthesizing the monetary and fiscal policies.
 Further, with the IS-LM curve analysis, we are better able to explain the effect of changes
in certain important economic variables such as desire to save, the supply of money,
investment, demand for money on the rate of interest and level of income.

Characteristics of the IS-LM Graph

The IS-LM graph consists of two curves, IS and LM. Gross domestic product (GDP), or (Y), is
placed on the horizontal axis, increasing to the right. The interest rate, or (i or R), makes up the
vertical axis.

The IS curve depicts the set of all levels of interest rates and output (GDP) at which total
investment (I) equals total saving (S). At lower interest rates, investment is higher, which
translates into more total output (GDP), so the IS curve slopes downward and to the right.

The LM curve depicts the set of all levels of income (GDP) and interest rates at which money
supply equals money (liquidity) demand. The LM curve slopes upward because higher levels of
income (GDP) induce increased demand to hold money balances for transactions, which
requires a higher interest rate to keep money supply and liquidity demand in equilibrium.

The intersection of the IS and LM curves shows the equilibrium point of interest rates and
output when money markets and the real economy are in balance. Multiple scenarios or points
in time may be represented by adding additional IS and LM curves.

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In some versions of the graph, curves display limited convexity or concavity. Shifts in the
position and shape of the IS and LM curves, representing changing preferences for liquidity,
investment, and consumption, alter the equilibrium levels of income and interest rates.

Limitations of the IS-LM Model:

The IS-LM model, however, suffers from two serious limitations
 It is a comparative-static equilibrium model. It ignores the time-lags which are important
in examining the effects of economic policy changes.
 If has been called the fix-price model. The model does not enable us to examine the
effects of changes in aggregate demand on both output and prices. If we take the
Keynesian version of the model, then we have to assume a constant price level and so we
cannot analyses the problem of inflation. On the other side, if we take the neoclassical
version of the model, which applies when full employment is reached the price level is
determined by the nominal money supply and output is assumed to be determined
exogenously.
 In view of these limitations of the IS-LM model, Professor Patinkin suggested a more
detailed general equilibrium framework which could bring into sharp focus the
differences between the classical and the Keynesians. He has arrived at the conclusion
that the two models are special cases of a general equilibrium model Prof. Milton
Friedman has developed a new flex price model to determine also the price level.

A Critique of the IS-LM Curve Model

The IS-LM curve model makes a significant advance in explaining the simultaneous
determination of the rate of interest and the level of national income. It represents a more
general, inclusive and realistic approach to the determination of interest rate and level of income.
Further, the IS-LM model succeeds in integrating and synthesizing fiscal with monetary policies,
and theory of income determination with the theory of money. But the IS-LM curve model is not
without limitations. Firstly, it is based on the assumption that the rate of interest is quite flexible,
that is, free to vary and not rigidly fixed by the Central Bank of a country.

If the rate of interest is quite inflexible, then the appropriate adjustment explained above will not
take place. Secondly, the model is also based upon the assumption that investment is interest-

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elastic, that is, investment varies with the rate of interest. If investment is interest-inelastic, then
the IS-LM curve model breaks down since the required adjustments do not occur.

Thirdly, Don Patinkin and Milton Friedman have criticized the IS-LM curve model as being too
artificial and over-simplified. In their view, division of the economy into two sectors – monetary
and real – is artificial and unrealistic. According to them, monetary and real sectors are quite
interwoven and act and react on each other.

Further, Patinkin has pointed out that the IS-LM curve model has ignored the possibility of
changes in the price level of commodities. According to him, the various economic variables
such as supply of money, propensity to consume or save, investment and the demand for money
not only influence the rate of interest and the level of national income but also the prices of
commodities and services. Patinkin has suggested a more integrated and general equilibrium
approach which involves the simultaneous determination of not only the rate of interest and the

level of income but also of the prices of commodities and services.

Conclusion

1st Research paper:

Fiscal policy in IS-LM analysis

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 William L. Silber

It has been demonstrated that traditional IS-LM analysis has not treated the bond-finance and
new money-finance cases of government deficits symmetrically. When proper treatment is given
to the former case, it has found that in the simple world of IS-LM analysis, government
expenditure financed by selling bonds to the public can be contractionary. Even when GNP does
go up due to G, the increase that occurs is overstated in the traditional IS-LM model of income
determination. The failure to incorporate- rate the monetary aspects of debt finance into the LM
function is the major source of confusion. While other studies have treated this question, it has
never been formally incorporated into IS-LM models. This has led to incorrect conclusions
regarding the multiplier effects of government spending.
We also noted that there is still a case in which it is possible to experiment with a fixed LM
curve. If the deficit is financed with a combined increase in money and debt the LM curve could
remain constant. This will occur when the increase in the supply of M just compensates for the
increase in the demand for M brought about by the simultaneous increase in bond supply. Thus,
within the IS-LM framework it is still possible to examine fiscal policy with a fixed LM curve
although that occurs in a situation of mixed money and bond finance rather than pure bond
finance.

2nd research paper:

Will the New Keynesian Macroeconomics Resurrect The IS-LM Model?

Robert G. King
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New Keynesian macroeconomics has pushed the idea that traditional IS-LM analysis remains the
best way to think about the determination of aggregate demand. This essay has challenged that
view, arguing that expectations are typically omitted from that analysis, and that they are
quantitatively important determinants of aggregate demand. But it has raised a question that will
the attempt to resurrect the IS-LM model divert the profession from this essential line of
research? After two decades of rational expectations research, the agenda for academic
researchers and policy economists should hold two main issues. First, economists should be-as
many are-constructing new small-scale dynamic theoretical models to take the place of the IS-
LM apparatus. And the synthesis that is envisioned by John Campbell (1991) is not very
different from the one envisioned by King, Plosser and Rebelo (1988a, b). The framework will
be the basic neoclassical model; rational expectations will play a central role; and the effects of
various frictions will be systematically explored. Second, economists should be-although few
currently are-constructing medium-size dynamic models that can serve as laboratories for
thinking about the details of policy choice. Ultimately, that activity is best done as a joint product
by researchers working in academic and policy institutions. The attempt to resurrect the IS-LM
model is unlikely to have much direct effect on the first activity: it is simply too major a
component of ongoing academic research. That fact lends an inevitability to the ultimate demise
of the IS-LM model, but it leaves open the issue of how far away is the long run. But the
insistence on the continued utility of the IS-LM framework will have a negative, direct effect on
the second task: it will contribute to postponing the development of a new generation of macro
econometric policy models in which rational expectations play a central role. As a result of the
intellectual capital accumulated under the rational expectations program, we are now at a point
where it is feasible, though hardly costless, to execute this development. The danger is that
macroeconomists and policy-makers will pay too much attention to the new Keynesian
advertising, and assume for too long that the old product is a sound one.

3rd research paper:

Macroeconomic Implications of the Monetary Policy Committee

Recommendations: An IS-LM Framework
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 Khyati Kathuria1 and Pawan Whig

The stance taken by the monetary policy committee have strong micro and macroeconomic
impacts on the economy. Given that Indian economy had been losing pace in the global economy
certain bold decisions were taken by the MPC and the Ministry of Finance in the year 2019 in the
MPC meeting. Such decisions have a strong impact of the economy. This study tried to study the
impact by connecting it to the theoretical framework of macroeconomics in diagrammatic
fashion using IS-LM and AD-AS framework. It was found that though the welfare oriented the
policies did not treat the actual disease the economy was suffering from that is the lacking
consumer demand. As neither firm would raise the output in reaction to a tax cut if the
consumers are not willing to spend. Therefore, it is suggested that the more effective solution
would be to inject more liquidity by increasing the consumer’s disposable income.

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