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IS–LM model, or Hicks–Hansen model, is a two-dimensional
macroeconomic Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, an ...
tool that shows the relationship between
interest rates An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
and assets market (also known as real output in goods and services market plus money market). The intersection of the "
investment Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...
saving" (IS) and " liquidity preference
money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circu ...
" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in
national income A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP), net national income (NNI), and adjusted nat ...
when the price level is fixed in the short-run; second, the IS–LM model shows why an
aggregate demand curve In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is ...
can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies. The model was developed by
John Hicks Sir John Richards Hicks (8 April 1904 – 20 May 1989) was a British economist. He is considered one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economic ...
in 1937 and was later extended by
Alvin Hansen Alvin Harvey Hansen (August 23, 1887 – June 6, 1975) was an American economist who taught at the University of Minnesota and was later a chair professor of economics at Harvard University. Often referred to as "the American Keynes", he was a w ...
, as a mathematical representation of Keynesian macroeconomic theory. Between the 1940s and mid-1970s, it was the leading framework of macroeconomic analysis. While it has been largely absent from macroeconomic research ever since, it is still a backbone conceptual introductory tool in many macroeconomics textbooks. By itself, the IS–LM model is used to study the short run when
prices A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in t ...
are fixed or sticky and no
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
is taken into consideration. But in practice the main role of the model is as a path to explain the AD–AS model.


History

The IS–LM model was introduced at a conference of the
Econometric Society The Econometric Society is an international society of academic economists interested in applying statistical tools to their field. It is an independent organization with no connections to societies of professional mathematicians or statisticians. ...
held in Oxford during September 1936. Roy Harrod, John R. Hicks, and James Meade all presented papers describing
mathematical model A mathematical model is a description of a system using mathematical concepts and language. The process of developing a mathematical model is termed mathematical modeling. Mathematical models are used in the natural sciences (such as physics, ...
s attempting to summarize
John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...
' '' General Theory of Employment, Interest, and Money''. Hicks, who had seen a draft of Harrod's paper, invented the IS–LM model (originally using the
abbreviation An abbreviation (from Latin ''brevis'', meaning ''short'') is a shortened form of a word or phrase, by any method. It may consist of a group of letters or words taken from the full version of the word or phrase; for example, the word ''abbrevia ...
"LL", not "LM"). He later presented it in "Mr. Keynes and the Classics: A Suggested Interpretation". 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 Real business-cycle theory (RBC theory) is a class of new classical macroeconomics models in which business-cycle fluctuations are accounted for by real (in contrast to nominal) shocks. Unlike other leading theories of the business cycle, RBC t ...
and new Keynesian theories. For a contemporary and alternative reinvention of the IS-LM approach that uses Keynesian Search Theory, see Roger Farmer's work on the IS-LM-NAC model, part of his broader research agenda which studies how beliefs independently influence macroeconomic outcomes.


Formation

The point where the IS and LM 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 Real gross domestic product (real GDP) is a macroeconomic measure of the value of economic output adjusted for price changes (i.e. inflation or deflation). This adjustment transforms the money-value measure, nominal GDP, into an index for quantity ...
.


IS (investment–saving) curve

The IS curve shows the causation from interest rates to planned investment to national income and output. For the investment–saving curve, the
independent variable Dependent and independent variables are variables in mathematical modeling, statistical modeling and experimental sciences. Dependent variables receive this name because, in an experiment, their values are studied under the supposition or dema ...
is the interest rate and the
dependent variable Dependent and independent variables are variables in mathematical modeling, statistical modeling and experimental sciences. Dependent variables receive this name because, in an experiment, their values are studied under the supposition or dema ...
is the level of income. 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 IS curve represents the locus where total spending (consumer spending + planned private investment + government purchases + net exports) equals total output (real income, ''Y'', or GDP). The IS curve also represents the equilibria where total private investment equals total saving, with saving equal to consumer saving ''plus'' government saving (the budget surplus) ''plus'' foreign saving (the trade surplus). The level of real GDP (Y) is determined along this line for each
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
. Every level of the real interest rate will generate a certain level of investment and spending: lower interest rates encourage higher investment and more spending. 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, the IS curve shows the causation from interest rates to planned fixed investment to rising national income and output. The IS curve is defined by the equation :Y = C \left(-\right) + I \left(\right) + G + NX(Y), where ''Y'' represents income, C(Y-T(Y)) represents consumer spending increasing as a function of disposable income (income, ''Y'', minus taxes, ''T''(''Y''), which themselves depend positively on income), I(r) represents business investment decreasing as a function of the real interest rate, ''G'' represents government spending, and ''NX''(''Y'') represents net exports (exports minus imports) decreasing as a function of income (decreasing because imports are an increasing function of income).


LM (liquidity-money) curve

The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium. It shows where money demand equals money supply. For the LM curve, the independent variable is income and the dependent variable is the interest rate. In the money market equilibrium diagram, the liquidity preference function is the willingness to hold cash. The liquidity preference function is downward sloping (i.e. the willingness to hold cash increases as the interest rate decreases). Two basic elements determine the quantity of cash balances demanded: # 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. As GDP is considered exogenous to the liquidity preference function, changes in GDP shift the curve. # 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 In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for example ...
of holding money rather than investing in securities increases. So, as interest rates rise, speculative demand for money falls. Money supply is determined by central bank decisions and willingness of commercial banks to loan money. Money supply in effect is perfectly inelastic with respect to nominal interest rates. 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 M/P=L(i,Y), 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. 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 In economics and political science, fiscal policy is the use of government revenue collection ( taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variabl ...
") 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 In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is ...
. 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 In macroeconomics, particularly in the history of economic thought, the Treasury view is the assertion that fiscal policy has ''no'' effect on the total amount of economic activity and unemployment, even during times of economic recession. This ...
"). Rightward shifts of the IS curve also result from
exogenous In a variety of contexts, exogeny or exogeneity () is the fact of an action or object originating externally. It contrasts with endogeneity or endogeny, the fact of being influenced within a system. Economics In an economic model, an exogen ...
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 Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for federal funds, very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money s ...
. 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 A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in t ...
are fixed or sticky and no
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
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.


Introduction of the new full equilibrium (FE) component: The IS–LM–FE model

Sir
John Hicks Sir John Richards Hicks (8 April 1904 – 20 May 1989) was a British economist. He is considered one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economic ...
, a
Nobel laureate The Nobel Prizes ( sv, Nobelpriset, no, Nobelprisen) are awarded annually by the Royal Swedish Academy of Sciences, the Swedish Academy, the Karolinska Institutet, and the Norwegian Nobel Committee to individuals and organizations who make o ...
, created the model in 1937 as a graphical representation of the ideas introduced by
John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...
in his influential 1936 book, The General Theory of Employment, Interest, and Money. In his original IS–LM model, Hicks assumed that the price level was fixed, reflecting John Maynard Keynes' belief that wages and prices do not adapt quickly to clear markets. The introduction of an adjustment to Hicks' loose assumption of a fixed price level requires allowing the price level to change. Allowing the price level to change necessitates the addition of a third component, the full equilibrium (FE) condition. When this component is added to the IS–LM model, a new model called IS–LM–FE emerges. The IS–LM–FE model is widely used in cyclical fluctuations analysis, forecasting, and macroeconomic policymaking. There are many advantages to using the IS–LM–FE model as a framework for both classical and
Keynesian Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...
analyses: First, rather than learning two different models for classical and Keynesian analyses, a single model can be used for both. Second, using a single framework highlights the many areas of agreement between the
Keynesian Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...
and classical approaches while also emphasizing the differences between them. Furthermore, since various versions of the IS–LM–FE model (along with its ideas and terminology) are frequently used in economic and macroeconomic policy analyses, studying this framework will help to understand and engage in contemporary economic debates. Three approaches are used when analyzing this economic model: graphical, numerical, and algebraic.


Reinventing IS-LM: the IS-LM-NAC model

In the IS-LM-NAC model, the long-run effect of monetary policy depends on the way people form beliefs. Roger Farmer and Konstantin Platonov study a case they call 'persistent adaptive beliefs' in which people believe, correctly, that shocks to asset values are permanent. The important innovation in this work is a model of the labor market in which there can be a continuum of long-run steady state equilibria.


See also

* Keynesian cross * AD–IA model * IS/MP model * Mundell–Fleming model *
National savings In economics, a country's national saving is the sum of private and public saving. It equals a nation's income minus consumption and the government spending. Economic model Closed economy with public deficit or surplus possible In this ...
* Policy mix


References


Further reading

* * * * * * * * * * * * * * *


External links

* Krugman, Paul
There's something about macro
– An explanation of the model and its role in understanding macroeconomics. * Krugman, Paul
IS-LMentary
– A basic explanation of the model and its uses. * Wiens, Elmer G
IS–LM model
– An online, interactive IS–LM model of the Canadian economy. {{DEFAULTSORT:Is Lm Model Economics curves Economics models General equilibrium theory Keynesian economics 1937 in economics