IS–LM model
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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, and ...
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 money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less. As short-term securities became a commodity, the money market became a compon ...
). 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 i ...
saving Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in, for example, a deposit account, a pension account, an investment fund, or as cash. Saving also involves reducing expenditures, such as recur ...
" (IS) and "
liquidity preference __NOTOC__ In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book ''The General Theory of Employment, Interest and Money'' (1936) to expl ...
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 Circulation (curren ...
" (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 nati ...
when the price level is fixed in the short-run; second, the IS–LM model shows why an aggregate demand curve 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 John Maynard Keynes ...
, 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 the c ...
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 reductio ...
is taken into consideration. But in practice the main role of the model is as a path to explain the
AD–AS model The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output (economics), output through the relationship of aggregate demand (AD) and aggregate supply (AS). It is based on the theory of ...
.


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 Sir Henry Roy Forbes Harrod (13 February 1900 – 8 March 1978) was an English economist. He is best known for writing ''The Life of John Maynard Keynes'' (1951) and for the development of the Harrod–Domar model, which he and Evsey Domar devel ...
, John R. Hicks, and
James Meade James Edward Meade, (23 June 1907 – 22 December 1995) was a British economist and winner of the 1977 Nobel Memorial Prize in Economic Sciences jointly with the Swedish economist Bertil Ohlin for their "pathbreaking contribution to the ...
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 ''The General Theory of Employment, Interest and Money'' is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and ...
''. 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 macroeconomic model, models in which business-cycle fluctuations are accounted for by Real vs. nominal in economics, real (in contrast to nominal) Shock (economics) ...
and
new Keynesian New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroec ...
theories. For a contemporary and alternative reinvention of the IS-LM approach that uses Keynesian Search Theory, see
Roger Farmer Roger Edward Alfred Farmer is a British/American economist. He is currently a professor at the University of Warwick and is a Distinguished Emeritus Professor and former Chair of the Economics department at the University of California, Los Ange ...
'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 demand ...
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 demand ...
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 Locus (plural loci) is Latin for "place". It may refer to: Entertainment * Locus (comics), a Marvel Comics mutant villainess, a member of the Mutant Liberation Front * ''Locus'' (magazine), science fiction and fantasy magazine ** ''Locus Award' ...
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, th ...
. 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 In macroeconomics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable. For example, suppose variable ''x'' changes by ''k'' units, which causes ano ...
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 Transactions demand, in economic theory, specifically Keynesian economics and monetary economics, is one of the determinants of the demand for money, the others being asset demand and precautionary demand. Overview The transactions demand for mo ...
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 The speculative or asset demand for money is the demand for highly liquid financial assets — domestic money or foreign currency — that is not dictated by real transactions such as trade or consumption expenditure. Speculative demand arises fro ...
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 In economics, elasticity measures the percentage change of one economic variable in response to a percentage change in another. If the price elasticity of the demand of something is -2, a 10% increase in price causes the demand quantity to fall b ...
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 Real may refer to: Currencies * Brazilian real (R$) * Central American Republic real * Mexican real * Portuguese real * Spanish real * Spanish colonial real Music Albums * ''Real'' (L'Arc-en-Ciel album) (2000) * ''Real'' (Bright album) (2010) ...
amount ''M''/''P'' (as opposed to the nominal amount ''M''), with ''P'' representing the
price level The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...
, 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 Within the budgetary process, deficit spending is the amount by which spending exceeds revenue over a particular period of time, also called simply deficit, or budget deficit; the opposite of budget surplus. The term may be applied to the budget ...
("
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 variables ...
") 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 The accelerator effect in economics is a positive effect on private fixed investment of the growth of the market economy (measured e.g. by a change in Gross Domestic Product). Rising GDP (an economic boom or prosperity) implies that businesses in g ...
, 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 vie ...
"). 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 exogeno ...
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 very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
. 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 the c ...
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 reductio ...
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 The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output (economics), output through the relationship of aggregate demand (AD) and aggregate supply (AS). It is based on the theory of ...
) which allow for a flexible
price level The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...
. 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 out ...
, 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 ''The General Theory of Employment, Interest and Money'' is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and ...
. 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 The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...
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 and ...
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 and ...
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 Roger Edward Alfred Farmer is a British/American economist. He is currently a professor at the University of Warwick and is a Distinguished Emeritus Professor and former Chair of the Economics department at the University of California, Los Ange ...
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 The Keynesian cross diagram is a formulation of the central ideas in Keynes' ''General Theory of Employment, Interest and Money''. It first appeared as a central component of macroeconomic theory as it was taught by Paul Samuelson in his textbook ...
* AD–IA model * IS/MP model *
Mundell–Fleming model The Mundell–Fleming model, also known as the IS-LM-BoP model (or IS-LM-BP model), is an economic model first set forth (independently) by Robert Mundell and Marcus Fleming. Reprinted in Reprinted in The model is an extension of the IS–LM mo ...
*
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 The policy mix is the combination of a country's monetary policy and fiscal policy. These two channels influence growth and employment, and are generally determined by the central bank and the government (e.g., the United States Congress) respect ...


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