Use precise geolocation data. Select personalised content. Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. 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.
The three critical exogenous, i. 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. 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. 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. 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.
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.
Many economists, including many Keynesians, object to the IS-LM model for its simplistic and unrealistic assumptions about the macroeconomy. In fact, Hicks later admitted that the model's flaws were fatal, and it was probably best used as "a classroom gadget, to be superseded, later on, by something better.
The model is a limited policy tool, as it cannot explain how tax or spending policies should be formulated with any specificity. This significantly limits its functional appeal. It has very little to say about inflation, rational expectations, or international markets, although later models do attempt to incorporate these ideas. The model also ignores the formation of capital and labor productivity. John Hicks. Keynes and the 'Classics'; A Suggested Interpretation. Accessed Aug.
John Maynard Keynes. Steven Kates. Like the aggregate expenditure model, it takes the price level as fixed. But whereas that model takes the interest rate as exogenous—specifically, a change in the interest rate results in a change in autonomous spending—the IS-LM model treats the interest rate as an endogenous variable. The basis of the IS-LM model is an analysis of the money market and an analysis of the goods market, which together determine the equilibrium levels of interest rates and output in the economy, given prices.
The model finds combinations of interest rates and output GDP such that the money market is in equilibrium. This creates the LM curve. The model also finds combinations of interest rates and output such that the goods market is in equilibrium. This creates the IS curve. The equilibrium is the interest rate and output combination that is on both the IS and the LM curves. The LM curve represents the combinations of the interest rate and income such that money supply and money demand are equal.
The demand for money comes from households, firms, and governments that use money as a means of exchange and a store of value. The law of demand holds: as the interest rate increases, the quantity of money demanded decreases because the interest rate represents an opportunity cost of holding money.
When interest rates are higher, in other words, money is less effective as a store of value. Money demand increases when output rises because money also serves as a medium of exchange. When output is larger, people have more income and so want to hold more money for their transactions. The supply of money is chosen by the monetary authority and is independent of the interest rate. Thus it is drawn as a vertical line. The equilibrium in the money market is shown in Figure When the money supply is chosen by the monetary authority, the interest rate is the price that brings the market into equilibrium.
Sometimes, in some countries, central banks target the money supply. Alternatively, central banks may choose to target the interest rate. This was the case we considered in Chapter 10 "Understanding the Fed". Figure To trace out the LM curve, we look at what happens to the interest rate when the level of output in the economy changes and the supply of money is held fixed. At the higher level of income, money demand is shifted to the right; the interest rate increases to ensure that money demand equals money supply.
At each point along the LM curve, money supply equals money demand. We have not yet been specific about whether we are talking about nominal interest rates or real interest rates. In fact, it is the nominal interest rate that represents the opportunity cost of holding money. When we draw the LM curve, however, we put the real interest rate on the axis, as shown in Figure The simplest way to think about this is to suppose that we are considering an economy where the inflation rate is zero.
In this case, by the Fisher equation, the nominal and real interest rates are the same. In a more complete analysis, we can incorporate inflation by noting that changes in the inflation rate will shift the LM curve. Changes in the money supply also shift the LM curve. It incorporates both the dependence of spending on the real interest rate and the fact that, in the short run, real GDP equals spending.
The IS curve is shown in Figure The IS curve is downward sloping: as the real interest rate increases, the level of spending decreases. The dependence of spending on real interest rates comes partly from investment. As the real interest rate increases, spending by firms on new capital and spending by households on new housing decreases.
Consumption also depends on the real interest rate: spending by households on durable goods decreases as the real interest rate increases. The connection between spending and real GDP comes from the aggregate expenditure model.
Given a particular level of the interest rate, the aggregate expenditure model determines the level of real GDP. Now suppose the interest rate increases. This reduces those components of spending that depend on the interest rate. In the aggregate expenditure framework, this is a reduction in autonomous spending. The equilibrium level of output decreases. Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and output.
Note that both relationships are combinations of interest rates and output. Solving these two equations jointly determines the equilibrium. This is shown graphically in Figure This just combines the LM curve from Figure Comparative statics results for this model illustrate how changes in exogenous factors influence the equilibrium levels of interest rates and output.
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