Key Takeaways
- IS-LM models short-run interest-output equilibrium.
- IS curve slopes down; LM curve slopes up.
- Fiscal shifts IS; monetary shifts LM curve.
- Equilibrium balances goods and money markets.
What is IS-LM Model?
The IS-LM model is a foundational macroeconomic framework that depicts the short-run equilibrium between interest rates and real output by combining the goods market (IS curve) and the money market (LM curve) under fixed prices. It helps explain how fiscal and monetary policies influence economic activity and interest rates.
This model, rooted in Keynesian economics, was developed by John Hicks and Alvin Hansen to clarify the interaction between investment-savings decisions and liquidity preference.
Key Characteristics
The IS-LM model is defined by several essential features that shape its insights into economic equilibrium.
- IS Curve: Represents combinations of interest rates and output where goods market equilibrium occurs, with investment equaling savings.
- LM Curve: Shows money market equilibrium where real money supply matches liquidity preference.
- Short-run focus: Assumes fixed prices, emphasizing demand-driven output changes without supply-side adjustments.
- Fiscal and Monetary Policy Impact: Fiscal expansion shifts the IS curve right, while monetary expansion shifts the LM curve right.
- Limitations: Ignores supply shocks and inflation dynamics, and does not incorporate forward-looking expectations found in models influenced by James Tobin.
How It Works
The IS curve slopes downward because higher interest rates increase borrowing costs, reducing investment and aggregate demand. Conversely, the LM curve slopes upward since higher output raises money demand, pushing interest rates up to equilibrate money supply and demand.
Equilibrium is found at the intersection of these curves, where both goods and money markets clear simultaneously. Fiscal policy, such as government spending changes, shifts the IS curve, while monetary policy actions, like adjusting the money supply, move the LM curve.
Examples and Use Cases
The IS-LM model is instrumental in analyzing real-world economic scenarios and policy effects.
- Airlines: Companies like Delta experience fluctuations in investment and borrowing costs influenced by interest rate movements explained by the IS-LM framework.
- Banking Sector: Interest rate changes derived from LM shifts impact banks, making insights from guides on best bank stocks relevant for investors.
- Bond Markets: Monetary policy effects on interest rates also influence bond ETFs, as detailed in resources about best bond ETFs.
Important Considerations
While the IS-LM model offers valuable intuition on macroeconomic policy trade-offs, it assumes fixed prices and does not incorporate inflation dynamics or supply-side factors. Its static nature limits analysis of long-run growth or expectations-driven behavior.
Integrating the IS-LM framework with other concepts such as price elasticity and the theories of David Ricardo can provide a more comprehensive economic understanding. When applying the IS-LM model, consider its assumptions and complement it with broader macroeconomic tools for policy evaluation.
Final Words
The IS-LM model captures how fiscal and monetary policies influence output and interest rates in the short run. To apply its insights, monitor shifts in government spending and central bank actions to anticipate economic changes.
Frequently Asked Questions
The IS-LM model is a macroeconomic framework developed by John Hicks and Alvin Hansen that illustrates the short-run equilibrium between interest rates and real output by combining the goods market (IS curve) and the money market (LM curve) under fixed prices.
The IS curve shows combinations of interest rates and output where aggregate demand equals output, meaning planned investment equals saving. It slopes downward because higher interest rates reduce investment and spending, lowering output.
The LM curve slopes upward because as output (income) increases, the demand for money rises, leading to higher interest rates to balance money supply with money demand since holding money becomes more costly compared to bonds.
Expansionary fiscal policy shifts the IS curve right, increasing output and interest rates, while expansionary monetary policy shifts the LM curve right, raising output but lowering interest rates. Combined policies can amplify output growth.
Equilibrium occurs at the intersection of the IS and LM curves, where both the goods market and money market are balanced simultaneously for a given price level.
During fiscal expansion, such as increased government spending or tax cuts, aggregate demand rises, shifting the IS curve rightward, leading to higher output and interest rates at equilibrium.
The model assumes sticky (fixed) prices in the short run and focuses on demand-determined output. It typically models a closed economy but can be extended to include open economy features like net exports.
Changes in money supply shift the LM curve; for example, an increase in real money balances shifts LM right, lowering interest rates and increasing output by making credit cheaper and stimulating investment.
