The IS-LM model, which signifies “investment-saving” (IS) and “liquidity preference-money supply” (LM), is a pivotal Keynesian macroeconomic model. This model demonstrates how the market for economic goods and the loanable funds market interact, projecting how interest rates and output find their short-run equilibrium.
Key Insights
- The IS-LM model elucidates how the aggregate market for real goods intersects with the financial market to determine the equilibrium rate of interest and total output in the macroeconomy.
- IS-LM encapsulates “investment-saving” (IS) and “liquidity preference-money supply” (LM).
- The model explains how changes in market preferences influence equilibrium levels of GDP and market interest rates.
Delving Into the IS-LM Model
In 1937, British economist John Hicks introduced the IS-LM model, shortly after his compatriot John Maynard Keynes presented The General Theory of Employment, Interest, and Money in 1936. Essentially, Hicks’ model graphically represents Keynes’s theories and primarily operates as a heuristic device today.
The cornerstone variables influencing the IS-LM model are liquidity, investment, and consumption. The model predicates that liquidity revolves around the size and velocity of the money supply, whereas investment and consumption levels are shaped by the marginal decisions of individual actors.
In the IS-LM context, the relationship between GDP (output) and interest rates is evaluated. The model reduces the entire economy to two principal markets—output and money—whose supply and demand dynamics propel the economy toward an equilibrium state.
Key Features of the IS-LM Graph
The IS Curve
The IS curve illustrates the set of all interest rate and output (GDP) levels where total investment equates to total saving. Notably, at lower interest rates, investment surges, leading to augmented total output (GDP). As a result, the IS curve inclines downward and to the right.
The LM Curve
The LM curve represents the set of all income (GDP) and interest rate levels where money supply matches money (liquidity) demand. The LM curve inclines upward because higher levels of GDP spark increased demand for holding money balances for transactions, requiring a higher interest rate to maintain equilibrium between money supply and liquidity demand.
The Intersection of IS and LM Curves
Where the IS and LM curves intersect marks the equilibrium point of interest rates and output, indicating a balance between money markets and the real economy. Changes in preferences for liquidity, investment, and consumption can shift the position and shape of these curves, thus altering equilibrium levels of income and interest rates.
Addressing the Limits of the IS-LM Model
Despite its historical significance, many economists criticize the IS-LM model for its simplified and somewhat unrealistic portrayal of the macroeconomy. The model struggles to address concurrent high unemployment and inflation or provide detailed policy guidance for tax or spending initiatives. Additionally, central banks now typically utilize interest-rate rules rather than directly targeting the money supply, reducing the model’s applicability.
Even John Hicks later acknowledged the model’s shortcomings, considering it more of a “classroom gadget” rather than a robust policy tool. Although the original framework has seen several updates, subsequent advanced iterations attempt to integrate factors like inflation, rational expectations, and international markets.
Moreover, the model bypasses the intricacies of capital formation and labor productivity, further limiting its functional appeal.
Frequently Asked Questions
Is the IS-LM model actually utilized today?
The IS-LM model sees limited usage primarily as a quick decision-making tool because of its oversimplification, making it unfit for thorough policy formulation.
Why does the LM curve slope upward?
The LM curve’s upward slope results because a higher GDP induces greater demand to hold money for transactions, consequently raising interest rates to keep the money supply and liquidity in equilibrium.
Who developed the IS-LM model?
The IS-LM model was developed by British economist John Hicks in 1936, based on theories by British economist John Maynard Keynes presented just a few months earlier.
Conclusion
The IS-LM model acts as an analytical tool illustrating how the market for economic goods intersects with the loanable funds market. It designates the short-term equilibrium of interest rates and output, encapsulating the forces of liquidity, investment, and consumption. Despite being an oversimplified mechanism, it can offer quick, albeit limited, insights when detailed economic planning is not feasible.
Related Terms: Keynesian economics, interest rates, GDP, liquidity preference.
References
- John Hicks, via JSTOR. “Mr. Keynes and the ‘Classics’; A Suggested Interpretation”. Econometrica, Vol. 5, No. 2 (April 1937), Pages 147–159.
- John Maynard Keynes, via Internet Archive. “The General Theory of Employment, Interest, and Money”. Harcourt Brace Jovanovich, 1953.
- Duke University, Department of Economics. “Introduction: Seven Decades of the IS-LM Model”, Pages 3–4 of PDF.
- Bartleby. “What Is IS-LM Analysis?”
- Journal of Young Investigators. “Can the IS/LM Model Truly Explain Macroeconomic Phenomena?”
- Steven Kates, via Google Books. “Macroeconomic Theory and Its Failings”, Page 130. Edward Elgar, 2010.
