2.3.2.10 Simple IS – LM Model

The IS-LM model is a simple macroeconomic framework used to analyze the relationship between real output (represented by the IS curve) and the interest rate (represented by the LM curve) in an economy. It was first introduced by economists John Hicks and Alvin Hansen in the 1930s as an extension of John Maynard Keynes’ General Theory. The IS-LM model provides insights into the interactions between goods and money markets and how changes in certain economic variables can affect equilibrium output and interest rates.

The IS Curve: The IS curve represents the equilibrium in the goods market and shows the combinations of output (Y) and the interest rate (r) at which the total demand for goods and services (aggregate demand) equals total output (aggregate supply). The IS curve is derived from the investment-savings (IS) relationship and the goods market equilibrium.

Factors that shift the IS curve:

1. Changes in autonomous consumption (C): An increase in autonomous consumption leads to higher aggregate demand and shifts the IS curve to the right.
2. Changes in investment (I): An increase in investment leads to higher aggregate demand and shifts the IS curve to the right.
3. Changes in government spending (G): An increase in government spending leads to higher aggregate demand and shifts the IS curve to the right.
4. Changes in net exports (X – M): An increase in net exports (exports minus imports) leads to higher aggregate demand and shifts the IS curve to the right.

The LM Curve: The LM curve represents the equilibrium in the money market and shows the combinations of output (Y) and the interest rate (r) at which the demand for money equals the money supply. The LM curve is derived from the liquidity preference theory, which posits that the demand for money is influenced by the interest rate.

Factors that shift the LM curve:

1. Changes in money supply (M): An increase in the money supply shifts the LM curve to the right.
2. Changes in money demand: Factors such as changes in income, price levels, and interest rates influence money demand. An increase in money demand shifts the LM curve to the left.

Equilibrium in the IS-LM Model: The equilibrium in the IS-LM model occurs at the point where the IS and LM curves intersect. At this equilibrium, the goods market (IS) is in balance with the money market (LM), and there are no tendencies for output or interest rates to change. The economy operates at the level of output and interest rate consistent with the given levels of investment, government spending, net exports, money supply, and money demand.

Policy Implications: The IS-LM model provides a useful framework for policymakers to understand the impact of changes in fiscal and monetary policies on the economy. For example:

1. Expansionary Fiscal Policy: An increase in government spending or a reduction in taxes will shift the IS curve to the right, leading to higher output and potentially higher interest rates.
2. Contractionary Fiscal Policy: A decrease in government spending or an increase in taxes will shift the IS curve to the left, leading to lower output and potentially lower interest rates.
3. Expansionary Monetary Policy: An increase in the money supply will shift the LM curve to the right, leading to lower interest rates and potentially higher output.
4. Contractionary Monetary Policy: A decrease in the money supply will shift the LM curve to the left, leading to higher interest rates and potentially lower output.