IS-LM Model: What It Is, IS and LM Curves, Characteristics, Limitations

Overview

• IS-LM Model: A Keynesian macroeconomic model showing interaction between the market for economic goods (Investment-Saving or IS) and the money market (Liquidity preference-Money supply or LM).
• Purpose: Illustrates short-run equilibrium between interest rates and output.

Key Takeaways

• Describes how real goods and financial markets interact, balancing interest rates and total output.
• Used to describe changes in GDP and market interest rates due to market preference changes.

Understanding the IS-LM Model

• Origin: Introduced by John Hicks in 1937, based on Keynes’s theories from 1936.
• Critical Variables:
  • Liquidity: Determined by money supply size and velocity.
  • Investment and Consumption: Determined by marginal decisions of individual actors.
• IS-LM Graph: Examines output (GDP) vs. interest rates, simplifying economy to two markets (output and money)

Characteristics of the IS-LM Graph

• Axes: GDP on horizontal; interest rate on vertical.

IS Curve

• Represents levels where total investment equals total saving.
• Downward sloping: Lower interest rates increase investment and GDP.

LM Curve

• Represents levels where money supply equals liquidity demand.
• Upward sloping: Higher income increases money demand, requiring higher interest rates.

Intersection of IS and LM Curves

• Shows equilibrium point of interest rates and output.
• Can represent multiple scenarios with additional curves.

Limitations of the IS-LM Model

• Criticisms:
  • Simplistic and unrealistic assumptions.
  • Cannot address high unemployment and inflation simultaneously.
  • Limited use due to central banks' interest-rate targeting.
  • Described by Hicks as best used as a classroom tool.
• Revisions and Weaknesses:
  • Not useful for tax/spending policy formulation.
  • Lacks explanation of inflation, rational expectations, or international markets.
  • Ignores capital formation and labor productivity.

Frequently Asked Questions

• Usefulness: Limited to quick decision-making, not for sophisticated policy setting.
• Development: Created by John Hicks in 1936, based on Keynes’s earlier theories.

Conclusion

• IS-LM Model: A tool for analyzing the intersection of economic goods and loanable funds market.
• Limitations: Simplistic, hence useful for quick decisions rather than detailed policy making.