IS-LM Model

Updated on January 29, 2024

What Is IS-LM Model?

The IS-LM model is an acronym for “investment-savings” (IS) and “liquidity preference-money supply” (LM). It is a macroeconomic instrument that illustrates the relationship between real production and interest rates on the money market and the market for goods and services. It is a widely recognized summary of Keynesian theory.

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The intersection of the IS and LM curves signifies equilibrium. From IS-LM Model, two interpretations emerge; first, it explains changes in national income at a fixed price level. Second, it explains why the aggregate demand curve moves. It is also used to study economic swings and find pertinent stabilization policies.

Key Takeaways

  • The IS-LM model is a macroeconomic tool that illustrates the link between interest rates and real production in the money and goods and services markets.
  • The IS-LM model is an acronym for “investment-savings” (IS) and “liquidity preference-money supply (LM).
  • Examining the models facilitates comprehension of the fluctuations in national income and the changes in the demand curve. This aids in the formulation of economic policies that stabilize economic swings.
  • A significant shortcoming of the model is that it disregards the crucial time lag when analyzing the implications of economic policy changes.

IS-LM Model Explained

IS-LM model in economics is also called as Hicks-Hansen model. The “IS-LM Model” depicts the relationship between interest rates and the asset market (also known as actual output in goods and services and money markets). Higher the interest rate, the lesser the demand for money. This principle is utilized to model money and income in an economy.

The models are used to determine equilibrium or balance points. Or to locate values where the amount of money required and the amount of cash available for investment coincide. The analyses derived from the models are utilized to make macroeconomic policy decisions.

IS-LM BP model and IS-LM PC model are further applications of the LM model in macroeconomics. IS-LM PC model examines the output and inflation dynamics. The IS-LM model in open economy works as IS-LM BP model, which is an extension of the original one.

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In the original IS-LM model in economics, the vertical axis shows interest rates, whereas the horizontal axis shows total nominal income. The downward-sloping IS curve represents the area where investment (a function of interest rates) and savings (a function of income) are equal. Whereas, the upward-sloping LL curve illustrates the locations where the money stock matches the amount necessary to satisfy liquidity preference. Also, it is worth noting that the original diagrams included “LL” rather than “LM.”

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Graph

Two intersecting lines graphically represent the model. The horizontal axis Y represents national income, often a real gross domestic product. Similarly, ‘i’ denotes the real interest rate on the vertical axis ‘X.’

In case of the IS-LM model in open economy, IS refers to the investment and savings equilibrium. Implying total expenditure equals total output. Where total expenditure can include consumer spending, planned private investment, government purchases, and net-exports . Total output implies real-income or GDP Each point reflects equilibrium in savings and investment. Consequently, every interest rate level creates a particular amount of anticipated fixed investment and consumption.

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The IS LM curve illustrates real income levels and interest rate combinations (when the money market is in equilibrium). An upward sloping curve depicts the relationship between finance and the economy. Each point on the curve represents a specific equilibrium position in the money market based on a certain income level.

The IS LM curve swings to the right as the liquidity preference function changes in response to an increase in GDP. IS LM curve adjustments are studied to anticipate a rise in interest rates. Therefore, the slope of the LM function of IS-LM model calculations is positive.

Since this model is non-dynamic, the nominal and real-interest-rate have a fixed connection. In addition to the predicted inflation rate, which is exogenous in the near run, both numbers are identical. Similarly, money demand relies on the nominal interest rate. This junction signifies a short-term balance in the real and financial industries. Hence, this circumstance produces a unique combination of the interest rate and real GDP (where both the money and product markets are in equilibrium).

Example

Let us understand the concept of IS-LM model in open economy with the help of a suitable example.

Let us assume that a country is growing very fast and its output has increased from 3000 to 5000. So, along with increase in output in the country, the income of the people will also rise. This will in turn give rise to savings and also investments. However, due to rise in spending, the demand for cash will also go up.

From here we understand that if the initial demand for cash was 1000, now it might have gone up to 2000. But since the flow of money in the economy is fixed to the amount of 1000, it will lead to a shortage of funds, which will force the government to increase the interest rates. This will again lead to shift in the output, where the now equilibrium will be created. So, the new interest rate is the new equilibrium real interest rate of the economy. The LM curve in the graph shows the relation between the output of the economy and the percentage of the real interest rate.

Due to the above situation, the LM curve is sloping upwards. It shows that due to an increase in output, the demand for money also rises, forcing the real interest rate to move upwards.

Assumptions

Let us try to analyse and point out some important assumptions of the theory of IS-LM model of income determination, as given below;

  • All businesses make similar products, which are utilized for consumption and residential investment.
  • There is no influence of aggregate supply on the equilibrium level of income, defined by aggregate demand.
  • The only assets in the financial-market are money and bonds.
  • The theory assumes a closed economy, which means that there will be no amount of trade with foreign countries or any capital inflow from them. The entire focus is on domestic economy and rise in output, interest rate and change in money supply within it.
  • It also assumes a price level that do not change in the short run, meaning that even in case of change in the output, the prices are not altered. This in turn helps in focusing on employment and output.
  • The assumption of IS-LM model of income determination also takes into account that the investment is not influenced by the change in interest rate, but it actually affects the decision related to savings and consumption.
  • The IS curve can be derived based on the assumption that the investment will be equal to the savings. This fact is very crucial because it helps in determining the inetrst and the output relation.

However, we can conclude about the assumptions by noting that the theory is a straightforward representation of the entire economy, and there are a lot of assumptions that cannot happen in reality. Thus, even though it is valuable and clear to understand, scientists and economists may make many changes and incorporate more realistic ideas.

Limitations

The IS-LM model serves as the conceptual foundation for the vast majority of governmental and commercial macro-econometric models. However, every model has certain limitations. Consequently, those of IS-LM Model are listed below:

  • Earlier models did not consider inflation. The model did not anticipate conditions in which prices would exhibit long-term upward or downward movements.
  • The IS-LM model is predominantly static. It disregards the crucial time lag when analyzing the implications of economic policy changes. As a result, the use of the “Phillips-curve,” is done to address the model’s flaws.
  • It has a number of assumptions that are not realistic like fixed supply of money, investments and no open economy. This is not the situation of a real world.
  • The model mainly focuses on short term analysis where the price level does not change.
  • The IS-LM model calculations also assume that firms and individuals with a particular preference for liquidity can decide the amount of money they wish to hold at any specific interest rate. However, liquidity preference depends on many factors the firm or individual does not control.
  • It also does not account for the changes and adjustments that take place in a country like change in consumer expectation, adapting to changes or any condition resulting from any shocks.
  • The model treats the financial market as a one that is very simple. However, the financial market is very complex and there are various financial instruments, time horizons, problems and solutions to them.

Thus, to handle the limitations, the theory should develop more realistic, practical, and sophisticated assumptions for better uses.

Frequently Asked Questions (FAQs)

What is IS-LM model?

This method is utilized in macroeconomics. Policymakers can use it to forecast national income patterns and get insight into the shift of demand curves and economic disturbances. The analysis is then utilized to formulate economic strategies to rein the results.

What are the endogenous and exogenous variables in the IS-LM model?

The endogenous variable in an economic model is the variable that the model itself explains. For instance, interest rate. Exogenous variables impact endogenous variables but come from outside the model. For example, the money supply is an external variable in the LM model for determining interest rates.

IS-LM model Keynesian version?

Keynesian models are macroeconomic theories and models that illustrate how total economic expenditure, or aggregate demand, has a considerable influence on inflation and economic productivity. The LM curve is a type of Keynesian IS-LM model.

Effects of fiscal policy on IS-LM model?

The IS curve shifts outward (on the right) due to increased aggregate demand for goods and services caused by increased autonomous government spending. However, as the money supply does not change, the LM curve does not move.

This article is a guide to what is IS-LM Model. We explain it with example, its assumptions, graph and the various limitations of the model. You can learn more about financing from the following articles –

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Comments

  1. Vaibhavi Pandey says

    This is really very helpful and easy to understand . Simplified content

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