What does IS-LM stand for?

IS-LM Model: “investment-saving” (IS) and “liquidity preference-money supply” (LM) models are part of the Keynesian macroeconomics field. They show how the market for economic goods (IS) and the loanable funds market (LM), also known as the money market, interact. It’s shown as a graph where the IS and LM curves meet to show the short-term balance between output and interest rates.

How to Understand the IS-LM Model

British economist John Hicks first applied the IS-LM model in 1937. This was not long after another British economist, John Maynard Keynes, released The General Theory of Employment, Interest, and Money in 1936. Although Hicks’ model is mainly used as a guide today, it was once a structured way to show Keynes’ ideas visually.

In the IS-LM model, liquidity, investment, and consumption are the three most important external factors. The idea says that liquidity is based on how much money is in circulation and how fast it moves. The small decisions that each person makes determine the amounts of spending and consumption.

The IS-LM graph shows the link between interest rates and output, or gross domestic product (GDP). The economy is made up of only two markets: money and output. The supply and demand in these two markets move the economy toward a balance point.

What the IS-LM graph looks like

There are two shapes on the IS-LM graph. They are called IS and LM. The horizontal line shows GDP, which goes up to the right. The vertical line is made up of the interest rate.

The IS Line

When interest rates and GDP are at the same level, total investment (I) equals total saving (S). The IS curve shows this. When interest rates are low, more money is invested, which leads to more total output (GDP). This is why the IS curve goes down and to the right.

The LM Line

The LM curve shows all the income (GDP) and interest rates that make the money supply equal to the desire for money (liquidity). The LM curve goes up because people want to hold more money in their accounts for trade when GDP goes up. This means the interest rate needs to go up to keep the money supply and liquidity demand balanced.

The Point Where the IS and LM Curves Meet

When the money markets and the real economy are balanced, the IS and LM curves meet where interest rates and output are equal. By adding more IS and LM curves, you can show more than one situation or point in time.

Some forms of the graph show curves with only a tiny amount of convexity or concavity. The equilibrium income and interest rate levels change when the IS and LM curves move and change their shape. These changes show how people’s liquidity, investment, and consumption choices change.

What the IS-LM Model Can’t Do

Many economists, including many Keynesians, don’t like the IS-LM model because it makes too many unrealistic claims about the economy as a whole. It doesn’t explain why unemployment and inflation are both so high at the same time. The fact that central banks no longer target the money supply but instead use an interest-rate rule is also detrimental.

In the end, even Hicks agreed that the model was severely flawed and would probably work best as “a classroom gadget, to be superseded later on by something better.”6 Since then, so-called “new” or “optimized” IS-LM systems have been changed.

The model is not a very useful tool for policymaking because it doesn’t give detailed advice on making tax or spending policies. For practical reasons, this makes it much less helpful. It doesn’t mention rational expectations, inflation, or foreign markets. However, later models have tried to include these ideas. The model also doesn’t consider how capital and labor output are formed.

Does anyone use the IS-LM model?

Today, the IS-LM approach is only used as a shortcut to help people make decisions quickly. It’s useless for making tax or spending plans because it’s too simple. Its creator, John Hicks, referred to it as “a classroom gadget” and predicted that something more cutting-edge would take its place in the future.

Why does the LM curve go up?

The LM curve increases because people need to hold more money for trade when the gross domestic product (GDP) increases. This increases interest rates, which keeps the money supply and cash in balance.

Who came up with the IS-LM model?

In 1936, a British economist named John Hicks created the IS-LM model. He based it on ideas that another British economist, John Maynard Keynes, had written about just a few months before.

Conclusion

• The IS-LM model shows how tangible and financial goods markets work together to balance the economy’s interest rate and total output.
• The terms “investment-saving” (IS) and “liquidity preference-money supply” (LM) are used to describe this pair.
• If market tastes change, IS-LM can be used to show how the equilibrium levels of GDP and market interest rates are affected.