IS-LM Model : Meaning, Components, Working and Criticism

What is the IS-LM Model?

The economic theories suggested by economist John Maynard Keynes in the 1930s can be described and explained through the IS-LM model. In 1936 when Keynes published their magnum opus, “The General Theory of Employment, Interest, and Money”, economist John Hicks constructed the IS-LM model in 1937. IS-LM Model is a macroeconomic tool that shows the interaction between interest rates and production within the money market. This model highlights the main ideas of Keynesian economic theory and its full form is Investment-Savings and Liquidity Preference-Money Supply. In addition, it represents the equilibrium that emerges between real production and interest rates.

Geeky Takeaways:

• The IS-LM model is derived from “Investment Savings” (IS) and “Liquidity Preference-Money Supply” (LM).
• The model explains the impact of changes in market preferences on the levels of market interest rates and GDP that are in equilibrium.
• The IS-LM model is also known as the Hicks-Hansen Model.
• It offers insights into the complicated aspects of the economy.

Components of IS-LM Model

The IS-LM model includes components such as monetary and fiscal policy, liquidity preference, and the balance between investment and saving:

• Monetary Policy: This involves the central bank’s management of the money supply and interest rates to achieve macroeconomic goals. It plays a pivotal role in influencing economic stability and controlling inflation.
• Fiscal Policy: This encompasses government decisions on spending and taxation, directly impacting aggregate demand. It serves as a potent tool for policymakers to navigate economic conditions and stimulate growth.
• Liquidity Preference: Reflects individuals’ inclination to hold cash rather than invest it. This psychological aspect influences economic decisions and plays a role in shaping monetary policy.
• Investment-Saving Balance: This represents the intricate relationship between savings and investment, a critical factor in understanding the impact of economic policies on investment decisions and overall economic growth.

IS Curve and LM Curve

The IS-LM Model comprises the IS Curve and LM Curve:

IS Curve:

The IS Curve outlines the correlation between real interest rates and output levels. It shows the impact of investment and government spending changes on AD (Aggregate Demand) and Economic Equilibrium. The shift in the IS curve directly impacts the equilibrium output level which can provide valuable insights to policymakers in fiscal policy changes.

Figure 1 shows the IS curve graphically. The goods market is shown on the left side and the IS curve is shown on the right side. The real GDP is shown on the X-axis and the real interest rate is shown on the Y-axis. This curve shows the equilibrium in the goods market at different real interest rate levels. A particular level of economic output is associated with each equilibrium. The real interest rate is in equilibrium when the saving and investment curves are the same.

Figure 1

This can be better understood with an example. Suppose the real interest rate is 5%, and the output in the economy is 8000 units. Now, the output increases from 8,000 units to 10,000 units in an economy. The increased output increases the savings resulting in a shift from S₁ to S₂. This increase in savings leads to a decrease in the real interest rates. The new equilibrium shifts from point A to B, with higher output and lower interest rates. Due to this negative relationship between output and real interest rate, the IS curve is downward sloping.

LM Curve:

The LM curve shows the connection between central bank-induced interest rate adjustments and the equilibrium between nominal and real money supplies. When RBI changes interest rates and money supply, it can directly impact the position of the LM curve, influencing real income, output, and overall economic activity. LM curve can help policymakers maintain monetary equilibrium and promote sustainable economic growth.

Figure 2 shows the LM curve graphically. The assets market is shown on the left and the LM curve on the right. The real GDP is shown on the X-axis and the real interest rate is shown on the Y-axis. This curve shows the asset market equilibrium at different real interest rate levels. When the demand for money intersects with its supply, the asset market is in equilibrium.

Figure 2

This can be better understood with an example. Let’s suppose the real interest rate is 5%, the output in the economy is 8,000 units, and the money supply is ₹2,000 (which is also the money that a person wants to hold). Now, the output increases from 8,000 to 10,000 units in an economy. The increased output can increase the income level, which increases the spending and ultimately increases the demand for cash. This shifts the demand curve from left to right. The quantity of money increases from 2,000 to 2,200 but the supply is fixed at 2,000 which ultimately leads to a shortage of money in the economy. This increases the interest rate from 5% to 6%. Thus, there is a new equilibrium at 10,000 units and a 6% interest rate. Due to this positive relationship between the increase in output and real interest rate, the LM curve is upward-sloping.

How does the IS-LM Model Work?

The IS-LM model establishes a link between the determination of interest rates in the money market and the equilibrium level in the goods and money market. It also works on making a balance between savings and investments with the help of market forces. Interest rates play an important role in shaping the overall economic equilibrium. Several monetary policy tools such as open market operations can change the supply of money, which can influence interest rates. When the central bank makes changes in the money supply, it also has an influence on money market and goods market equilibriums. This can provide valuable insights while making policy decisions and making economic predictions.

Figure 3 shows the LM curve graphically. The equilibrium occurs at the intersection of IS (investment-savings) curve, LM (liquidity preference-money supply) curve and FE curve (Full employment). The equilibrium point shows the equilibrium in all the three markets; IS (goods market) curve, LM (asset market) curve, and FE curve (labour market).

Figure 3

Difference between IS Curves and LM Curves in the IS-LM Model

Basis	IS Curve	LM Curve
Representation	It shows combinations of National Income (Y) and Interest Rates (r), where total spending equals total production.	It shows combinations of Interest Rates and Income (Y) where money supply equals money demand.
Derivation	It is based on the investment-savings relationship which shows how changes in interest rates can influence planned investment and national income.	It is based on liquidity preference-money supply which shows how changes in income can influence the demand for money.
Behavior	The IS model slopes downward because of a negative relationship between interest rates and planned investment.	The LM model slopes upward because of a positive relationship between income and the demand for money.

Monetary and Fiscal Policies in IS-LM Curve Model

1. Fiscal Policy in the IS-LM Model

a. Expansionary Fiscal Policy: In the IS-LM framework, an upsurge in government spending or a tax reduction prompts a rightward shift in the IS curve. This shift elevates national income and interest rates, signifying heightened aggregate demand due to increased government expenditure. The impact extends to both income and interest rates, influencing economic equilibrium.

b. Contractionary Fiscal Policy: Conversely, a decrease in government spending or a tax increase shifts the IS curve leftward, resulting in diminished national income and interest rates. This leftward shift indicates a reduction in aggregate demand owing to decreased government spending, affecting both income and interest rates within the IS-LM model.

2. Monetary Policy in the IS-LM Model

a. Expansionary Monetary Policy: Within the IS-LM model, an expansionary monetary policy involves increasing the money supply, leading to a downward shift in the LM curve. This shift brings about lower interest rates and potentially an augmented national income. The policy aims to invigorate economic activity by reducing borrowing costs and fostering investment.

b. Contractionary Monetary Policy: On the contrary, a contractionary monetary policy involves decreasing the money supply, causing an upward shift in the LM curve. This shift results in higher interest rates and potentially decreased national income. The policy aims to mitigate inflation by elevating borrowing costs and diminishing investment within the IS-LM framework.

Criticisms of IS-LM Model

1. Static Nature: The IS-LM model’s primary limitation lies in its static nature, emphasizing short-term analysis while overlooking time lags in policy implementation. This inherent characteristic restricts its effectiveness in capturing the dynamic and evolving nature of economic processes over time. It may struggle to provide insights into the consequences of delayed policy responses.

2. Unrealistic Assumptions: A noteworthy drawback stems from the model’s reliance on unrealistic assumptions, such as a closed economy, fixed money supply, and static investments. This departure from the complexities of the real world undermines its applicability, as economic systems are inherently open and subject to dynamic changes. These assumptions may oversimplify the intricate interactions within a globalized economic environment.

3. Limited Policy Tools: The IS-LM model’s explanatory power is hampered by its inability to provide a nuanced understanding of tax or spending policies. The model lacks specificity in detailing the intricacies of policy tools, limiting its practical application in real-world economic scenarios. Its oversights may hinder policymakers from seeking comprehensive guidance on intricate fiscal measures.

4. Ignorance of Inflation: Early versions of the model face criticism for neglecting the consideration of inflation. By assuming rigid prices in the short run, the IS-LM model overlooks a critical aspect of economic dynamics, hindering its accuracy in forecasting and analysis. Ignoring inflation dynamics may result in an incomplete understanding of economic phenomena.

5. Simplistic View of Financial Markets: The model’s portrayal of financial markets is criticized for its simplistic nature, disregarding the intricate realities of multiple financial instruments and varying time horizons. This oversimplification hampers the model’s ability to capture the complexities inherent in real-world financial systems comprehensively. The model may struggle to represent the diverse array of financial instruments and their impacts on market dynamics.

6. Conflict with Modern Monetary Policy: A fundamental misalignment arises in the IS-LM model’s focus on controlling the money supply, a concept that clashes with contemporary monetary policy practices. In modern economic frameworks, interest rates have emerged as the primary target of monetary policy, highlighting the model’s divergence from current policy strategies. This misalignment poses challenges for policymakers relying on interest rate mechanisms for economic stabilization.

7. Insufficient Explanation of International Trade: Another notable limitation is the model’s inadequate consideration of international trade and exchange rates, critical components in the global economic landscape. These elements are necessary for the model’s relevance in understanding and predicting the complexities of interconnected economies. Its limitations in addressing global economic interactions may limit its usefulness in a highly interconnected world.

IS-LM Model – FAQs

What is the main assumption of the IS-LM model?

The main assumption is that prices, especially wages, remains constant or predetermined in the short run. This includes two schedules that reflects goods and money market equilbrium.

What are the primary properties of the LM curve?

The LM curve reveals an upward slope, highlighting that with a constant bond supply and money supply, a boost in national income and product leads to a higher interest rate.

What factors can impact the LM curve?

The changes occur due to changes in money demand and supply. An increase (or decrease) in money supply leads to a lower or higher interest rate at each income level, which can lead to right shift or left shift respectively in LM curve.

Why is the LM curve positively sloped?

The LM curve slopes positively because when income increases, money demand also increases and bond demand decreases, while interest rate is constant.

How will the LM curve shift?

The LM curve shifts to the right or left when there’s an increase or decrease in the money supply or real money balances.