Introduction
The IS-LM model is a fundamental framework in macroeconomics used to analyze the interaction between the real and monetary sectors of the economy. Developed by John Hicks and Alvin Hansen, it represents equilibrium in both the goods market (IS curve) and the money market (LM curve). This model helps understand how fiscal and monetary policies affect income, interest rates, and overall economic activity.
What is the IS Curve?
The IS curve (Investment-Saving curve) represents equilibrium in the goods market. It shows combinations of interest rates and output (income) where aggregate demand equals aggregate output.
Equation: Y = C(Y – T) + I(r) + G
Where:
- Y = national income
- C = consumption
- I = investment, which depends negatively on interest rate (r)
- G = government expenditure
- T = taxes
As interest rates rise, investment falls, leading to lower output. Hence, the IS curve slopes downward.
Implications of the IS Curve
- Negative Relationship: Shows inverse relationship between interest rates and output in the goods market.
- Fiscal Policy: A rise in government spending or a cut in taxes shifts the IS curve to the right, increasing output at every interest rate.
- Recession and Recovery: Useful in analyzing economic fluctuations due to changes in investment or consumption behavior.
What is the LM Curve?
The LM curve (Liquidity Preference–Money Supply) represents equilibrium in the money market. It shows combinations of interest rates and output where money demand equals money supply.
Equation: M/P = L(Y, r)
Where:
- M = nominal money supply
- P = price level
- L = liquidity preference or money demand
- Y = income (positively related)
- r = interest rate (negatively related)
As income increases, people demand more money, pushing up the interest rate. Hence, the LM curve slopes upward.
Implications of the LM Curve
- Positive Relationship: Shows positive relationship between interest rates and output in the money market.
- Monetary Policy: An increase in money supply shifts LM right (downward), reducing interest rates and increasing output.
- Inflation and Liquidity: Changes in price levels or money demand can shift the LM curve and affect economic equilibrium.
Factors Affecting the Position and Slope of the IS Curve
- Autonomous spending: Increase in government expenditure or consumer confidence shifts IS right.
- Taxes: Higher taxes reduce disposable income, shifting IS left.
- Interest sensitivity of investment: If investment is highly sensitive to interest rate, IS is flatter.
- Marginal Propensity to Consume (MPC): Higher MPC leads to steeper IS curve.
Factors Affecting the Position and Slope of the LM Curve
- Money supply: Increase shifts LM right; decrease shifts LM left.
- Price level: Higher prices reduce real money balances (M/P), shifting LM left.
- Income sensitivity of money demand: If demand for money rises rapidly with income, LM is steeper.
- Interest sensitivity of money demand: If demand for money is highly responsive to interest rate, LM is flatter.
Intersection of IS and LM
The point where IS and LM curves intersect represents simultaneous equilibrium in both goods and money markets. It determines the equilibrium level of interest rate and output in the economy.
Policy Analysis Using IS-LM Model
- Expansionary Fiscal Policy: Shifts IS to the right → higher income and interest rates.
- Expansionary Monetary Policy: Shifts LM to the right → lower interest rates, higher income.
- Monetary-Fiscal Coordination: Helps policymakers decide best policy mix in different scenarios.
Conclusion
The IS and LM curves form the core of the Keynesian model of income and interest rate determination. The IS curve represents goods market equilibrium and slopes downward, while the LM curve represents money market equilibrium and slopes upward. Their positions and slopes depend on behavioral parameters like consumption, investment, money demand, and policy variables like government spending and money supply. Together, they offer powerful insights into macroeconomic policy and its impact on output and interest rates.