IS-LM Model

Definition

The IS-LM Model, short for Investment-Saving-Liquidity Preference Money Supply, is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and money market. The ‘IS’ part represents the relationship between total spending and total income (output) in the goods and services market, while the ‘LM’ part stands for the equilibrium in the money market where money supply equates money demand. This model helps analyze the effects of different economic policies on interest rates and output.

Phonetic

The phonetics of the keyword “IS-LM Model” would be:”aye – ess – el – em moh – del”

Key Takeaways

<ol> <li>The IS-LM Model allows us to analyze the effect of the monetary and fiscal policy on the level of income and interest rate in an economy. It is named after the theorists John Hicks’ and Alvin Hansen’s interpretation of Keynes’ theory, representing Investment-Savings (IS) and Liquidity preference-Money supply (LM).</li> <li>It is a macroeconomic tool that demonstrates the relationship between interest rates and goods market and money market’s real output. It helps in understanding the dynamics of income, interest, and output in the short run.</li> <li>The IS-LM model also helps to explain the effects of various shocks to the economy. Depending on whether the shock occurs in the goods market (affecting the IS curve) or in the money market (affecting the LM curve), the effects on economic equilibrium — in terms of output and interest rates — can be substantial.</li></ol>

Importance

The IS-LM Model, also known as the Hicks-Hansen Model, is a fundamental tool in macroeconomic theory that illustrates the relationship between interest rates and assets market; it represents the intersection of the “investment-saving” (IS) and “liquidity preference-money supply” (LM) curves. This model is significant as it helps to depict different macroeconomic scenarios and enables economists to understand and predict the effects of fiscal and monetary policies on income and interest rates within an economy. It essentially bridges the gap between the classical and Keynesian theories, providing a comprehensive view of how an increase in income can increase the interest rate under certain circumstances, and how policy manipulations can influence general economic equilibrium.

Explanation

The IS-LM model is a macroeconomic tool used to represent the relationship between interest rates and real output in the financial market and the goods market. The purpose of this model is to illustrate how changes in either market can impact the equilibrium in an economy. It comprises of two components: the IS (Investment-Saving) curve, which analyses the goods market, and the LM (Liquidity Preference-Money Supply) curve that studies the financial market. The model operates under the assumption that the price level remains constant, allowing economists to concentrate on the short-run effects of economic policy.The IS-LM model serves as a useful tool in policy formation for fiscal and monetary authorities. By understanding how changes in government spending, taxes, and money supply affect interest rates and output, policymakers can make informed decisions to achieve macroeconomic objectives such as full employment, price level stability, and economic growth. For example, the model can show how an increase in government spending can boost economic output but might also lead to higher interest rates. Conversely, an expansion in the money supply might lower interest rates and stimulate investment and consumer spending, leading to an increase in output. Therefore, the IS-LM model helps in analyzing and predicting the potential impact of various fiscal and monetary policies.

Examples

The IS-LM Model (Investment Saving – Liquidity Preference Money Supply) is an economic model first introduced by John Hicks that describes the relationship between interest rates and assets market. The model represents the economy’s income (IS curve) and money market (LM curve). Let’s take a look at three possible real-world examples:1. The Great Recession (2007-2009): The financial crisis triggered a significant shift in the IS-LM model as policymakers attempted to stimulate the economy. Falling house prices led to a significant decrease in consumer spending, shifting the IS curve to the left (indicating a decline in total income in the economy). In response, central banks like the Federal Reserve lowered interest rates (a movement along the LM curve) in an effort to stimulate investment and consumption.2. The COVID-19 Pandemic: Governments across the world have had to implement drastic measures to support their economies during the pandemic. Many businesses closed or scaled back operations, causing an initial leftward shift in the IS curve. Central banks, again like the Federal Reserve, responded by lowering interest rates and implementing quantitative easing policies – a downward shift of the LM curve, to boost liquidity and encourage economic activity.3. Stagflation in the 1970s: In this era, many countries experienced stagnation (a leftward shift in the IS curve due to slow income growth) and inflation (an upward shift in the LM curve due to rapid money supply growth). The economic policies pursued, such as trying to stimulate the economy with increased government spending, often only exacerbated the issue by causing further shifts in the IS-LM model. It took a combination of tight monetary policy and supply-side reforms to eventually stabilize the situation.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Interest Rate
• Liquidity Preference
• Investment-Saving Equilibrium
• Monetary Policy
• Liquidity Trap

Sources for More Information

• Investopedia
• Economics Help
• Khan Academy
• Britannica