What Are the IS-LM Model?

The IS-LM model, which stands for "investment-savings" (IS) and "liquidity preference-money supply" (LM) is a
Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the
loanable funds market (LM) or money market. It is represented as a graph in which the IS and LM curves
intersect to show the short-run equilibrium between interest rates and output.

LM Curve

The LM curve represents the combinations of the interest rate and income such that money supply and money
demand are equal. The demand for money comes from households, firms, and governments that use money
as a means of exchange and a store of value. The law of demand holds: as the interest rate increases, the
quantity of money demanded decreases because the interest rate represents an opportunity cost of holding
money. When interest rates are higher, in other words, money is less effective as a store of value.

Money demand increases when output rises because money also serves as a medium of exchange. When
output is larger, people have more income and so want to hold more money for their transactions.

The supply of money is chosen by the monetary authority and is independent of the interest rate. Thus, it is
drawn as a vertical line. The equilibrium in the money market is shown in Figure 31.28 "Money Market
Equilibrium". When the money supply is chosen by the monetary authority, the interest rate is the price that
brings the market into equilibrium. Sometimes, in some countries, central bank’s target the money supply.
Alternatively, central banks may choose to target the interest rate. (This was the case we considered
in Chapter 25 "Understanding the Fed".) Figure 31.28 "Money Market Equilibrium" applies in either case: if the
monetary authority targets the interest rate, then the money market tells us what the level of the money
supply must be.Figure 31.28 Money Market Equilibrium

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To trace out the LM curve, we look at what happens to the interest rate when the level of output in the
economy changes and the supply of money is held fixed. Figure 31.29 "A Change in Income" shows the money
market equilibrium at two different levels of real GDP. At the higher level of income, money demand is shifted
to the right; the interest rate increases to ensure that money demand equals money supply. Thus, the LM
curve is upward sloping: higher real GDP is associated with higher interest rates. At each point along the LM
curve, money supply equals money demand.

We have not yet been specific about whether we are talking about nominal interest rates or real interest
rates. In fact, it is the nominal interest rate that represents the opportunity cost of holding money. When we
draw the LM curve, however, we put the real interest rate on the axis, as shown in Figure 31.30 "The LM
Curve". The simplest way to think about this is to suppose that we are considering an economy where the
inflation rate is zero. In this case, by the Fisher equation, the nominal and real interest rates are the same. In a
more complete analysis, we can incorporate inflation by noting that changes in the inflation rate will shift the
LM curve. Changes in the money supply also shift the LM curve.Figure 31.29 A Change in Income

Figure 31.30 The LM Curve

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IS Curve

The IS curve relates the level of real GDP and the real interest rate. It incorporates both the dependence of
spending on the real interest rate and the fact that, in the short run, real GDP equals spending. The IS curve is
shown in Figure 31.29 "A Change in Income". We label the horizontal axis “real GDP” since, in the short run,
real GDP is determined by aggregate spending. The IS curve is downward sloping: as the real interest rate
increases, the level of spending decreases.Figure 31.31 The IS Curve

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The dependence of spending on real interest rates comes partly from investment. As the real interest rate
increases, spending by firms on new capital and spending by households on new housing decreases.
Consumption also depends on the real interest rate: spending by households on durable goods decreases as
the real interest rate increases.

The connection between spending and real GDP comes from the aggregate expenditure model. Given a
particular level of the interest rate, the aggregate expenditure model determines the level of real GDP. Now
suppose the interest rate increases. This reduces those components of spending that depend on the interest
rate. In the aggregate expenditure framework, this is a reduction in autonomous spending. The equilibrium
level of output decreases. Thus the IS curve slopes downwards: higher interest rates are associated with lower
real GDP.

Equilibrium

Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and
output. Note that both relationships are combinations of interest rates and output. Solving these two
equations jointly determines the equilibrium. This is shown graphically in Figure 31.32. This just combines the
LM curve from Figure 31.30 "The LM Curve" and the IS curve from Figure 31.31 "The IS Curve". The crossing of
these two curves is the combination of the interest rate and real GDP, denoted (r*,Y*), such that both the
money market and the goods market are in equilibrium.Figure 31.32

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Equilibrium in the IS-LM Model.

Comparative Statics:Comparative statics results for this model illustrate how changes in exogenous factors
influence the equilibrium levels of interest rates and output. For this model, there are two key exogenous
factors: the level of autonomous spending (excluding any spending affected by interest rates) and the real
money supply. We can study how changes in these factors influence the equilibrium levels of output and
interest rates both graphically and algebraically.

Variations in the level of autonomous spending will lead to a shift in the IS curve, as shown in Figure 31.33 "A
Shift in the IS Curve". If autonomous spending increases, then the IS curve shifts out. The output level of the
economy will increase. Interest rates rise as we move along the LM curve, ensuring money market equilibrium.
One source of variations in autonomous spending is fiscal policy. Autonomous spending includes government
spending (G). Thus an increase in G leads to an increase in output and interest rates as shown in Figure 31.33
"A Shift in the IS Curve".

Figure 31.33 A Shift in the IS Curve

Variations in the real money supply shift the LM curve, as shown in Figure 31.34 "A Shift in the LM Curve". If
the money supply decreases, then the LM curve shifts in. This leads to a higher real interest rate and lower
output as the LM curve shifts along the fixed IS curve.
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Figure 31.34 A Shift in the LM Curve