The IS-LM Model Made Simple!
By Steve Bain
The IS-LM model forms the cornerstone of the Keynesian economic model at the undergraduate level. It is not difficult to understand, but it is important to approach it from a step-by-step approach because there are quite a lot of moving parts involved.
To easily grasp this model, make sure that you understand the following pages in the order given:
- The Consumption Function
- The Keynesian Multiplier
- The IS Curve
- The LM Curve
Once you've mastered those pages, the rest of the model falls into place quite easily and this page will complete the basic model. That's not the end though, after having built the IS-LM Model I'll be adding links to complications and criticisms of it.
The second part of this page is devoted to those complications and criticisms that come from alternative schools of thought in economics. Keynesian economics has dominated government policy for many decades now, and on a website called 'Dying Economy' you wouldn't expect me to give it a pass and just rubber stamp it!
The IS-LM Diagram
The IS-LM diagram gives us a simple framework to understand Keynesian theory once you have mastered the concepts behind it - but again, you'll need to read my other pages to get the background information on that.
Putting the two component curves of the IS-LM model together gives us the Keynesian short-run model of economic management. The intersection of the two curves gives us the equilibrium level interest rate and output rate in the economy i.e. stability in both the goods/services market and the money market.
It helps to keep in mind that the price level is held constant in this diagram with short-run aggregate supply thought to be horizontal (indicating the there is spare capacity available such that output can expand without causing price level increases.
I should point out here that whilst the IS-LM model forms a fundamental basis of Keynesian economics, it wasn't actually developed by Keynes himself. It was developed in 1937 by Sir John Hicks - one year after Keynes' great work 'The General Theory of Employment, Interest and Money', as an interpretation of some loose ends in that work.
From this basic model of the economy, we can derive aggregate demand - control of which is the key requirement in the Keynesian toolbox for managing short-run economic fluctuations.
In the diagram below, the derivation of aggregate demand is illustrated.
If you have read my page about the LM curve, you'll be aware that each of these curves is drawn for a constant price level. That's because any increase in price will dilute the purchasing power of the nominal money stock, and that would require a new curve to be drawn.
The aggregate demand diagram on the other hand gives us various levels of income/output combinations against different price levels.
In simple terms, an increase in the price level (from P1 to P2 in the diagram) will reduce the purchasing power of the nominal money stock and thereby cause the LM curve to shift to the left. Then, by comparing the old equilibrium point in the IS-LM model to the new one, we can connect two different points on the aggregate demand curve.
This is illustrated in the diagram. A monetary contraction from LM1 to LM2 caused output to fall from Y1 to Y2 and caused the interest rate to increase from R1 to R2. Since we now have two different price level points, and two associated national income/output levels, we have two points along the aggregate demand curve.
Repeating this process for all the price level points etc will reveal the full aggregate demand curve.
Of course, for this illustration to work we need to hold all other variables constant. If not then the higher interest rate that resulted from the price increase and real money supply contraction would have knock-on effects, especially for investment.
The higher interest rate would lead to a fall of investment spending, and thereby cause a leftward shift of the IS curve and aggregate demand curve. This implies a further reduce income/output levels, whilst offsetting some of the interest rate & price level increases. Ultimately, a new equilibrium point would be reached with output below Y2, interest rates between R1 and R2, and prices between P1 and P2.
To add some extra realism/depth to the IS-LM model, its important to consider the implications of international trade and exchange rates, and for that I recommend my page about:
A Few Historical Notes
Keynes had been in favor of fiscal policy management to achieve the desired level of income/output, and that preference related to the international exchange rate system of the day, but for most of the last four or five decades the preferred policy tool has been monetary policy.
Visually a fiscal expansion would be seen as shifting the IS curve to the right when government spending in the goods market is increased - which would also directly boost the aggregate demand curve to the right. Alternatively, at times when the economy is overheating, Keynes advised that the government should cut its spending programs and instead reduce the national debt, so that funds would be available to boost the economy the next time a recession came along.
Of course, in modern times many western governments have continually held their feet on the accelerator pedals and run up massive bubbles in their economies whilst also going for a loose monetary policy that has brought interest rates to near zero levels. All of this has happened whilst racking up truly enormous levels of debt.
It seems that many government spending programs, most of which were initially intended to be temporary, have become embedded in the system and tough to remove. Politics often rears its ugly head in the world of macroeconomic management...
The government knows full well that keeping a bad project (which costs an apathetic majority a small amount of money) will usually lead to fewer votes lost than ending that project if it leads to significant loss of money for a politically motivated minority. The problem is that there are a huge number of these projects, and collectively they cost society a huge amount of resources that could be put to much better use elsewhere in the economy.
As Milton Friedman has famously quipped:
"There is nothing so permanent as a temporary government program."