IS/LM Curve

The IS/LM curve is a graphical model which explains the relationship between the interest rate and income or output. It is a Keynesian construct. It is also known as the Hicks-Hansen IS-LM Model. It establishes much of the foundations for modern macroeconomics.

The IS/LM model takes into consideration the various economic players in a market: producers, consumers, and government. It then reconciles them via the money and product markets. The product market balanced demand with national income while the money market balances demand for money with the supply of money given by the central banks.

The equilibrium the IS-LM model produces in is the demand equilibrium. This results in the adjustment of all economic aggregates in a way that product demand equals national income and money demand equals money supply.

Assumptions

• That the price level is constant
• That there is an unlimited supply of output from firms at that price level

IS

The IS element of the model is the IS curve, or the goods market equilibrium schedule (in contrast with the money market in LM). The IS curve shows the combinations of interest rates and output levels so that planned spending equals income. In short, the IS curve indicates how much firms would spend depending on various interest rates. The higher the interest rate, the less they would invest or spend.

To put the investment spending into a formula we have:

Let I = investment spending Let I (with a horizontal line above it) = exogenous or autonomous investment spending Let i = rate of interest Let b = sensitivity of investment spending

This equation says the lower the interest rate, the greater the investment. If the sensitivity to investment spending, or b, is large, a small interest rate increase creates a large decrease in investment spending.

LM

The LM part of the model is the LM curve, or the money market equilibrium schedule (in contrast with the goods market in IS). The LM curve shows the combinations of interest rates and output levels so that money demand equals money supply.

LM Slope

• The LM curve is positively sloped.
• An increase in income (and quantity of money demanded) has to occur with an increase in the interest rate, which cuts the amount of money demanded and establishes market equilibrium.
• A steeper LM curve will result from increased responsiveness of the demand for money to income, and lower responsiveness of the demand for money to the interest rate.
• A horizontal LM curve creates a liquidity trap as a result of hyper-sensitive demand for money.
• An increase in the money supply moves the curve to the right (slope remains the same).

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