Business, Legal & Accounting Glossary
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.
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.
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.
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This glossary post was last updated: 1st April, 2020 | 935 Views.