IS–LM model
The IS–LM model shows the relationship between interest rates and output in the short run in a closed economy.
The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves illustrates a "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the money markets.
The model was developed by John Hicks in 1937 and was later extended by Alvin Hansen as a mathematical representation of Keynesian macroeconomic theory.
As monetary policy since the 1980s and 1990s generally does not try to target money supply as assumed in the original IS–LM model, but instead targets interest rate levels directly, some modern versions of the model have changed the interpretation (and in some cases even the name) of the LM curve, presenting it instead simply as a horizontal line showing the central bank's choice of interest rate.
This allows for a simpler dynamic adjustment and supposedly reflects the behaviour of actual contemporary central banks more closely.
[5] It was particularly suited to illustrate the debate of the 1960s and 1970s between Keynesians and monetarists as to whether fiscal or monetary policy was most effective to stabilize the economy.
[3]: 507 As central banks started paying little attention to the money supply when deciding on their policy, this model feature became increasingly unrealistic and sometimes confusing to students.
[7] After 2000, this has led to various modifications to the model in many textbooks, replacing the traditional LM curve and story of the central bank influencing the interest rate level indirectly via controlling the supply of money in the money market to a more realistic one of the central bank determining the policy interest rate as an exogenous variable directly.
The multiplier effect of an increase in fixed investment resulting from a lower interest rate raises real GDP.
In summary, the IS curve shows the causation from interest rates to planned fixed investment to rising national income and output.
The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium.
The liquidity preference function is downward sloping (i.e. the willingness to hold cash increases as the interest rate decreases).
Keynesians argue spending may actually "crowd in" (encourage) private fixed investment via the accelerator effect, which helps long-term growth.
If the money supply is increased, that shifts the LM curve downward or to the right, lowering interest rates and raising equilibrium national income.
The fact that contemporary central banks normally do not target the money supply, as assumed by the original IS–LM model, but instead conduct their monetary policy by steering the interest rate directly, has led to increasing criticism of the traditional IS–LM setup since 2000 for being outdated and confusing to students.
[14] In this case, the LM curve becomes horizontal at the interest rate level chosen by the central bank, allowing a simpler kind of dynamics.
This premium allows for shocks in the financial sector being transmitted to the goods market and consequently affecting aggregate demand.
[3]: 195–201 Similar models, though called slightly different names, appear in the textbooks by Charles Jones[15] and by Wendy Carlin and David Soskice[14] and the CORE Econ project.
[14] Parallelly, texts by Akira Weerapana and Stephen Williamson have outlined approaches where the LM curve is replaced with a real interest rate rule.
[3] Others, among them Carlin and Soskice, refer to it as the "three-equation New Keynesian model",[14] the three equations being an IS relation, often augmented with a term that allows for expectations influencing demand, a monetary policy (interest) rule and a short-run Phillips curve.
[15] In 2016, Roger Farmer and Konstantin Platonov presented a so-called IS-LM-NAC model (NAC standing for "no arbitrage condition", in casu between physical capital and financial assets), in which the long-run effect of monetary policy depends on the way in which people form beliefs.
Whereas in the IS-LM model, high unemployment would be a temporary phenomenon caused by sticky wages and prices, in the IS-LM-NAC model high unemployment may be a permanent situation caused by pessimistic beliefs - a particular instance of what Keynes called animal spirits.
[19] The model was part of a broader research agenda studying how beliefs may independently influence macroeconomic outcomes.
