IS LM Model

What happens to the economy's overall production when everyone suddenly decides to save more? How does fiscal policy impact the interest rate and economic production? What happens when individuals expect higher inflation? Can the IS-LM model be used to explain all economic shocks? You'll find out the answers to these questions and much more by reaching the bottom of this article!

What is IS LM Model?

IS LM model is a macroeconomic model used to explain the relationship between the total output produced in the economy and the real interest rate. IS LM model is one of the most important models in macroeconomics. The acronyms 'IS' and 'LM' stand for 'investment savings' and 'liquidity money,' respectively. The acronym 'FE' stands for 'full employment.'

The model shows the effect of interest rates on the distribution of money between liquid money (LM), which is cash, and investment and savings (IS), which is money that people deposit into commercial banks and loan out to borrowers.

The model was one of the original theories of interest rates being primarily affected by the money supply. It was created in 1937 by economist John Hicks, building off the work of famous liberal economist John Maynard Keynes.

IS-LM Model Graph

The IS-LM model graph, used as a framework to analyze the relationship between real output and real interest rate in the economy, consists of three curves: the LM curve, the IS curve, and the FE curve.

The LM Curve

Figure 1 shows how the LM curve is constructed from the asset market equilibria. On the left-hand side of the graph, you have the asset market; on the right-hand side of the graph, you have the LM curve.

Fig. 1 - The LM curve

The LM curve is used to represent the equilibria that occur in the asset market at different real interest rate levels, such that each equilibrium corresponds to a certain amount of output in the economy. On the horizontal axis, you have the real GDP, and on the vertical axis, you have the real interest rate.

The asset market consists of real money demand and real money supply, which means that both the money demand and money supply are adjusted for price changes. The asset market equilibrium occurs where the money demand and money supply intersect.

When the real interest rate is 4%, and the output in the economy is 5000, the amount of cash individuals want to hold is 1000, which is also the supply of money determined by the Fed.

What if the economy's output increased from 5000 to 7000? When output increases, it means that individuals are receiving more income, and more income means spending more, which also increases the demand for cash. This causes the money demand curve to shift to the right.

The quantity of money demanded in the economy increases from 1000 to 1100. However, as the money supply is fixed at 1000, there's a shortage of money, which causes the interest rate to increase to 6%.

The new equilibrium after output has risen to 7000 occurs at a 6% real interest rate. Notice that with the increase in output, the equilibrium real interest rate in the asset market increases. The LM curve depicts this relationship between the real interest rate and output in the economy via the asset market.

The LM curve is an upward-sloping curve. The reason for that is because when output increases, the money demand increases, which raises the real interest rate in the economy. As we've seen from the asset market, an increase in output is usually associated with an increase in the real interest rate.

The IS Curve

Figure 2 shows how the IS curve is constructed from the goods market equilibria. You have the IS curve on the right-hand side, and on the left-hand side, you have the goods market.

Fig. 2 - The IS curve

The IS curve represents the equilibria in the goods market at different real interest rate levels. Each equilibrium corresponds to a certain amount of output in the economy.

The goods market, which you can find on the left-hand side, consists of a saving and investment curve. The equilibrium real interest rate occurs where the investment curve equals the saving curve.

To understand how this is related to the IS curve, let's consider what happens when in an economy, the output increases from 5000 to 7000.

When the total output produced in the economy increases, the income also increases, which causes savings in the economy to increase, shifting from S1 to S2 in the goods market. The shift in saving causes the real interest rate in the economy to decline.

Notice that the new equilibrium at point 2 corresponds to the same point on the IS curve, where there is higher output and a lower real interest rate.

As the output increases, the real interest rate in the economy will decline. The IS curve shows the corresponding real interest rate that clears the goods market for each output level. Therefore, all the points on the IS curve correspond to an equilibrium point in the goods market.

The IS curve is a downward sloping curve because a rise in output increases national savings, which reduces the equilibrium real interest rate in the goods market.

The FE line

Figure 3 represents the FE line. The FE line stands for full employment.

Fig. 3 - The FE line

Note that the FE line is a vertical curve, meaning that regardless of the real interest rate in the economy, the FE curve does not change.

An economy is at its full employment level when the labor market is in equilibrium. Therefore, regardless of the interest rate, the output produced at full employment does not change.

IS-LM Model Graph: Putting it all together

After discussing each curve of the IS-LM Model, it is time to bring them into one graph, the IS-LM Model Graph.

Fig. 4 - IS-LM model graph

Figure 4 shows the IS-LM Model Graph. The equilibrium occurs at the point where all three curves intersect. The equilibrium point shows the amount of output produced at the equilibrium real interest rate.

The equilibrium point in the IS-LM model represents the equilibrium in all the three markets and is called a general equilibrium in the economy.

• The LM curve (asset market)
• The IS curve (goods market)
• The FE curve (labor market)

When these three curves intersect at the equilibrium points, all of these three markets in the economy are in equilibrium. Point E in Figure 4 above represents the general equilibrium in the economy.

IS-LM Model in Macroeconomics: Changes in the IS-LM Model

Changes in the IS-LM model occur when there are changes affecting one of the three curves of the IS-LM model causing them to shift.

The FE line shifts when there are changes in the labor supply, capital stock, or there is supply shock.

Fig. 5 - A shift in LM curve

Figure 5 above shows a shift in the LM curve. There are various factors that shift the LM curve:

• Monetary policy. LM is derived from the relationship between money demand and money supply; hence, a change in money supply will impact the LM curve. An increase in the money supply will shift the LM to the right, driving down interest rates, while a decrease in the money supply will drive up interest rates shifting the LM curve to the left.
• Price level. A change in the price level causes a change in real money supply, ultimately affecting the LM curve. When there is an increase in the price level, the real money supply drops, shifting the LM curve to the left. This results in a higher interest rate and less output produced in the economy.
• Expected inflation. A change in expected inflation causes a shift in money demand, affecting the LM curve. When expected inflation increases, the money demand drops, lowering the interest rate and causing the LM curve to shift to the right.

Fig. 6 - A shift in IS curve

When there is a change in the economy such that the national saving relative to investment is reduced, the real interest rate in the goods market will increase, causing the IS to shift to the right. There are various factors that shift the IS curve:

• Expected future output. A change in expected future output affects the savings in the economy, ultimately affecting the IS curve. When individuals expect future output to increase, they will reduce their savings and consume more. This drives up the real interest rate and causes the IS curve to shift to the right.
• Wealth. A change in wealth changes the saving behavior of individuals and therefore affects the IS curve. When there is an increase in wealth, savings fall, causing the IS curve to shift to the right.
• Government purchases. Government purchases affect the IS curve by affecting savings. When there is an increase in government purchases, the saving in the economy drops, increasing the interest rate and causing the IS curve to shift to the right.

IS-LM Model Example

There is an IS-LM model example in any monetary or fiscal policy that takes place in the economy.

Let's consider a scenario in which there is a change in monetary policy and use the IS-LM model framework to analyze what happens to the economy.

Inflation has been increasing across the world, and to fight the increase in inflation, some central banks around the world have decided to reduce the interest rate in their economies.

Imagine the Fed has decided to increase the discount rate, which reduces the money supply in the economy.

The change in money supply directly impacts the LM curve. When there is a decrease in the money supply, there is less money available in the economy, causing the interest rate to increase. The increase in interest rate makes holding money more expensive, and many demand less cash. This shifts the LM curve to the left.

Fig. 7 - Shift in IS-LM model due to monetary policy

Figure 7 shows what happens to the real interest rate and the real output produced in the economy. The changes in the asset market cause the real interest rate to increase from r₁ to r₂. The increase in the real interest rate is associated with a decline in output from Y₁ to Y₂, and the new equilibrium occurs at point 2.

This is the goal of contractionary monetary policy and is intended to reduce spending during periods of high inflation.

Unfortunately, a decrease in the money supply can also cause a reduction in output.

Typically, there is an inverse relationship between interest rates and economic output, though output can be affected by other factors as well.

IS-LM Model and Inflation

The relationship between the IS-LM model and inflation can be analyzed using the IS-LM model graph.

When there is an increase in the overall price level in the economy, the value of money individuals have in their hands drops.

That means that the real money supply in the economy drops. The decrease in the real money supply impacts the LM through the asset market. As the real money supply drops, there is less money available in the asset market, which causes the real interest rate to increase.

As a result, the LM curve shifts to the left, causing the real interest rate in the economy to increase and the overall output produced to drop.

Fig. 8 - Inflation and IS-LM Model

Figure 8 shows what happens in the economy when the LM curve shifts to the left. The equilibrium in the IS-LM model shifts from point 1 to point 2, which is associated with a higher real interest rate and lower output produced.

Fiscal Policy and IS-LM Model

The IS-LM model reveals the effects of fiscal policy through the movement of the IS curve.

When the government increases its spending and/or cuts taxes, known as expansionary fiscal policy, this spending is financed by borrowing. The federal government conducts deficit spending, which is spending that exceeds tax revenues, by selling U.S. Treasury bonds.

State and local governments can also sell bonds, though many borrow money directly from commercial lenders for projects after receiving voter approval in a process known as passing a bond. This increased demand for investment spending (IS) results in a rightward curve shift.

The increase in interest rates caused by an increase in government borrowing is known as the crowding out effect and can result in reduced Investment (IG) spending due to higher borrowing costs.

This can reduce the effectiveness of expansionary fiscal policy and make fiscal policy less desirable than monetary policy. Fiscal policy is also complicated due to partisan disagreements, as elected legislatures control state and federal budgets.

Assumptions of the IS-LM Model

There are multiple assumptions of the IS-LM model about the economy. It assumes that real wealth, prices, and wages are not flexible in the short run. Thus, all fiscal and monetary policy changes will have proportional effects on real interest rates and output.

It also assumes that consumers and investors will accept monetary policy decisions and purchase bonds when they are offered for sale.

A final assumption is that there is no reference to time in the IS-LM model. This affects investment demand, as much of the real-world demand for investment is linked to long-term decisions. Thus, consumer and investor confidence cannot be adjusted in the IS-LM model and must be considered static at some amount or ratio.

In reality, high investor confidence can keep demand for investment high despite rising interest rates, complicating the model. Conversely, low investor confidence can keep demand for investment low even if monetary policy significantly reduces interest rates.

IS-LM Model in an Open Economy

In an open economy, more variables affect the IS and LM curves. The IS curve will include net exports. This can be directly affected by foreign incomes.

An increase in foreign incomes will shift the IS curve to the right, increasing interest rates and output. Net exports are also affected by currency exchange rates.

If the U.S. dollar increases in value or appreciates, it will take more units of foreign currency to purchase a dollar. This will reduce net exports, as foreigners would have to pay more currency units to equal the domestic price of U.S. exported goods.

In contrast, the LM curve would be largely unaffected by an open economy, as the money supply is considered fixed.