Tribhuvan University

Faculty of Humanities and Social Sciences

Master in Economics
Ratna Rajyalaxmi Campus, Pradarshanimarga, Kathmandu

The IS-LM Model: Analyzing the Interaction of Real & Monetary Sectors
In partial fulfilment of the requirements of
Macroeconomics I (552)

Submitted to: Submitted by:

Faculty Name: Name:
Designation: Lecturer Roll No.:
Department of Economics Semester: First
Ratna Rajyalaxmi Campus Batch:
Date: 2024-06-24
Contents
Abstract....................................................................................................................................3
Introduction..............................................................................................................................4
Assumptions.............................................................................................................................5
Goods Market (IS curve) assumptions:.................................................................................5
Money Market (LM curve) assumptions:..............................................................................5
Investment-Savings (IS) Curve – Goods Market Equilibrium.....................................................6
Factors Causing a Shift in IS Curve........................................................................................7
Liquidity Preference-Money Supply (LM) Curve.......................................................................7
Factors Causing a Shift in LM Curve......................................................................................9
Equilibrium in the Goods and Money Markets.......................................................................10
Using the IS- LM Model to Analyze Fiscal Policy.....................................................................12
Using the IS-LM Model to Analyze Monetary Policy...............................................................13
Policy Implications..................................................................................................................14
Limitations of the IS-LM Model...............................................................................................15
Critiques and Alternatives.......................................................................................................15
Extensions and Modifications.................................................................................................16
Contemporary Macroeconomic Analysis................................................................................16
Conclusion..............................................................................................................................17
References:.............................................................................................................................17
 Abstract

This term paper provides an in-depth analysis of the IS-LM model, a key framework
in macroeconomic theory that examines the interaction between the real and monetary
sectors of the economy. The paper begins by introducing the historical background
and context of the IS-LM model, followed by an explanation of its underlying
assumptions and components. Subsequently, it explores the determination of output,
interest rates, and the aggregate price level within the IS-LM framework.
Furthermore, the paper discusses the policy implications and limitations of the model,
and examines its relevance in modern macroeconomic analysis. By delving into
various aspects of the IS-LM model, this paper aims to enhance the understanding of
its theoretical foundations and practical applications.

Keywords: IS-LM model, macroeconomic theory, real and monetary sectors, output
determination, policy implications.
 Introduction

The role of monetary variables in the Keynesian model was first pointed out by Nobel
laureate John R. Hicks in 1937. It has been shown by J.R. Hicks and others that with
greater insights into the Keynesian theory one finds that the changes in income caused
by changes in investment or propensity to consume in the goods market also influence
the determination of interest in the money market. The level of income which depends
on the investment and consumption demand determines the transaction demand for
money which affects the rate of interest. Hicks, Hansen, Lerner and Johnson have put
forward a complete and integrated model based on the Keynesian framework where in
the variables such as investment, national income, rate of interest, demand for and
supply of money are interrelated and mutually interdependent and can be represented
by the two curves called the IS and LM curves.

The IS-LM model is the basic model of aggregate demand that incorporates the
money market as well as the goods market. It lays particular stress on the channels
through which monetary and fiscal policy affect the economy. The IS-LM model is a
standard tool of macroeconomic that demonstrates the relationship between interest
rates and real output in the goods and services market and the money market. The
intersection of the IS and LM curves is the "General Equilibrium" where there is
simultaneous equilibrium in both markets. The IS-LM model stands as one of the
foundational frameworks in macroeconomics, offering valuable insights into the
interaction between the goods market and the money market. This model has played a
significant role in understanding the determination of equilibrium output and interest
rates in an economy. By examining the relationship between investment and saving
(IS curve) and the relationship between the liquidity preference and the money supply
(LM curve), the IS-LM model provides a framework for analyzing the impacts of
fiscal and monetary policy on aggregate demand and the overall state of the economy.

The IS-LM model, developed by John R. Hicks and Alvin Hansen in the late 1930s
and early 1940s, emerged as a response to the Great Depression. This period of
economic turmoil highlighted the need for a comprehensive framework that could
analyze the interplay between real and monetary sectors. Hicks' work built upon John
Maynard Keynes' General Theory of Employment, Interest, and Money, providing a
graphical representation of Keynesian economics.

Assumptions

Goods Market (IS curve) assumptions:

All firms produce similar goods: In this model, we assume that all firms produce
goods that are essentially the same. This helps us focus on the overall demand and
supply of goods in the economy without getting into specific details about different
products.

Flexible prices: We assume that firms are willing to adjust the supply of goods to
meet the demand at the given prices. This allows us to concentrate on understanding
the relationship between output and the interest rate without considering the
complexities of price adjustments.

Closed economy: The model assumes that there are no international trade activities.
By assuming a closed economy, we can simplify the analysis and exclude factors like
imports, exports, and exchange rates, which might complicate the understanding of
the relationship between output and interest rates.

Money Market (LM curve) assumptions:

Two assets: We consider two financial assets - money and bonds. Money is a liquid
asset that can be used for buying goods and services, while bonds are non-liquid
assets that pay interest.

Money doesn't earn interest: Money is assumed to not earn any interest. This
assumption reflects the idea that people hold money primarily for spending purposes
rather than earning returns on it.

Fixed real wealth: We assume that the total value of people's assets, known as real
wealth, remains constant in the short run. This simplifies the analysis by keeping the
focus on the relationship between interest rates and output without considering
changes in people's overall wealth.
 Investment-Savings (IS) Curve – Goods Market Equilibrium

The goods market includes trade in all goods and services that the economy produces
at a particular point in time. If the real commodity markets are in equilibrium, the
investment demand for internal and external funds and the internal and external
supply of saving, both in real terms, must also be equal to each other. This
equilibrium condition in the commodity markets may be summarized in an IS
schedule. The IS curve is the schedule of combinations of the interest rate and level of
income such that the goods market is in equilibrium. The goods market is in
equilibrium whenever the quantity of goods and services demanded equals the
quantity supplied, or when injections into the system equal leakages. Increases in the
interest rate reduce aggregate demand by reducing investment spending. Thus, at
higher interest rates, the level of income at which the goods market is in equilibrium
is lower. The IS curve relates different equilibrium level of national income with
various rates of interest. The IS curve is negatively sloped because an increase in the
interest rate reduces planned investment spending and therefore reduces aggregate
demand, thus reducing the equilibrium level of income.

The IS curve relates different equilibrium levels of national income with various rates
of Interest. The goods market is in equilibrium whenever the quantities of goods and
services demanded and supplied are equal. The IS curve describes equilibrium points
in the goods market. The combinations of aggregate output and interest rate for which
aggregate output produced equals aggregate demand.
Factors Causing a Shift in IS Curve

Changes in factors apart from interest rate that would shift the aggregate demand
would shift the IS curve. E.g. Increase in autonomous investment will shift the IS
curve to the right, while decrease in autonomous investment will shift the IS curve to
the left.

Shifted IS Curve

The IS curve will shift from IS1 to IS2 as a result of i) an increase in autonomous
consumer spending, ii) an increase in planned investment spending due to business
optimism, iii) an increase in government spending, iv) a decrease in taxes, or v) an
increase in net exports that is unrelated to interest rates. These changes shift the
aggregate demand function or IS curve upward and raise equilibrium output from Y1
to Y2 .
 Liquidity Preference-Money Supply (LM) Curve

The LM curve shows combinations of interest rates and levels of output such that
money demand equals money supply. Money is demanded for transactions and
speculative purposes. The transaction demand for money consists of the active
working balances held for the purpose of making business payments as they become
due. The transaction demand for money is positively related to the level of national
income. The speculative demand for money arises from the desire to hold money
balances instead of interest- bearing securities.The higher the rate of Interest, the
smaller is the quantity of money demanded for speculative or liquidity purposes
because the cost of holding inactive money balances is greater.

The condition for monetary equilibrium is that the demand for money is equal to the
supply of money. The supply of money is assumed by some monetary theorists to be
exogenously determined by the central bank. When the money market is in
equilibrium, the demand for money and the supply of money are equal to each other
and may be shown as an LM schedule. This LM schedule relates different rates of
interest and different levels of national income where the demand and supply of
money are in equilibrium.

The LM curve is positively sloped. Given the fixed money supply, an increase in the
level of income, which increases the quantity of money demanded, has to be
accompanied by an increase in the interest rate. This reduces the quantity of money
demanded and there by maintains money market equilibrium.
The LM curve relates the level of income with the rate of interest which is determined
by money market equilibrium corresponding to different levels of demand for money.
The money market is in equilibrium whenever the quantity of money demanded for
transactions and speculative purposes is equal to the given supply of money. The LM
curve describes the equilibrium points in the market for money- the combinations of
aggregate output and interest rate for which the quantity of money demanded equals
the quantity of money supplied.

Factors Causing a Shift in LM Curve

The LM curve is shifted by changes in the money supply. An increase in the money
supply shifts the LM curve to the right. Only two factors can cause the LM curve to
shift. Autonomous changes in money demand and changes in the money supply. The
LM curve shifts to the left if there is an increase in the money demand function which
raises the quantity of money demanded at the given interest rate and income level. On
the other hand, the LM curve shifts to the right if there is a decrease in the money
demand function which lowers the amount of money demanded at given levels of
interest rate.

Shifted LM Curve to the Right

The LM curve shifts to the right from LM1 to LM2 when the money supply increases
because, at any given level of aggregate output i.e. Y1 , the equilibrium interest rate
falls (Pt. A to A1 ) The LM curve shifts to the left if the stock of money supply is
reduced.

Shifted LM Curve to the Left

The LM curve shifts to the left from LM1 to LM2 when money demand increases
because, at any given level of aggregate output i.e. Y1, the equilibrium interest rate
rises (Pt. A to A1 ) Thus, the LM curve- which summarizes all the combinations of Y
and I that are consistent with money market equilibrium.
 Equilibrium in the Goods and Money Markets

The IS and LM schedules summarize the conditions that have to be satisfied in order
for the goods and money markets, respectively, to be in equilibrium. For simultaneous
equilibrium, interest rates and income levels have to be such that both the goods
market and the money market are in equilibrium

This condition is satisfied at point E. The equilibrium interest rate is therefore I0 and
the equilibrium level of income is Y0, given the exogenous variables, in particular,
the real money supply and fiscal policy. At point E, both the goods market and the
money market are in equilibrium.

Thus, the IS- LM curve model is based on : i) The investment – demand function, ii)
the consumption function, iii) the money demand function, and iv) the quantity of
money. Therefore, according to the IS-LM curve model both the real factors, namely
saving and investment, productivity of capital and propensity to consume and save,
and the monetary factors, that is, the demand for money and supply of money play a
part in the joint determination of the rate of interest and the level of income.

The interest rate and level of output are jointly determined by simultaneous
equilibrium of the goods and money markets. This occurs at the point of intersection
of the IS and LM curves.

Fiscal policy has its initial impact in the goods market, and monetary policy has its
initial impact mainly in the assets markets. But because the goods and assets markets
are closely interconnected, both monetary and fiscal policies have effects on both the
level of output and interest rates. Expansionary monetary policy moves the LM curve
to the right, raising income and lowering interest rates. Contractionary monetary
policy moves the LM curve to the left, lowering income and raising interest rates.
Expansionary fiscal policy moves the IS curve to the right, raising both income and
interest rates. Contractionary fiscal policy moves the IS curve to the left, lowering
both income and interest rates.

Using the IS- LM Model to Analyze Fiscal Policy

Keynesian economics, on which the IS-LM model is based, emphasizes the role of
fiscal policy in stabilizing the economy. Keynes (1936) argued that during times of
economic downturns, governments should increase spending to stimulate aggregate
demand and boost output and employment. Hicks (1980) extended this idea by
incorporating the IS-LM model, providing a graphical representation of the impact of
fiscal policy on output and interest rates.

We can use the IS- LM model to look at the impact of fiscal policy: Government
decisions on taxation and spending. Economists refer to increase in government
purchases or cuts in taxes as expansionary fiscal policy. Cuts in government
purchases and increases in taxes are referred to as contractionary fiscal policy.

An increase in government purchases or a cut in taxes increases expenditure on goods

and services, which in turn increases the production of goods and services. This is
reflected in a shift out of the IS curve.
Consider the impact of expansionary fiscal policy initially the economy is in
equilibrium at an interest rate of I0 and an output level of Y0. This implies that
spending on goods and services equals the production of goods and services while the
demand for money equals the supply of money.

Consider the impact of contractionary fiscal policy, we know that this would decrease
expenditure on goods and services and therefore shift the IS curve in. The decrease in
government purchases decreases expenditure on goods and service, which in turn
decreases the production of goods and services. This is reflected in a shift in of the IS
curve. At the original interest rate I0 output is now much lower and as a result the
demand for money is also less than the money supply. Equilibrium can only be
restored if there is a decrease in the interest rate. So we end up at a point i.e. I2 and
Y2.

Using the IS-LM Model to Analyze Monetary Policy

Monetary policy plays a crucial role in the IS-LM framework by influencing the
money supply and interest rates. The works of economists such as Milton Friedman
and Anna Schwartz (1963) have provided insights into the relationship between
monetary aggregates, such as money supply, and economic fluctuations. The IS-LM
model incorporates these insights, illustrating the impact of monetary policy on
interest rates and output levels. Monetary policy affects the economy, first, by
affecting the interest rate and then by affecting aggregate demand. An increase in the
money supply reduces the interest rate, increases investment spending and aggregate
demand, and thus increases equilibrium output.

An expansionary monetary policy, i.e., it increases the money supply, we showed that
this would cause the LM curve to shift to the right. This causes GDP to rise and
interest rates to fall in the economy.
Intuitively, expansionary monetary policy has a positive impact on Y because the
increase in money supply causes interest rates to fall in order to restore money market
equilibrium on the goods market side, the lower interest rates result in increased
investment spending which in turn increases Y.

The opposite would be true for contractionary monetary policy. The decrease in
money supply causes interest rates to rise in order to restore money market
equilibrium on the goods market side, the higher interest rates result in decreased
investment spending, which in turn lowers Y.

The question of the monetary- fiscal policy mix arises because expansionary
monetary policy reduces the interest rate while expansionary fiscal policy increases
the interest rate. Accordingly, expansionary fiscal policy increases output while
reducing the level of investment, expansionary monetary policy increases output.
Governments have to choose the mix in accordance with their objectives for economic
growth, or increasing consumption, or from the view point of their beliefs about the
desirable size of the government.

Policy Implications

The IS-LM model provides insights into the impact of fiscal and monetary policy on
output, interest rates, and the aggregate price level. It highlights the importance of
coordinated policy actions to achieve desired economic outcomes. For example,
during recessions, expansionary fiscal and monetary policies can help stimulate
output and employment.

The policy implications of the IS-LM model have been subject to extensive discussion
and analysis. The model suggests that fiscal and monetary policies can be effective in
influencing aggregate demand and stabilizing the economy. However, the magnitude
and timing of policy interventions, as well as potential crowding-out effects and lags,
have been areas of debate among economists.

Limitations of the IS-LM Model

While the IS-LM model offers valuable insights, it has several limitations. It assumes
a closed economy with fixed exchange rates, disregards expectations, and
oversimplifies the financial sector. Furthermore, the model does not fully capture the
complexities of modern economies, such as international trade, globalization, and
financial innovation.

The assumptions and simplifications of the IS-LM model have been subjects of
critique and exploration. Economists such as Robert Lucas (1976) have argued for the
importance of incorporating rational expectations and forward-looking behavior into
macroeconomic models. Additionally, the financial crisis of 2008 highlighted the
need to account for financial intermediation and the role of the banking sector in
macroeconomic analysis.
 Critiques and Alternatives

Over the years, economists have presented various critiques of the IS-LM model and
proposed alternative frameworks. Some argue that incorporating expectations and
forward-looking behavior is crucial for understanding macroeconomic dynamics.
New Keynesian models and dynamic stochastic general equilibrium (DSGE) models
have gained popularity as alternatives to the IS-LM framework.

New Keynesian models, developed by economists such as Greg Mankiw and Olivier
Blanchard, build upon the IS-LM framework while incorporating forward-looking
behavior, price rigidities, and nominal frictions. These models aim to provide a more
micro founded and rigorous foundation for Keynesian economics, addressing some of
the limitations of the IS-LM model.

Extensions and Modifications

To address some of the limitations, economists have extended and modified the IS-
LM model. Open economy versions, which consider international trade and exchange
rate movements, have been developed. Additionally, incorporating financial frictions
and modeling the banking sector has been a focus of research to capture the financial
sector's influence on macroeconomic outcomes.

Work by economists such as Maurice Obstfeld and Kenneth Rogoff (1995) expanded
the IS-LM framework to incorporate open economy features, considering the impact
of exchange rate fluctuations and capital flows on output and interest rates.
Furthermore, researchers such as Ben Bernanke and Mark Gertler (1990) have
explored the role of financial frictions and the banking sector within the IS-LM
framework.

Contemporary Macroeconomic Analysis

Despite its limitations, the IS-LM model remains relevant in contemporary

macroeconomic analysis. It serves as a foundational framework and provides intuition
for understanding the effects of policy interventions. Moreover, it acts as a starting
point for more sophisticated models that incorporate additional features and
complexities.

In recent years, economists have continued to refine and extend the IS-LM framework
to address its limitations and enhance its relevance in the modern context. DSGE
models, which combine microeconomic foundations with dynamic modeling, have
gained prominence in macroeconomic analysis. These models often incorporate
elements of the IS-LM framework while accounting for expectations, market
imperfections, and heterogeneous agents.
 Conclusion

This term paper has provided a comprehensive analysis of the IS-LM model,
examining its assumptions, components, and equilibrium conditions. It has discussed
the policy implications and limitations of the model, highlighting its relevance in
macroeconomic analysis. The IS-LM model continues to serve as a fundamental tool
in macroeconomic analysis, providing insights into the interaction between the real
and monetary sectors. However, further research and development of more
comprehensive frameworks are necessary to capture the complexities of modern
economies and enhance our understanding of macroeconomic dynamics.

In conclusion, the IS-LM model remains a vital building block in macroeconomic

theory. Its simplicity and intuitive nature make it a valuable tool for analyzing the
interplay between real and monetary factors in the economy. Nonetheless, economists
must continue refining and extending this model to address its limitations and ensure
its relevance in the ever-evolving field of macroeconomics.
 References:

- Bernanke, B., & Gertler, M. (1990). Financial Fragility and Economic Performance.
The Quarterly Journal of Economics, 105(1), 87-114.

- Friedman, M., & Schwartz, A. J. (1963). A Monetary History of the United States,
1867-1960. Princeton University Press.

- Hicks, J. R. (1937). Mr. Keynes and the Classics: A Suggested Interpretation.

Econometrica, 5(2), 147-159.

- Hicks, J. R. (1980). IS-LM: An Explanation. Journal of Post Keynesian Economics,

3(2), 139-154.

- Keynes, J. M. (1936). The General Theory of Employment, Interest and Money.

Macmillan.

- Lucas, R. E. (1976). Econometric Policy Evaluation: A Critique. Carnegie-

Rochester Conference Series on Public Policy, 1(1), 19-46.

- Obstfeld, M., & Rogoff, K. (1995). Exchange Rate Dynamics Redux. Journal of
Political Economy, 103(3), 624-660.