Chapter 10: The IS-LM Model 1 of 6

Abstract
This chapter introduces the IS-LM model, a cornerstone of short-run macroe-
conomic analysis, which integrates the goods market (IS curve) and the money
market (LM curve) to explain how output and interest rates are determined.
Building on the sticky-price assumption central to short-run business cycle
theory, the model illustrates the effects of fiscal and monetary policies on the
economy. Drawing on concepts from N. Gregory Mankiw’s Macroeconomics
(2003), such as aggregate demand, consumption behavior, and macroeco-
nomic variables, this chapter provides a theoretical foundation, mathemat-
ical derivations, policy implications, and a case study of the 1964 tax cut.

1 Introduction

Macroeconomics studies the economy as a whole, focusing on variables like out-

put, inflation, and unemployment (Mankiw, 2003, p. 4). The IS-LM model, devel-
oped by John Hicks and Alvin Hansen, is a key framework for analyzing short-
run economic fluctuations. It integrates the goods market (Investment-Saving,
or IS) and the money market (Liquidity preference-Money supply, or LM) to de-
termine equilibrium output (real GDP) and interest rates. Unlike the classical
model, which assumes flexible prices (Mankiw, p. 15), the IS-LM model assumes
sticky prices, making it suitable for short-run analysis (p. 13).
This chapter explores the IS-LM model’s components, derives its equilibrium,
and examines how fiscal and monetary policies affect the economy. It connects
to Mankiw’s discussion of consumption (pp. 448–460), fiscal policy (p. 456), and
macroeconomic data (pp. 17–24), providing a practical tool for understanding
policy debates and economic events.

2 The IS Curve: The Goods Market

2.1 Deriving the IS Curve

The IS curve represents combinations of interest rates (r) and output (Y ) where
the goods market is in equilibrium, meaning aggregate demand equals aggre-
gate supply. Aggregate demand is the sum of consumption (C), investment (I),
government purchases (G), and net exports (N X):

Y = C + I + G + NX

- Consumption (C): Consumption depends on disposable income (Y − T ), where

T is taxes. Following Keynes’s consumption function (Mankiw, p. 460), we as-
sume:
C = a + b(Y − T )
where a is autonomous consumption, and b (0 < b < 1) is the marginal propen-
sity to consume (MPC). Mankiw’s discussion of consumption theories (pp. 448–
460) suggests more complex models (e.g., permanent-income hypothesis), but the
Keynesian form is used for simplicity.
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- Investment (I): Investment is inversely related to the real interest rate (r), as
higher interest rates increase borrowing costs, reducing investment:

I = I(r), I ′ (r) < 0

- Government Purchases (G) and Taxes (T ): These are exogenous policy vari-
ables. - Net Exports (N X): For simplicity, we assume a closed economy (N X =
0).
Substituting into the equilibrium condition:

Y = C(Y − T ) + I(r) + G

Y = a + b(Y − T ) + I(r) + G

Solving for Y :
Y − bY = a − bT + I(r) + G
Y (1 − b) = a − bT + I(r) + G
1
Y = [a − bT + I(r) + G]
1−b

This equation shows that output depends on the interest rate via investment.
Since I ′ (r) < 0, higher interest rates reduce investment, lowering output. The
IS curve is downward-sloping in the r-Y plane, as higher interest rates reduce
aggregate demand, requiring lower output for goods market equilibrium.

2.2 Graphical Representation

The IS curve slopes downward because a higher interest rate reduces invest-
ment, lowering aggregate demand and output. Shifts in the IS curve occur due
to changes in exogenous variables like government spending or taxes. For ex-
ample, an increase in G shifts the IS curve rightward, increasing output at any
given interest rate.

3 The LM Curve: The Money Market

3.1 Deriving the LM Curve

The LM curve represents combinations of interest rates and output where the
money market is in equilibrium, meaning money demand equals money supply.
Money demand depends on income (for transactions) and the interest rate (the
opportunity cost of holding money):

( )d
M
= L(r, Y )
P
where M is the nominal money supply, P is the price level (fixed in the short
run due to sticky prices, Mankiw, p. 13), and L(r, Y ) is the liquidity preference
Chapter 10: The IS-LM Model 3 of 6

function, with Lr < 0 (lower interest rates increase money demand) and LY > 0
(higher income increases transactions demand).
Money supply is exogenous, set by the central bank:
( )s
M M
=
P P

In equilibrium:
M
L(r, Y ) =
P

For a fixed M /P , higher output (Y ) increases money demand, requiring a higher

interest rate (r) to reduce money demand and restore equilibrium. Thus, the LM
curve is upward-sloping.

3.2 Graphical Representation

The LM curve slopes upward because higher output increases money demand,
pushing up interest rates to balance the money market. Shifts in the LM curve
occur due to changes in the real money supply (M /P ). An increase in M shifts
the LM curve rightward, reducing interest rates for any given output.

4 Equilibrium in the IS-LM Model

4.1 Equilibrium Output and Interest Rate

The economy is in equilibrium where the IS and LM curves intersect, determin-

ing the interest rate and output level where both the goods and money markets
clear. Mathematically, solve the IS and LM equations simultaneously:

1
Y = [a − bT + I(r) + G]
1−b
M
L(r, Y ) =
P
The intersection yields equilibrium Y and r. This equilibrium reflects short-run
output, which may differ from the natural rate due to sticky prices (Mankiw, p.
13).

4.2 Graphical Equilibrium

The equilibrium point shows the interest rate and output level consistent with
both market equilibria. Shocks or policy changes shift the IS or LM curves, alter-
ing the equilibrium.
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5 Policy Analysis Using the IS-LM Model

5.1 Fiscal Policy

Fiscal policy, such as changes in government spending or taxes, shifts the IS

curve. Consider an increase in government spending (∆G > 0):
- The IS curve shifts rightward, as higher G increases aggregate demand. - At
the initial interest rate, output rises, increasing money demand. - The higher
money demand pushes up interest rates along the LM curve, partially offsetting
the output increase (crowding out).
The net effect is higher output and interest rates. Mankiw’s case study of the
1964 tax cut (p. 456) illustrates this: a permanent tax cut increased disposable
income, boosting consumption and shifting the IS curve rightward, stimulating
the economy.

5.2 Monetary Policy

Monetary policy, such as changes in the money supply, shifts the LM curve. An
increase in the money supply (∆M > 0):
- Shifts the LM curve rightward, as higher M /P reduces interest rates. - Lower
interest rates stimulate investment, increasing output via the IS curve.
The result is higher output and lower interest rates. This aligns with Mankiw’s
discussion of the Federal Reserve’s role in combating inflation (p. 4).

5.3 Policy Effectiveness

The IS-LM model highlights that policy effectiveness depends on the slopes of the
IS and LM curves:
- A flat IS curve (high interest sensitivity of investment) amplifies fiscal policy
effects. - A flat LM curve (high interest sensitivity of money demand) amplifies
monetary policy effects.

6 Case Study: The 1964 Tax Cut

The 1964 tax cut, discussed by Mankiw (p. 456), provides a practical applica-
tion of the IS-LM model. Announced as a permanent reduction in tax rates, it in-
creased disposable income, raising consumption (consistent with the permanent-
income hypothesis, pp. 454–455). In the IS-LM framework:
- The tax cut shifted the IS curve rightward, increasing aggregate demand. - Out-
put and interest rates rose, stimulating economic growth. - The permanent na-
ture of the tax cut ensured a significant consumption response, unlike the 1968
temporary tax surcharge, which had negligible effects due to consumers’ expec-
tations (p. 456).
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This case underscores the importance of expectations in policy effectiveness, as

highlighted in Mankiw’s discussion of rational expectations (p. 457).

7 Connection to Consumption Theories

Mankiw’s Chapter 16 (pp. 448–460) on consumption provides microeconomic

foundations for the IS curve. The Keynesian consumption function (C = f (Y ))
underpins the IS curve’s derivation, but advanced theories refine this:
- Life-Cycle Hypothesis (Modigliani, pp. 449–452): Consumption depends on
lifetime income, implying that permanent tax cuts have larger effects than tem-
porary ones. - Permanent-Income Hypothesis (Friedman, pp. 453–455): Con-
sumption responds to permanent income, explaining the weak response to the
1968 tax surcharge. - Random-Walk Hypothesis (Hall, pp. 456–457): Consump-
tion changes are unpredictable, suggesting policy impacts depend on unexpected
changes.
These theories enhance the IS-LM model by clarifying how fiscal policy affects
consumption and aggregate demand.

8 Limitations of the IS-LM Model

- Sticky Prices: The model assumes fixed prices, limiting its applicability to the
short run (Mankiw, p. 13). In the long run, flexible prices lead to classical out-
comes (p. 15). - Expectations: The basic model ignores expectations, though
rational expectations (p. 457) can be incorporated. - Open Economy: The closed-
economy assumption excludes net exports, which Mankiw notes are central to
global macroeconomics (p. 4).

9 Summary

The IS-LM model is a powerful tool for analyzing short-run macroeconomic fluc-
tuations. By integrating the goods and money markets, it explains how out-
put and interest rates respond to fiscal and monetary policies. Grounded in
sticky prices, it aligns with Mankiw’s short-run business cycle theory (p. 15).
The model’s policy insights, illustrated by the 1964 tax cut, highlight its rele-
vance, while consumption theories (pp. 448–460) provide microeconomic depth.
Despite limitations, the IS-LM model remains a cornerstone of macroeconomic
analysis.

10 Key Concepts

• IS curve
• LM curve
• Aggregate demand
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• Sticky prices
• Fiscal policy
• Monetary policy
• Crowding out
• Marginal propensity to consume
• Liquidity preference

11 Questions for Review

1. What does the IS curve represent, and why is it downward-sloping?

2. How does an increase in the money supply affect the LM curve and equi-
librium output?
3. Explain the crowding-out effect in the context of fiscal policy.

12 Problems and Applications

1. Using the IS-LM model, analyze the impact of a simultaneous increase in

government spending and money supply.
2. How would a temporary tax cut affect the economy differently from a per-
manent tax cut, according to the IS-LM model and the permanent-income
hypothesis?
3. Discuss how the slope of the LM curve affects the effectiveness of monetary
policy.