IS–LM model

The model’s central result is that output and the interest rate are jointly determined by equilibrium in the goods and money markets. The downward-sloping IS curve traces points where planned expenditure equals output: lower interest rates generally stimulate investment and interest-sensitive consumption, raising equilibrium output. The upward-sloping LM curve traces points where real money demand equals the real money stock: as output rises, transactions demand for money increases, so a higher interest rate is needed to preserve money-market equilibrium when the money supply is fixed.

In a basic closed economy, the IS relation can be written as Y = C(Y − T) + I(r) + G, while the LM relation follows from M/P = L(Y,r). Here Y is output, r is the interest rate, G is government purchases, T is taxation, M is nominal money, and P is the price level. The intersection is a comparative-static equilibrium, not a complete theory of inflation, growth, employment, or financial institutions.

Fiscal expansion usually raises output and the interest rate in the standard IS–LM framework. Higher government purchases or lower taxes shift the IS curve to the right; the resulting increase in income raises money demand, and the interest rate rises until the money market clears. The higher rate partially reduces private investment, producing the model’s classic “crowding out” effect.¹

Monetary expansion usually lowers the interest rate and raises output in the short run. An increase in the real money supply shifts the LM curve to the right, reducing the interest rate at a given level of income and encouraging interest-sensitive spending. The size of either policy effect depends on the slopes of the curves, the responsiveness of investment and money demand, the exchange-rate regime, and whether prices are treated as fixed. In a liquidity trap, very low rates and highly interest-sensitive money demand can make conventional monetary policy weak.

The model originated in John Hicks’s 1937 interpretation of The General Theory of Employment, Interest and Money and was later developed in textbook form by Alvin Hansen. Hicks used the IS and LM schedules to express a relationship between Keynesian income determination, investment, liquidity preference, and monetary equilibrium.² The framework became a standard teaching device because it displays the interaction of aggregate demand and financial conditions with two curves on one diagram.

Its principal use is comparative statics: analysts can ask how a change in taxes, public spending, the money stock, or autonomous investment changes equilibrium output and interest rates. Open-economy versions add the exchange rate and external balance, while later models replace the LM curve with an interest-rate rule set by a central bank. Modern New Keynesian models generally derive policy and demand relationships from explicit expectations and intertemporal choices rather than treating the money stock as the central policy instrument.³

The IS–LM diagram compresses several institutional choices that matter in practice. “Money” may mean currency plus bank deposits or a broader aggregate, and the relevant interest rate may be a policy rate, a market yield, or a borrowing rate facing households and firms. The model also assumes a meaningful distinction between a fixed price level in the short run and flexible prices over longer horizons; once prices change, the real money supply and the position of LM change as well.⁴

The framework has also been criticized for treating expectations, credit markets, and distributional effects too simply. Financial stress can widen spreads even when a policy rate is unchanged, and banks may ration credit rather than merely respond to one market-clearing interest rate. In an open economy, capital mobility and exchange-rate arrangements alter policy effectiveness, a point developed in the Mundell–Fleming extension.⁵ These limitations do not eliminate IS–LM’s value as a map of basic short-run interactions, but they caution against reading its intersection as a full forecast.

IS curve

The set of output and interest-rate combinations at which the goods market is in equilibrium.

LM curve

The set of output and interest-rate combinations at which real money demand equals the real money supply.

Liquidity preference

The desire to hold wealth in liquid money balances rather than less-liquid assets, often modeled as depending on income and interest rates.

Crowding out

A reduction in private spending, especially investment, caused by higher interest rates following expansionary fiscal policy.

Liquidity trap

A situation in which very low interest rates and highly elastic money demand limit the effect of increasing the money supply.