IS-LM Model
Candlefocus EditorThe IS curve is a representation of the market for all goods in the economy, including physical goods, services and financial assets. The curve assumes that the rate of investment, the rate of savings, and the monetary supply all remain fixed. By definition, the intersection of the IS curves and the LM curves result in an equilibrium for the macroeconomy.
The LM curve is a representation of the market for financial and loanable goods where liquidity preference and the amount of money supply are held constant. The LM curve is an inverse relationship, that is, a higher rate of interest attracts more money, while a lower rate of interest results in less money being supplied.
The IS-LM Model creates a framework to analyze the effects of both fiscal and monetary policy changes. A shift in the IS curve, caused by a change in aggregate demand, can cause output to increase, or decrease. Similarly, a shift in the LM curve, resulting from a change in interest rates, will also impact output and the equilibrium levels of GDP.
The IS-LM Model provides an easy way to explain macroeconomic phenomena, such as changes in the general price level, output, and the rate of interest due to an imbalance of supply and demand in the macroeconomy. This is because it gives a simple explanation that relates fiscal/monetary policy to aggregate output.
Because of its simplicity, the IS-LM Model has been very influential in the field of macroeconomics since the 1940's and is still widely used today. Its use has been further popularized by its application in computer-based models, such as the neoclassical growth model, in order to study the macroeconomic effects of policy decisions.
The IS-LM Model does have some limitations, however. It does not explicitly assume the existence of money, which is critical for analyzing changes in money supply as it is exchangeable for all other goods and services, or account for price or income elasticity, which is important for understanding the effects of taxation. Furthermore, the model does not account for the role of government spending and debt, nor does it incorporate important features of the financial sector, such as the price of money and various types of risk. In spite of these limitations, the IS-LM Model remains an invaluable tool for understanding macroeconomic scenarios.