What is the IS-LM Model? – Complete Lesson in 2023

What is the IS-LM Model? – Complete Lesson in 2023

What does the IS-LM model explain?

Basically, IS-LM model analyses the goods market and money market to determine the equilibrium real output level and interest rate under the given price level. At the equilibrium point of the IS-LM model, the equilibrium for both the goods market (IS) and the money market (LM) meets each other.

In the IS-LM model, “IS” stands for investment savings, and “LM” stands for “liquidity money”.

One of the first theories that suggested the money supply had the greatest influence on interest rates was the IS-LM model. Based on the ideas of prominent liberal economist John Maynard Keynes, it was developed by economist John Hicks in 1937.

The distribution of money between liquid money (LM), which is cash, and investment and savings (IS), which is money that people deposit in commercial banks and lend to borrowers, is shown as a function of interest rates.

The IS-LM model can be defined as a great method to determine the level of short-run real gross domestic product (real GDP) in the economy.

Other economic models explain the real GDP level of an economy are,

  • AD – AS model
  • Aggregate expenditure model.

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What is the difference between IS curve and LM curve?

What is the concept of IS curve?

IS curve is a combination of many equilibrium points of the goods market (total savings equals total investments) at various real interest rates and real output levels.

IS curve has a downward slope. Because there is a negative relationship between the national savings and the real output level of the economy. On the other hand, when the interest rate increases, the level of spending decreases. Because when interest rate is increasing, people decreases their domestic consumption, investment and net exports. So, the aggregate expenditure of the economy is decreasing. In other words, the output level of the economy decreases. This relationship is presented by the IS curve as follows.

IS curve

What is the concept of LM curve?

LM curve is a combination of many equilibrium points of the assets market (money supplied equals money demanded) at various real interest rates and real output levels.

LM curve have an upward slope. Because there is a positive relationship between the quantity of money and real output level of the economy.

Households, businesses, and governments that use money as a medium of trade and a store of value are the sources of the demand for it. According to the law of demand, as interest rates rise, less money is demanded since storing money has an opportunity cost associated with it. In other words, money is less useful as a store of value when interest rates are higher. On the other hand, when interest rates decrease, the demand for money is increasing. As a result of the high money demand, the real output of an economy rises.

 The money supply of a country is decided by the central bank of a country by setting the interest rates. High-interest rates decrease the money supply and low-interest rates increase the money supply. As a result of the high money supply, the real output of an economy rises.

Following graph shows the money market demand and supply forces and equilibrium of the money market. Horizontal axis of the money market shows the quantity of money and vertical axis shows the nominal interest rate. When money demand equals to the money supply, money market equilibrium is occurred (at the point E1).

money market graph

LM curve

The following graph shows the derivation of the LM (liquidity money) curve under money market changes. According to the following money market graph, at the point E1, the money market equilibrium exists (the point where the money supply curve intersects the MD1 money demand curve). LM curve is a combination of many equilibrium points of the money market (money supplied equals money demanded). Point E1 equilibrium point of the money market is presented by point A of the LM curve.

After that money demand shifted to the MD2. Money market equilibrium has shifted to the E2. At point E2, the money supply curve intersects the MD2 money demand curve. Point E2 equilibrium point of the money market is presented by point B of the LM curve.

LM curve

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IS-LM model graph

The following graph shows the IS LM model. Vertical axis presents the interest rate and horizontal axis presents the aggregate income level or output. At the point E1, IS curve and LM curve are intersected each other. At this point, we can determine the equilibrium output level of the economy and it is Y1.

is lm model graph

IS-LM model shifts

We can identify two major factors for IS-LM model shifts. They are the shift of the LM curve and the shift of the IS curve.

If LM curve shift to the left, the real output will be decreased and the interest rate will be increased. On the other hand, if the LM curve shifts to the right, the real output will be increased and the interest rate will be decreased. Following IS-LM curve shows the impact of shifting the LM curve to the rightward.

lm curve shift

If IS curve shift to the left, the real output will be decreased and the interest rate will be decreased. On the other hand, if the IS curve shifts to the right, the real output will be increased and the interest rate will be increased. Following IS-LM curve shows the impact of shifting the IS curve to the rightward.

is curve shift

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