The IS curve moves to the right, causing higher interest rates and expansion in the "real" economy (real GDP).

The IS/LM model, first developed by Sir John Hicks and Alvin Hansen, has been used from 1937 onwards to summarize a major part of Keynesian macroeconomics. Sir John Richard Hicks ( April 8, 1904 May 20, 1989) was one of the most important and influential Economists and Religious Inclusivists Alvin Harvey Hansen (1887-1975 once referred to as "the American Keynes" brought the 1930s Keynesian economics revolution to the United States. Year 1937 ( MCMXXXVII) was a Common year starting on Friday (link will display the full calendar of the Gregorian calendar. In Economics Keynesian economics (ˈkeɪnziən also Keynesianism and Keynesian Theory) is based on the ideas of twentieth-century British economist Macroeconomics is a branch of Economics that deals with the performance structure and behavior of a national or regional Economy as a whole

Formulation

The model is presented as a graph of two intersecting lines in the first quadrant.

The horizontal axis represents national income or real gross domestic product and is labelled Y. The distinction between real versus nominal value occurs in many fields The vertical axis represents the nominal interest rate, i. Interest is a fee paid on borrowed capital Assets lent include Money, Shares, Consumer goods through Hire purchase, major assets

The IS schedule is drawn as a downward-sloping curve. Slope is used to describe the steepness incline gradient or grade of a straight line. The initials IS stand for "Investment/Saving equilibrium" but since 1937 have been used to represent the locus of all equilibria where total spending (Consumer spending + planned private Investment + Government purchases + net exports) equals an economy's total output (equivalent to real income, Y, or GDP). To keep the link with the historical meaning, the IS curve can represent the equilibria where total private investment equals total saving, where the latter equals consumer saving plus government saving (the budget surplus) plus foreign saving (the trade surplus). Either way, in equilibrium, all spending is desired or planned; there is no unplanned inventory accumulation (i. e. , no general glut of goods and services). A general glut is caused by too much production in all fields of production in comparison with what resources are available to consumption to purchase said production ^[1] The level of real GDP (Y) is determined along this line for each interest rate. Interest is a fee paid on borrowed capital Assets lent include Money, Shares, Consumer goods through Hire purchase, major assets

Thus the IS schedule is a locus of points of equilibrium in the "real" (non-financial) economy. In Mathematics, a locus ( Latin for "place" plural loci) is a collection of points which share a property Given expectations about returns on fixed investment, every level of interest rate (i) will generate a certain level of planned fixed investment and other interest-sensitive spending: lower interest rates encourage higher fixed investment and the like. Investment or investing is a term with several closely-related meanings in Business management, Finance and Economics, related to saving Income is at the equilibrium level for a given interest rate when the saving consumers choose to do out of that income equals investment (or, more generally, when "leakages" from the circular flow equal "injections"). Consumers refers to individuals or households that use goods and services generated within the economy. In Economics, the term circular flow of income or circular flow refers to a simple economic model which describes the reciprocal circulation of income between producers A higher level of income is needed to generate a higher level of saving (or leakages) at a given interest rate. Alternatively, the multiplier effect of an increase in fixed investment raises real GDP. In economics the multiplier effect refers to the idea that an initial spending rise can lead to an even greater increase in National income. Both ways explain the downward slope of the IS schedule. In sum, this line represents the line of causation from falling interest rates to rising planned fixed investment (etc. ) to rising national income and output.

The LM schedule is an upward-sloping curve representing the role of finance and money. The initials LM stand for "Liquidity preference/Money supply equilibrium" but is easier to understand as the equilibrium of the demand to hold money (as an asset and for use in everyday transactions) and the supply of money by banks and the central bank. Money is anything that is generally accepted as Payment for Goods and services and repayment of Debts. A central bank, reserve bank, or monetary authority is the entity responsible for the Monetary policy of a country or of a group of member states The interest rate is determined along this line for each level of real GDP.

In a closed economy, the IS curve is defined as: , where Y represents income, C(Y − T) represents consumer spending as a function of disposable income (income, Y, minus taxes, T), I(r) represents investment as a function of the real interest rate, and G represents government spending. In this equation, the level of G (government spending) and T (taxes) are presumed to be exogenous, meaning that they are taken as a given. Exogenous (or exogeneous) (from the Greek words "exo" and "gen" meaning "outside" and "production" refers to an action or In a similar fashion, the LM curve is defined as M / P = L(r,Y), where the supply of money is represented as the real money balance M/P (as opposed to the nominal balance M), with P representing a price deflator, equals the demand for money L, which is some function of the interest rate and the level of income. The distinction between real versus nominal value occurs in many fields To adapt this model to an open economy, a term for net exports (exports, X, minus imports, M) would need to be added to the IS equation. An economy with more imports than exports would have a negative net exports number.

Rising GDP (Y) implies an increased transactions demand for money and liquidity preference. Finance Theory John Maynard Keynes developed the Liquidity Preference of Interest in the General Theory of Employment Interest and Money. With a given and inelastic money supply curve, the equilibrium interest rate (i) rises. This explains the upward slope of the LM curve.

The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors (though not necessarily in other sectors, such as labor markets): both product markets and money markets are in equilibrium. General equilibrium theory is a branch of theoretical Microeconomics. This equilibrium yields a unique combination of interest rates and real GDP.

Shifts

One hypothesis is that a government's deficit spending ("fiscal policy") has an effect similar to that of a lower saving rate or increased private fixed investment, increasing the amount of aggregate demand for national income at each individual interest rate. Deficit spending is the amount by which a government private company or individual's spending exceeds income over a particular period of time also called simply "deficit" Fiscal policy, taking the scope of Budgetary policy, refers to government policy that attempts to influence the direction of the economy through changes in government taxes In Economics, aggregate demand is the total demand for final goods and services in the economy ( Y) at a given time and Price level. An increased deficit by the national government shifts the IS curve to the right. This raises the equilibrium interest rate (from i₁ to i₂) and national income (from Y₁ to Y₂), as shown in the graph above.

The graph indicates one of the major criticism of deficit spending as a way to stimulate the economy: rising interest rates lead to crowding out – i. Deficit spending is the amount by which a government private company or individual's spending exceeds income over a particular period of time also called simply "deficit" In economics crowding out theoretically occurs when the Government expands its borrowing to finance increased expenditure or cuts taxes (i e. , discouragement – of private fixed investment, which in turn may hurt long-term growth of the supply side (potential output). In Economics, potential output (also referred to as "natural gross domestic product" refers to the highest level of real Gross Domestic Product Keynesians respond that deficit spending may actually "crowd in" (encourage) private fixed investment via the accelerator effect, which helps long-term growth. The accelerator effect in economics refers to a positive effect on private Fixed investment of the growth of the market economy (measured e Further, if government deficits are spent on productive public investment (e. g. , infrastructure or public health) that directly and eventually raises potential output.

The IS/LM model also allows for the role of monetary policy. Monetary policy is the process by which the Government, Central bank, or monetary authority of a country controls (i the Supply of Money, If the money supply is increased, that shifts the LM curve to the right, lowering interest rates and raising equilibrium national income.

In all this, the price level is assumed as fixed and no inflation is taken into consideration. A price level is a hypothetical measure of overall prices for some set of goods and services in a given region during a given interval normalized relative to some In economics inflation or price inflation is a rise in the general level of prices of goods and services over a period of time To include them and other crucial issues, several further curves and diagrams are needed. To keep everything in one sheet, one has to shift from the representation through diagrams (in Cartesian spaces) to graphs (nodes and arrows), as defined by Graph theory. In Mathematics and Computer science, graph theory is the study of graphs: mathematical structures used to model pairwise relations between objects An interactive graph of all IS-LM variables and their linkages is provided at http://www.economicswebinstitute.org/essays/is-lm2.htm.

History

The IS/LM model was born at the Econometric Conference held in Oxford during September, 1936. Roy Harrod, John R. Hicks, and James Meade all presented papers describing mathematical models attempting to summarize John Maynard Keynes' General Theory of Employment, Interest, and Money. Sir Roy Forbes Harrod ( February 13, 1900 &ndash March 8, 1978) was an English Economist. Sir John Richard Hicks ( April 8, 1904 May 20, 1989) was one of the most important and influential Economists and Religious Inclusivists James Edward Meade ( June 23 1907, Swanage, Dorset December 22 1995, Cambridge) was a British Economist Note The term model has a different meaning in Model theory, a branch of Mathematical logic. John Maynard Keynes 1st Baron Keynes CB (ˈkeɪnz "cains" (5 June 1883 &ndash 21 April 1946 was a British Economist whose ideas The General Theory of Employment Interest and Money was written by the English economist John Maynard Keynes. Hicks, who had seen a draft of Harrod's paper, invented the IS/LM model. He later presented it in "Mr. Keynes and the Classics: A Suggested Interpretation"^[2].

Hicks later agreed that the model missed important points from the Keynesian theory ^[3]. The problem was that it presents the real and monetary sectors as separate, something Keynes attempted to transcend. In addition, an equilibrium model ignores uncertainty. A shift in the IS or LM curve will cause change in expectations, causing the other curve to shift. Most modern macroeconomists see the IS/LM model as being at best a first approximation for understanding the real world.

Although the model is generally not taught at the graduate level, a few graduate programs (UNC Greensboro, Auburn University, Florida State, and West Virginia University) continue to use it as part of the macroeconomics curriculum. It is also still the dominant paradigm in undergraduate macroeconomics textbooks.

References

Related Models

• AD-AS Model
• AD-IA Model
• Mundell-Fleming model

See also

• Policy-mix

External links

• Elmer G. The AD-AS or Aggregate Demand-Aggregate Supply model is a macroeconomic model that explains Price level and output through the relationship of The Aggregate Demand-Inflation Adjustment model builds on the concepts of the IS/LM model and the AD-AS models essentially in terms of changing interest rates in response The Mundell-Fleming model is an economic model first set forth by Robert Mundell and Marcus Fleming. Wiens: IS-LM Model - An On-line, Interactive IS-LM Model of the Canadian Economy.
• The Hicks-Hansel IS-LM Model: [1] in-depth comment and explanation.