IS–LM model

• 1. Introduction

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  On a single graph, the IS-LM model, also called the Hicks-Hansen model, plots a downward-sloping IS curve against an upward-sloping LM curve. Where the two lines cross is meant to represent a single moment of general equilibrium. At that point, the market for goods and the market for money are both settled at once. For decades this crossing point anchored how economists explained recessions, tax cuts, and shifts in the money supply. Then a shift in how central banks set interest rates made one of the model's core assumptions look outdated. What convinced generations of economists to build their understanding of interest rates and output around two intersecting lines? And what eventually pushed the model out of research while it stayed in the classroom?

• 2. Three Papers, One Model

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  In September 1936, the Econometric Society held a conference in Oxford where Roy Harrod, John R. Hicks, and James Meade each presented papers. Each paper tried to translate John Maynard Keynes' General Theory of Employment, Interest, and Money into a mathematical model.

  Hicks had already seen a draft of Harrod's paper before building his own version. He first labeled it with the letters LL, not LM. He later presented the finished model in a paper called Mr. Keynes and the Classics: A Suggested Interpretation.

  By 1937, Hicks had introduced the completed model, and Alvin Hansen joined him in extending it through the early 1940s. Hansen built substantially on Hicks' original contribution. Their finished version would soon become required material for an entire generation of economics students.

• 3. Decades At The Center

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  Between the 1940s and the mid-1970s, the IS-LM model served as the leading framework for macroeconomic analysis. It shaped how professors explained recessions and policy debates to their students.

  During the 1960s and 1970s, the model became the natural stage for the debate between Keynesians and monetarists. The disagreement centered on whether fiscal policy or monetary policy did more to stabilize the economy. Afterward, this argument faded and left more attention on a different problem: the model's assumption that prices never move.

• 4. A Model Blind To Inflation

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  In the 1950s and early 1960s, the IS-LM model's assumption of a fixed price level barely mattered, since inflation was not yet a pressing concern. That assumption meant the model could not, by itself, explain rising prices at all.

  Rising inflation through the late 1960s and into the 1970s made the fixed-price assumption a real problem. Economists responded by extending the model to include aggregate supply in some form. The clearest example is the AD-AS model, which can be described as an IS-LM model with an added supply side that explains rising prices.

  Even with that patch, the entire model still rested on two hand-drawn curves, IS and LM, whose exact shapes were about to matter enormously.

• 5. Two Curves, One Equilibrium

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  Where the IS and LM schedules intersect marks a short-run equilibrium in the real and monetary sectors of the economy. That balance does not necessarily extend to other markets, such as labor. This single crossing point yields one specific combination of the interest rate and real GDP.

  On the IS curve, the interest rate sits on the vertical axis and GDP, or Y, sits on the horizontal axis, and the line slopes downward. It traces every combination where total spending, meaning consumer spending plus planned private investment plus government purchases plus net exports, equals total output.

  The same curve also marks where total private investment equals total saving. Saving here means consumer saving, government saving as a budget surplus, and foreign saving as a trade surplus. Lower interest rates encourage more investment and more spending at any given point along the curve. A multiplier effect then turns that extra investment into a larger rise in real GDP, which is why the IS curve slopes downward.

  On the LM curve, income is the independent variable and the interest rate is the dependent one, tracing where money demand equals money supply. The liquidity preference function behind it slopes downward: people want to hold more cash as the interest rate falls.

  Transactions demand, the need to hold cash for everyday purchases and a precautionary cushion against emergencies, rises directly with real GDP. Speculative demand, the choice to hold cash instead of securities, moves the opposite way. It falls as the interest rate rises, since holding cash then costs more in missed investment returns.

  Money supply itself is set by the central bank and by how willing commercial banks are to lend. That makes it a vertical line, unaffected by the interest rate. When GDP rises, the liquidity preference function shifts rightward and pulls the interest rate up with it, which is why the LM curve slopes upward.

  Economists label the equilibrium point using the interest rate i and income Y. Both are about to move once fiscal or monetary policy enters the picture.

• 6. What Moves The Curves

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  An increase in government deficit spending acts much like a lower saving rate or a jump in private fixed investment. It raises the demand for goods at every interest rate. This shifts the IS curve to the right, pushing the equilibrium interest rate from i1 to i2 and national income from Y1 to Y2. Economists call this resulting equilibrium level of national income aggregate demand.

  Keynesians argue that this same deficit spending can crowd in, or encourage, private fixed investment through what is called the accelerator effect, aiding long-term growth. When deficits fund productive public investment, such as infrastructure or public health, that spending can directly raise potential output. It does not necessarily raise output by more than the private investment it displaced.

  How much crowding out occurs depends on the shape of the LM curve. Along a relatively flat LM curve, a shift in the IS curve raises output substantially while barely moving the interest rate. Along a vertical LM curve, the same rightward IS shift raises interest rates but leaves output unchanged, a case known as the Treasury view.

  Rightward shifts in the IS curve can also come from exogenous jumps in investment spending, consumer spending, or export spending from outside the modeled economy. A drop in import spending has the same rightward effect. Each of these raises both income and the interest rate. Changes in the opposite direction shift the IS curve the opposite way.

  On the monetary side, an increase in the money supply shifts the LM curve downward, lowering interest rates and raising national income. A drop in liquidity preference, perhaps from improved transaction technology, shifts the LM curve downward in the same way. All of this assumed the central bank was steering the economy by controlling the money supply, an assumption that would not survive the 1990s.

• 7. When Central Banks Changed Course

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  From the early 1990s, central banks abandoned money-supply targets and shifted toward targeting inflation directly, using an interest rate rule to reach their goal. As central banks stopped watching the money supply, the IS-LM model's central assumption grew increasingly unrealistic and confusing for students.

  In 2000, David Romer proposed replacing the traditional IS-LM framework with an IS-MP model. It swapped the upward-sloping LM curve for a horizontal MP curve, where MP stands for monetary policy. John B. Taylor independently made a similar recommendation the same year. After 2000, many textbooks followed suit. They replaced the LM curve's old story of a central bank steering rates indirectly through the money market. In its place came a simpler picture: a central bank directly setting its policy rate.

  Olivier Blanchard's widely used textbook Macroeconomics adopted this horizontal LM curve starting with its seventh edition in 2017. In that version, the LM curve sits flat at whatever interest rate the central bank chooses, which allows for simpler dynamics. The vertical axis can represent either the nominal or the real interest rate. Using the real rate lets inflation enter the model in a simple way.

  Output is still set by where the IS and LM curves cross. The LM curve now shifts only from a change in monetary policy or in inflation expectations. This version also separates two interest rates: the policy rate set by the central bank and the market rate that actually drives firms' investment decisions. The market rate equals the policy rate plus a premium, reflecting risk or the market power of commercial banks. That premium is what lets shocks from the financial sector reach the goods market and affect demand.

  Similar approaches appear under different names in textbooks by Charles Jones, by Wendy Carlin and David Soskice, and in the CORE Econ project. Akira Weerapana and Stephen Williamson took a related route, replacing the LM curve with a real interest rate rule instead.

  Today, the traditional IS-LM model is largely absent from macroeconomic research. It still serves as a backbone teaching tool in many textbooks, and its influence lives on inside larger models built on top of it.

• 8. Building Bigger, Believing Differently

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  By itself, the IS-LM model only works for the short run, when prices are fixed or sticky and inflation is left out of the picture. Adding a supply relation lets economists stretch it to also cover the medium run, sometimes described as the difference between classical and Keynesian analysis. In the Aggregate Demand-Aggregate Supply model, every point on the aggregate demand curve comes from running the IS-LM model at one particular price level.

  Raise the price level, and the real money supply, M divided by P, falls. That fall pushes the LM curve higher and lowers aggregate demand at that price level. This inverse relationship, higher prices producing lower demand, is what gives the aggregate demand curve its negative slope.

  In a 2018 textbook called Macroeconomics, Daron Acemoglu, David Laibson, and John A. List combined this setup with a supply relation. They named the result the IS-LM-FE model, with FE standing for full equilibrium.

  Many modern textbooks swap the price level for inflation itself, plotting output against the change in prices rather than the price level. In this version, the supply-side relation usually comes from a Phillips curve linking inflation to the unemployment gap. Policymakers care about inflation levels more than the price level itself, which makes this framing more useful to them. Olivier Blanchard calls his version of this the IS-LM-PC model, with PC standing for Phillips curve. Wendy Carlin and David Soskice, whose textbook also replaced the LM curve with the central bank's chosen rate, call theirs the three-equation New Keynesian model. It combines an IS relation, a monetary policy rule, and a short-run Phillips curve.

  In 2016, Roger Farmer and Konstantin Platonov introduced an IS-LM-NAC model, where NAC stands for a no arbitrage condition between physical capital and financial assets. Their version lets the long-run effect of monetary policy depend on how people form their beliefs. The standard IS-LM model treats high unemployment as a temporary result of sticky wages and prices. The IS-LM-NAC model allows it to become a permanent condition driven by pessimism, an instance of what Keynes called animal spirits. Farmer and Platonov built this into a broader research agenda examining how beliefs alone might shape economic outcomes, independent of prices or wages.