Keynesian IS-LM Model
In the short run, the economy moves to the intersection of the
IS and LM curves (ﬁgure
in ﬁnancial markets, putting the economy on the LM curve.
Figure 1: IS-LM Intersection
A shift in either the IS curve or the LM curve can cause a
business-cycle ﬂuctuation. Different economic forces shift the
IS and LM curves, so the curves shift independently.
A change in aggregate demand shifts the IS curve but not the
A change in the demand or supply of money or bonds shifts the
LM curve but not the IS curve.
For an economy in recession, Keynesians take the price level as
exogenous. Any drop in the price level in response to excess
supply is minimal.
Monetary policy is exogenous. With the price level taken as
exogenous, the money supply sets the position of the LM curve.
Monetary policy has no effect on the IS curve.
Expansionary monetary policy shifts the LM curve down
). The money supply increases, and the interest rate
falls. The economy moves down along the IS curve: the fall in
the interest rate raises investment demand, which has a
multiplier effect on consumption.
Figure 2: Expansionary Monetary Policy
Fiscal policy is exogenous. The level of government
expenditure and taxation and the tax code set the position of the
Fiscal policy has no direct effect on the LM curve. Increased
government spending or a tax cut is assumed to be ﬁnanced by
borrowing. The money supply does not change, so the LM
curve does not change.
Expansionary ﬁscal policy shifts the IS curve to the right
). The multiplier effect on consumption raises the
national income and product. The increase in the interest rate
partially offsets the expansionary effect.
Figure 3: Expansionary Fiscal Policy
The Keynesian IS-LM model is a model of disequilibrium, not
The IS curve does not represent the condition that demand
equals supply for goods.
Instead the IS curve represents the condition that demand
equals product. There is excess supply, with demand and
product less than supply.
The LM curve deals with stocks, not ﬂows.
Portfolio demand and supply set the position of the LM curve.
The LM curve is entirely independent of desired investment
and saving. Instead these factors inﬂuence the IS curve.
Desired saving is not the demand for bonds; a ﬂow cannot
equal a stock. Desired investment is not the supply of bonds.
The aggregate demand curve is a construction derived from the
IS-LM model. A given price level P ﬁxes the real money
/P, which sets the LM curve.
The national income and product determined by the IS-LM
intersection can then be seen as a decreasing function of P. If P
falls, the real money supply M
/P rises. The LM curve shifts
down, so y rises.
Aggregate supply is just the productive capacity of the
economy at full employment and is taken as exogenous.
In recession, aggregate demand is less than aggregate supply
Figure 4: Aggregate Demand and Supply
Consider a given price level P.
An autonomous increase in aggregate demand shifts the IS
curve right. National income and product increase, as the
IS-LM intersection moves to the right and up.
Hence the aggregate demand curve shifts right.