The is-lm model translates the General Theory of Keynes into neoclassical terms



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The IS-LM model translates the General Theory of Keynes into neoclassical terms (often called the neoclassic synthesis )

  • The IS-LM model translates the General Theory of Keynes into neoclassical terms (often called the neoclassic synthesis )

  • It was proposed by John Hicks in 1937 in a paper called “Mr Keynes and the "Classics": A Suggested Interpretation” and enhanced by Alvin Hansen (hence it is also called the Hicks-Hansen model).

  • The model examines the combined equilibrium of two markets :

    • The goods market, which is at equilibrium when investments equal savings, hence IS.
    • The money market, which is at equilibrium when the demand for liquidity equals money supply, hence LM.
    • Examining the joint equilibrium in these two markets allows us to determine two variables : output Y and the interest rate i.


The model rests on two fundamental assumptions

  • The model rests on two fundamental assumptions

    • All prices (including wages) are fixed.
    • There exists excess production capacity in the economy
  • This is a complete change in perspective compared to classical economics:

    • The level of demand determines the level of output and employment.
    • There can be an equilibrium level of involuntary unemployment.
  • Why can there be insufficient demand ?

    • Criticism of Say’s law: Uncertainty can lead to precautionary saving rather than consumption.
    • Monetary criticism: the preference for liquidity can lead to under-investment as savings are kept in the form of liquidity.


The IS-LM model has become the “standard model” in macroeconomics.

  • The IS-LM model has become the “standard model” in macroeconomics.

  • Its essential contribution (linked to that of Keynes) is this potential equilibrium unemployment:

    • Such a situation is impossible in earlier neoclassic models, as the price of labour (like all prices) is assumed to adjust naturally until supply and demand for labour are balanced.
  • This is why IS-LM (1937!!) remains central to modern macroeconomics, and has been extended to explain more markets/ variables:





The IS curve shows all the combinations of interest rates i and outputs Y for which the goods market is in equilibrium

  • The IS curve shows all the combinations of interest rates i and outputs Y for which the goods market is in equilibrium

  • However, a simplifying assumption we made initially was that investment I was exogenous

    • We know that investment actually depends negatively on the level of interest


The Investment function

  • The Investment function

    • Is the sum of private investment (endogenous) and public investment (exogenous)
    • Here, the interest rate has a real interpretation: it is the marginal profitability of investment


The Savings function

  • The Savings function

    • Is obtained from the aggregate demand equation, subtracting investment and consumption:
    • S=Y-C-T
    • S= -C0 +(1-c)(Y-T)










The LM curve shows all the combinations of interest rates i and outputs Y for which the money market is in equilibrium

  • The LM curve shows all the combinations of interest rates i and outputs Y for which the money market is in equilibrium

    • It is based on the money market equilibrium we have examined last two weeks
  • This time the interest rate i has a monetary interpretation:



Liquidity preference: Given a level of output Y, the level of interest i adjusts so that the demand for money (given by the liquidity function L) equals the exogenous supply:

  • Liquidity preference: Given a level of output Y, the level of interest i adjusts so that the demand for money (given by the liquidity function L) equals the exogenous supply:

  • M = Money supple (exogenous)

  • P = Level of prices (exogenous by assumption)



Simplifying assumption: The liquidity function, which gives the demand for real money balances, can be decomposed depending on the type of demand

  • Simplifying assumption: The liquidity function, which gives the demand for real money balances, can be decomposed depending on the type of demand

  • There are two motives for demanding real money balances:

    • The transaction and precautionary motive L1(Y) : The money demanded in order to be able to transact in the future (function of the level of output)
    • The speculation motive L2(i) : The money demanded for purposes of speculation (opportunity cost of the interest rate). When interest is high, people don’t want to hold money, whereas when the rates are low, money demanded increases.
















IS-LM can be used to assess the impact of exogenous shocks on the endogenous variables of the model (interest rates and output)

  • IS-LM can be used to assess the impact of exogenous shocks on the endogenous variables of the model (interest rates and output)

  • One can also evaluate the effectiveness of the policy mix, i.e. the combination of:

    • Fiscal policy: changes to government spending and taxes
    • Monetary policy: changes to money supply


Fiscal policy affects the equilibrium in the goods market, via changes in G and T.

  • Fiscal policy affects the equilibrium in the goods market, via changes in G and T.

    • We’ve seen that this influences the IS curve.
  • The shift in IS affects both endogenous variables (output and interest rate)

    • In the previous weeks, we assumed that investment was exogenous (There was no interest rate in the basic model)
    • I did not change when G or T were changed
    • This is no longer the case with IS-LM : there is a crowding out effect




Remember that the equilibrium condition of the economy can be expressed as:

  • Remember that the equilibrium condition of the economy can be expressed as:

  • G – T = S(Y ) – I(i )

  • Now that we have integrated interest rates...

  • If G-T increases (fiscal policy), the economy attempts to correct the disequilibrium by:

    • Increasing S (multiplier effect on output)
    • Reducing I (crowding out on private investment)


Monetary policy affects the equilibrium in the money market, via changes in M.

  • Monetary policy affects the equilibrium in the money market, via changes in M.

    • We’ve seen that this influences the LM curve.
  • As for fiscal policy, the shift in LM affects both endogenous variables (output and interest rate)

    • Money is not neutral !!
    • This is one of the central contributions of Keynes
    • This conclusion will change somewhat when we examine AS-AD (IS-LM with inflation)












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