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16 The IS-LM
Analysis

Chapter Outline
16.1

Introduction to The Concept of Equilibrium

16.2

The Money Market Demand, Supply and Equilibrium

16.3

Derivation of LM Curve

16.4

The Product Market Equilibrium Output

16.5

Derivation of IS Curve

16.6

Policy Analysis in IS-LM Framework

16.7

Introducing the Price Level The Keynes and Pigou Effect

16.8

Why We Do Not Use The IS-LM Framework

16.8

Limitations of IS-LM Analysis

This Chapter is about IS-LM analysis, a framework we also reject outright. However, during the current crisis, it
has been used by notable economists who have held it out as an approach that still has relevance. In that vein we
have decided to include it as a separate chapter even though, at first, we had excluded it from the book.
However, we dont go the next step and derive and utilise the full AD-AS model that flows from the IS-LM
approach and is the main organising framework for the orthodox exposition.

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16.1

Introduction to The Concept of Equilibrium

Soon after the publication of Keyness General Theory, British economist J.R. Hicks published an article that
attempted to integrate the insights he felt were useful in the General Theory with those of the so-called
Classics that Keynes had opposed. We discussed the debate between Keynes and the Classics in Chapter 15.
The so-called Neo-classical synthesis that emerged and dominated macroeconomic thinking, particularly the
textbook expositions, was built on the work of J.R. Hicks and his IS-LM model (see box for more discussion).
The IS and LM curves are the equilibrium relationships pertaining, respectively, to the product (goods) market
(investment = saving) and the money market (demand for money (liquidity preference) equals money supply).
The representation of the goods market equilibrium in terms of simple equality between investment and saving
reflected the historical period that the model was developed the simplifying assumption was that we would
gain essential insights into income determination by assuming a closed economy without government.
The IS equation was subsequently extended to allow for the impact of governments and net exports on aggregate
demand.
The income-expenditure model we considered in Chapter 12 allowed the interest rate to impact on investment
and hence aggregate demand and output in the goods market. The interest rate was considered to be determined
by the equality of money demand and supply in the money market.
The IS-LM approach thus was built on the interdependence of the equilibrium states in the two markets. The
general IS-LM approach showed how the equilibrium solution for output (employment) and the interest rate was
simultaneous. We needed to know what the interest rate was to solve the level of income and the level of income
to solve the interest rate.
In an analytical sense, there were two unknowns output and the interest rate and two equations to allow us to
solve the unknowns.
The IS-LM model is an early example of a general equilibrium model that remains fashionable in mainstream
economics.

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16.2

The Money Market Demand, Supply and Equilibrium

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16.3

Derivation of The LM Curve

We assume that the price level is constant. The IS-LM model allows us to introduce price level changes but at
present we are operating in real terms.
Money market equilibrium requires that the demand for money equals the supply. We use the term money
demand to refer to the willingness to hold cash balances as part of a wealth portfolio.
The demand for money or as Keynes called it the liquidity preference is a function of the level of income
and the interest rate.
Three motives have been identified for holding liquid balances (money) in preference to other assets:
Transactions Motive people need money to engage in daily transactions. Thus the demand for liquidity will
be some proportion of total national income.
Precautionary Motive at times major events occur that need to be resolved through transactions for
example, maintaining a cash balance to pay for engine repairs on a car. This motive also tends to vary with
national income as the higher is the level of economic activity, the higher are the overall transactions.
Speculative Motive Keynes contribution, which we considered in Chapter 15 was to highlight that money is
not simply a means of exchange. People used money in times of uncertainty over movements in interest rates.
They have a choice between holding money which earns no interest return or purchasing an interest-bearing
asset, which has less liquidity. Keynes juxtaposed the decision to hold money or bonds. If the interest rate is
expected to rise, the price of bonds falls and capital losses would be expected. So at lower interest rates more
people would prefer to hold money than take a chance that they would lose should they invest in bonds.
Alternatively, if the interest rate falls, the price of bonds rises and capital gains would be enjoyed. At higher
interest rates, more people will form the view that rates will fall rather than rise and the liquidity preference will
be lower.
The other way of thinking about the impact of interest rates is to realise that the opportunity cost of holding
money rises when interest rates are higher because holding money negates the alternative of holding an interestearning asset.
Figure 16.1 shows the liquidity preference function for a range of income levels. The nominal rate of interest is
on the vertical axis and the volume of money demand is on the horizontal axis.
The money demand curve (L) is downward sloping with respect to the interest rate and shifts outwards at higher
income levels (Y1 < Y2).
The higher is the interest rate, the lower will be the demand for liquidity, other things equal. However, at any
interest rate, the higher is the level of national income, the higher will be the demand for money.
The money demand curve is smooth and non-linear because of diversity of opinion. For example, as interest
rates rise, wealth holders progressively form the view that they have reached their maximum. Eventually
everybody adopts the same expectation.
The money supply (Ms) is assumed to be controlled by the central bank via the monetary base and the money
multiplier determines the quantity of money supplied for a given base.
We can thus capture that assumption as a vertical line. The intersection of the money demand and money supply
curves determines the interest rate.
This is faithful to Keynes departure from the Classics who considered the interest rate to mediate saving and
investment (that is, a real variable). Keynes noted that the nominal interest rate was a monetary variable
determined by the demand for liquidity and the supply of money available.

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Figure 16.1

Money Market Equilibrium

Interest Rate
(i)

i1

i0

MS1

L (i, Y1)

L (i, Y0)

Money Demand (L) and Money Supply (Ms)

If the national income level was Y0 then the intersection of the relevant liquidity preference function and the
money supply line would generate an interest rate of i0 Point A.
What would happen if income rose to Y1?
At the current interest rate i0 there would now be an excess demand for liquidity (measured by the segment AB)
and this would lead to the interest rate rising until the excess demand was eliminated at C (i1) given that the
money supply would be fixed.
What would happen if the central bank increased the money supply?
Figure 16.2 shows the impact of an increase in the money supply from Ms1 to Ms1.
At national income level Y0 and Ms1, the interest rate is i0 and the money market is in equilibrium at Point A.
If the money supply rises to Ms2 then there is an excess supply of money at i0 (measured by the segment AB)
and the interest rate would drop until is reached i2 Point D, where the demand for money is again equal to the
money supply.
You can also see that if we start at Point A and the national income level rose to Y1 the interest rate could be
held constant at i0 if the central bank accommodates the increased demand for money at the higher income level
by increasing the money supply to Ms2.

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Figure 16.2

The Impact of An Increase in The Money Supply From Ms1 to Ms2

Interest Rate
(i)

i1

i0

MS1

MS2

L (i, Y1)

i2

L (i, Y0)

Money Demand (L) and Money Supply (MS)

We are now in a position to derive the LM curve which shows all combinations of income and interest rates that
are consistent with money market equilibrium.
Figure 16.3 shows the derivation of the LM curve. From the money market diagram, the Points A, B and C
represent equilibrium states where money demand equals money supply for different levels of income.
Each equilibrium point is thus a unique combination of income and interest rates.
We can translate this understanding to a new graph (right-hand panel) where national income (Y) is on the
horizontal axis and the interest rate (i) is on the vertical axis.
If we trace the respective equilibrium points across into the income-interest space diagram we get a series of
points that are consistent with money market equilibrium.
The intersection of all those points is the LM curve.

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Figure 16.3

The LM Curve

Interest
Rate (i)

Interest
Rate (i)

MS1
C

i2

i2

i1

LM Curve

i1
L (i,Y2)

A
i0

A
L (i,Y1)

i0

L (i,Y0)
Money Demand and Supply

Y0

Y1

Y2
Income (Y)

Advanced Material: John Hicks on His IS-LM Framework

John Richard Hicks was a British economist who invented the IS-LM general equilibrium macroeconomic
framework.
In his 1937 article published in Econometrica Mr. Keynes and the Classics; A Suggested Interpretation
Hicks sought to provide an interpretation of Keynes General Theory within a single diagram the IS-LL
model. As the model became popularised and standard macroeconomic textbook fare, the terminology became
IS-LM to describe the product market equilibrium (IS) and the money market equilibrium (LM).
The IS-LM model was designed to demonstrate how the determination of total real output was dependent on the
interdependent outcomes in the product and money markets.
Hicks said he invented a little apparatus (the IS-LM framework) to bring together Keynesian and Classical
economics into an integrated model.
By the 1970s, Hicks started to sign his academic papers John Hicks rather than J.R. Hicks, which reflected his
growing sense of rejection of his earlier work.
In 1975, to formalise is transition away from his earlier views, he wrote (Page 365):
J.R. Hicks [is] a neoclassical economist now deceased John Hicks [is] a nonneo-classic who is quite disrespectful towards his uncle.
The issue was that he began to realise that the static equilibrium IS-LM model left out the key contribution of
Keynes the importance of time and endemic uncertainty.
For example, in the IS-LM model the current flow of investment is meant to be sensitive to interest rate changes
in the same period, which is one way in which the money market outcome influences the product market
equilibrium. But investment in any period is largely pre-determined by decisions made in previous periods.
In 1980, Hicks wrote that he rejected the way in which is little apparatus had been deployed by economists and
the policy interpretations they had drawn from it.
He said (1980: 139):
The IS-LM diagram, which is widely, but not universally accepted as a convenient synopsis of
Keynesian theory, is a thing for which I cannot deny that I have some responsibility. It first saw
the light in a paper of my own, Mr. Keynes and the Classics (1937) I have, however, not
concealed that, as time has gone on, I have myself become dissatisfied with it [the] diagram

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is now much less popular with me than I think it still is with many other people
By way of conclusion, he wrote (1980: 152-153):
I accordingly conclude that the only way in which IS-LM analysis usefully survives as
anything more than a classroom gadget, to be superseded, later on, by something better is in
application to a particular kind of causal analysis, where the use of equilibrium methods, even a
drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the
equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a
pedantic manner) not because I want to tell the applied economist, who uses such methods, that he
is in fact committing himself to anything which must appear to him to be so ridiculous, but
because I want to ask him to try to assure himself that the divergences between reality and the
theoretical model, which he is using to explain it, are no more than divergences which he is
entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to
overlook them. But the issue is one which needs to be faced in each case.
When one turns to questions of policy, looking toward the future instead of the past, the use of
equilibrium methods is still more suspect. For one cannot prescribe policy without considering at
least the possibility that policy may be changed. There can be no change of policy if everything is
to go on as expected-if the economy is to remain in what (however approximately) may be
regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy
will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a
new equilibrium; but there must necessarily be a stage before that equilibrium is reached. There
must always be a problem of traverse. For the study of a traverse, one has to have recourse to
sequential methods of one kind or another.
The last point was telling. While the intersection of given IS and LM curves might reflect conditions now, the
other points on the respective curves are what John Hicks called theoretical constructions (1980: 149) and
surely do not represent, make no claim to represent, what actually happened.

Note that at interest rate, i0, the LM curve is flat and becomes steeper at higher interest rates. What does that
mean? The horizontal segment of the LM curve relates to the presence of the liquidity trap, which was named
by English economist Dennis Robertson, who in the 1930s, worked closely with J.M. Keynes at Cambridge
University.
The liquidity trap arises at some minimum interest rate (which could be zero) where everybody forms the view
that the only direction for interest rates is up. The equivalent expectation is that everybody considers that capital
losses will be incurred on bond portfolios because when interest rates rise, bond prices fall.
The result is that once interest rates reach this minimum level, all people will prefer to hold any new money in
the form of cash instead of bonds.
In Chapter 15 of The General Theory of Employment, Interest and Money, Keynes said (1936: 207):
There is the possibility that, after the rate of interest has fallen to a certain level, liquiditypreference may become virtually absolute in the sense that almost everyone prefers cash to
holding a debt which yields so low a rate of interest. In this event the monetary authority would
have lost effective control over the rate of interest Moreover, if such a situation were to arise, it
would mean that the public authority itself could borrow through the banking system on an
unlimited scale at a nominal rate of interest.
As we will see when we consider policy analysis within the IS-LM framework, the existence of a liquidity trap
renders monetary policy ineffective as a counter-stabilising tool.
Monetary policy is characterised in this framework as the central bank manipulating the money supply and
when the interest rate is at i0 in Figure 16.3, increasing the money supply would have no impact on interest rates
or the price of bonds. In other words, monetary policy changes cannot alter the level of national income.
In a liquidity trap, a rise in the money supply leads to an equal rise in the demand for money and as a result the
interest rate does not change. We will consider this in more detail later in the Chapter.
The LM curve is upward sloping at higher levels of income because as national income rises, the demand for
money increases and at each given money supply, the interest rate has to rise to ration the excess money demand
and retain money market equilibrium.

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The slope of the LM curve is steeper:

The more sensitive the demand for money (transactions and precautionary motives) is to
national income changes. Thus, small changes in national income lead to large changes in
excess money demand at a given money supply level. The rise in interest rates to restore
money market equilibrium, other things equal, has to be larger as a consequence.

The less sensitive the speculative demand for money is to changes in interest rates. Thus, for a
given excess demand for money, the interest rate increase that is required to restore money
market equilibrium is larger.

While the horizontal LM curve (liquidity trap case) is one extreme, the other extreme is sometimes referred to as
the Classical Case, which describes a vertical LM curve.
The Classical case arises from a demand for money function which is not sensitive to the interest rate. In other
words, money is considered to be a means of exchange only and the speculative demand for money (which
renders the overall demand for money sensitive to interest rates) is ignored.
In these cases, the demand for money shifts outwards when income rises and inwards when it fall. As a
consequence there is only one national income level consistent with money market equilibrium for a given
money supply and the LM curve is vertical.
In the Appendix to this Chapter we derive an analytical solution to the IS-LM framework for advanced studies,
which show the impact of these two sensitivities (elasticities).
Shifts in the LM curve arise from changes in the money supply. Refer back to Figure 16.2, which showed that
for a given money demand curve, interest rates fall when the money supply rises. The reasoning was that at a
given money market equilibrium combination of interest rates and income, a rise in the money supply generates
an excess supply of money, which requires interest rates to fall to stimulate the demand for money sufficiently
to absorb the extra money.
In terms of the LM curve, this means that at higher levels of money supply, equilibrium interest rates will be
lower at each income level which translates into a shift outwards in the LM. The opposite occurs when the
money supply falls.
The LM curve can also shift if there is an autonomous change in liquidity preference, which means the money
demand rises (falls) at each income level depending on whether the preference for liquidity rises (falls).
For example, if people become more pessimistic about the future they may use increased cash holdings as a
haven from uncertainty. This will lead to an outward shift in the money demand curve so that for a given money
supply, interest rates will be higher at each income level.

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16.4

The Product Market Equilibrium Output

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16.5

Derivation of The IS Curve

The IS curve shows all combinations of interest rates and income where the product (goods) market is in
equilibrium. So unlike the simple income-expenditure model we developed in Chapter 12, the IS curve
framework requires us to incorporate information about the money market (interest rates) in our understanding
of equilibrium in the product market.
In Chapter 12 we developed the real expenditure model of income determination. From the National Accounting
framework we know that total expenditure (E) in the domestic economy in any particular period can be
expressed as:

(16.1)

E = C + I + G + (X M)

Equation (16.1) is identical to Equation (12.2). As it stands, Equation (16.1) is an accounting statement by dint
of the definitions and sources of aggregate spending.
The equilibrium level of national income (Y) is determined by aggregate expenditure, such that Y = E. The task
of Chapter 12 was then to understand the behaviour of each of the expenditure components in Equation (16.1)
and theorise how they interact to determine national income.
At that stage we assumed that firms in aggregate plan a fixed volume of investment spending in each period. We
were concerned at that stage of the text in tracing out the implications of changes in autonomous (exogenous)
components of expenditure (investment, government, exports etc) on national income via the multiplier process.
However, in Chapter 2, we develop a more detailed model of investment spending, which allows us to take into
account the impact on capital formation of changes in interest rates.
As a preview, we assume that rather than being exogenous, total investment spending is influenced, in part, by
expectations of future economic conditions and the interest rate.
Business firms are continually forming expectations about future output. Firms have to make resource
commitments (working capital, labour etc) well in advance of realisation (sales) and so the scale of production
at any point in time reflects the guesses they make in a highly uncertain world.
Further, for given expectations about future sales and revenue, a firms investment decisions will also be
influenced by the cost of capital goods, which, in turn, will be affected by the interest rate.
If interest rates rise, the cost of funds necessary to invest in new capital equipment rises and so marginal projects
(relative to expected revenue) may become unprofitable. In other words, investment is likely to be an inverse
function of the interest rate, other things being equal.
In other words, we might hypothesise that total investment is given as:

(16.2)

I = b1 b2i

where b1 is an autonomous component of investment and b2 is the interest-rate sensitivity of investment to

interest rate changes.
The higher is b2, the more investment will decline (rise) for a given interest rate rise (fall).
The IS-LM framework retains the insight of Keynes that planned savings is a positive function of national
income. A more detailed analysis of the General Theory would also reveal that Keynes considered that the
interest rate might also influence consumption spending (via wealth impacts). Further, the purchase of consumer
durables such as white goods, which might require access to consumer credit.
However, for now, to keep the argument simple, we assume that the interest rate only impacts on investment.
In Chapter 12 we assumed that firms in the economy are quantity-adjusters and so prices are fixed in the shortterm. Figure 12.7 brought together the 45o aggregate supply curve with the aggregate demand curve (E). It
showed that equilibrium national income occurs when the Aggregate Demand Function cuts the 45o line.
At this point, the aggregate demand expectations formed by the firms, which motivated their decisions to supply
Y* are consistent with the planned expenditure E* by consumers, firms, government and the external
economy.
Figure 16.4 augments Figure 12.7 by adding in the impact of Equation (16.2) that is, allowing investment to
be inversely impacted by interest rate changes.

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Product Market Equilibrium and Interest Rate Changes

Total Expenditure

Figure 16.4

E0 = C + I + G + NX, at i0

E*0

E1 = C + I + G + NX, at i1

E*1

Y*1

Y*0

National Income

The total expenditure curve, E = C + I + G + NX is drawn from a given interest rate. The lower the interest rate
(i0 < i1), the higher in investment (and total spending) at all income levels. As a consequence, the total
expenditure curve shifts upwards.
When interest rates rise, the total expenditure curve would shift downwards, other things equal.
Point A in Figure 16.4 shows the product market equilibrium associated with an interest rate of i0. So we know
that the combination of income level, Y*0 and interest rate level, i0 is an equilibrium combination in the product
market.
What happens if the interest rate was to rise to i1? Total investment would decline at all income levels and the
total expenditure curve would shift downward from E0 to E1.
The excess supply at the prior income level leads firms to cut back output and employment and national income
falls. A new product market equilibrium occurs when E*1 = Y*1.
So the combination of income level, Y*1 and interest rate level, i1 is an equilibrium combination in the product
market.
We thus have two combinations of interest rates and income levels which are consistent with product market
equilibrium. Clearly we could trace out the impact of many interest rate changes and thus many equilibrium
combinations of interest rates and income.
The IS curve is the line that joins all the equilibrium combinations of interest rates and national income. Figure
16.5 shows this derivation.

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The Derivation of The IS Curve

Interest
Rate (i)

Expenditure

Figure 16.5

E1 at i1

E1

i0

E0 at i0

A
E0

i1

IS Curve
Y0

Y1

Income (Y)

Y0

Y1

Income (Y)

Point A is one product equilibrium where the interest rate is i0 and total expenditure is E0 generating total
national income of Y0.
In the right-hand panel where the interest rate is on the vertical axis and national income is on the horizontal
axis, point A shows the combination of the interest rate and income which produce the product market
equilibrium shown in the left-hand pane.
If interest rates fell to i1, total expenditure rises to E1 as a result of the higher investment expenditure, which
leads to a rise in national income via the expenditure multiplier. Point B shows the new product market
equilibrium at (i1, Y1).
We could examine the impact of any number of interest rate changes on product market equilibrium in the left
panel and subsequently map these points into the right panel. The result would be the IS curve.
The IS curve therefore is a series of points corresponding to equilibrium combinations of national income and
interest rates in the product market.
It is clear that in the IS-LM framework, the money market impacts on the product market through the impact of
interest rate changes on investment. The change in income results from the initial response of investment to an
interest rate change then being multiplied through the expenditure system via induced consumption and leakages
to taxation and imports.
In other words, the total change in income that follows a change in the interest rate depends on the values of the
expenditure multiplier and the sensitivity of investment to interest rate changes.
What factors will shift the IS curve? First, any increase (decrease) in autonomous spending shifts IS up (down)
because for a given interest rate, the equilibrium level of national income rises (falls) when autonomous
spending rises (falls).
The magnitude of the shift up or down in the IS resulting from a rise (fall) in autonomous spending is
determined by the magnitude of the change in autonomous spending and the size of the expenditure multiplier.
For a given change in autonomous spending, the shift in the IS curve will be larger the larger is the value of the
expenditure multiplier.
The slope of the IS curve represents this overall sensitivity of national income to interest rate changes. The
larger is the expenditure multiplier and the larger is the sensitivity of investment to interest rate changes the
flatter the IS curve.
This is because for a given change in interest rates, the initial response of investment spending will be larger the
more responsive it is to the cost of capital, other things being equal.
In turn, a given change in investment will generate a larger (smaller) change in national income the larger
(smaller) is the value of the expenditure multiplier.

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If current period investment is very unresponsive to a change in the current interest rate, then the IS curve will
be very steep. It is argued by economists who consider time to be an important consideration in economic
analysis that investment spending plans are based on expectations of future revenue streams that were formed in
past periods.
The current periods flow of investment spending reflects these past decisions. The time it takes to evaluate
different projects, design the appropriate necessary capital equipment, source funding and then implement the
capital infrastructure suggests that current investment spending will be relatively insensitive to current changes
in interest rates.
We discuss this topic more in Chapter 22.
It should be clear from this discussion that changes in the tax rate (t), which impact on the value of the
expenditure multiplier will also impact on the slope of the IS curve. For example, a rise in the tax rate will cause
the IS curve to become steeper because it reduces the value of the expenditure multiplier a larger leakage from
the expenditure system.
Similarly, a rising saving propensity or propensity to import, which means that there are larger leakages from
the expenditure system each time income changes, will lead to a steeper IS curve.

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