The IS/LM Model
The IS/LM Model has suffered countless criticisms over the years. The outcome is that it is seldom held up as a satisfactory model of reality.
It survives in economics education because it captures the spirit of ideas that still carry intellectual weight and practical application.
The IS/LM Diagram
The IS Curve
Several Keynesian models incorporate an IS Curve. The expanded discussion covers all these cases.
The LM Curve
The LM Curve shows those points that are consistent with equilibrium in the supply and demand for money.
The LM Curve is upward sloping. An increase in income Y, given a constant money supply, must be accompanied by an increase in R to keep money demand constant.
A Note on Names
Hicks (1937) introduced the IS/LM diagram. The convention of the day was to refer to curves with two letters. The nomenclature IS for the curve representing the balance between investment and savings is obvious enough. Hicks actually referred to the other curve, representing the balance between money demand and money supply, as the LL curve. This evidently followed from his notation M = L(i) for the "liquidity preference" demand for money as a function of the interest rate. Somewhere, the LL curve became the LM curve.
The EconModel presentation for the basic IS/LM Model has the following features.
The EconModel presentation explains the following curves:
The EconModel presentation analyzes the effects of changes in:
Critical Assumptions [first?]
One Interest Rate
The Keynesian IS/LM Model assumes that the short-term and long-term interest rates are equal. This may or may not be a reasonable abstraction. The Yield Curve (EconReview). The Transmission Mechanism. The role of inflation expectations. Interest rates.
Prices are taken to be fixed. A second pass at this model (see below) introduces aggregate supply and demand, allowing the price level to be variable.
The second part of our treatment of the IS/LM Model incorporates flexible prices.