IS/LM model

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The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in both markets.[1] IS/LM stands for Investment Saving / Liquidity preference Money supply.

Contents

History

The IS/LM model was born at the Econometric Conference held in Oxford during September, 1936. Roy Harrod, John R. Hicks, and James Meade all presented papers describing mathematical models attempting to summarize John Maynard Keynes' General Theory of Employment, Interest, and Money. Hicks, who had seen a draft of Harrod's paper, invented the IS/LM model (originally using LL, not LM). He later presented it in "Mr. Keynes and the Classics: A Suggested Interpretation".[2]

Hicks later agreed that the model missed important points from the Keynesian theory, criticizing it as having very limited use beyond "a classroom gadget", and criticizing equilibrium methods generally: "When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect."[3] The first problem was that it presents the real and monetary sectors as separate, something Keynes attempted to transcend. In addition, an equilibrium model ignores uncertainty – and that liquidity preference only makes sense in the presence of uncertainty "For there is no sense in liquidity, unless expectations are uncertain."[4] A shift in the IS or LM curve will cause change in expectations, causing the other curve to shift. Most modern macroeconomists see the IS/LM model as being at best a first approximation for understanding the real world.

Although disputed in some circles and accepted to be imperfect, the model is widely used and seen as useful in gaining an understanding of macroeconomic theory. It is used in most college macroeconomics textbooks.

Formulation

The model is presented as a graph of two intersecting lines in the first quadrant.

The horizontal axis represents national income or real gross domestic product and is labelled Y. The vertical axis represents the real interest rate, i. Since this is a non-dynamic model, there is a fixed relationship between the nominal interest rate and the real interest rate (the former equals the latter plus the expected inflation rate which is exogenous in the short run); therefore variables such as money demand which actually depend on the nominal interest rate can equivalently be expressed as depending on the real interest rate.

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