The Basics
- Simple definition: A macroeconomic model showing the interaction of the goods market (IS curve) and money market (LM curve).
- Core idea: How interest rates and output are jointly determined.
- Think of it as: The supply and demand model for the whole economy.
What It Actually Means
Developed by Hicks and Hansen, the IS-LM model represents Keynesian theory. The IS curve shows combinations of interest rates and output where the goods market is in equilibrium (investment equals saving). The LM curve shows combinations where the money market is in equilibrium (money supply equals money demand). Their intersection determines short-run output and interest rates. Shifts in fiscal or monetary policy shift these curves and change outcomes.
Example
If Pakistan increases government spending, the IS curve shifts right, raising both output and interest rates. The central bank could offset the rate rise by expanding the money supply, shifting LM to the right. The model shows these interactions clearly.
Why It Matters
IS-LM remains a powerful teaching tool and framework for thinking about policy interactions. It helps understand debates about fiscal vs. monetary policy and coordination between them.
See also
Mundell-Fleming Model • Fiscal Policy • Monetary Policy • Aggregate Demand • Liquidity Preference
Read more about this with MASEconomics:
IS-LM Framework and Policy Analysis: Understanding Economic Interactions