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The abscissa represents national income or gross domestic product and is labelled Y. The ordinate represents the interest rate, r. The IS schedule is drawn as a downward-sloping curve. The LM schedule is an upward-sloping curve. The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors.
The IS schedule is a locus of points of equilibrium in the "real" economy. Given expectations about returns on investment, every level of income and interest rates will generate a certain level of planned investment: lower interest rates encourage higher investment. Income is at the equilibrium level for a given interest rates when the saving consumers choose to do out of that income equals investment. A higher level of income is needed to generate a higher level of saving at a given interest rate. This helps generate the downward slope of the IS schedule. In sum, this line represents the line of causation from falling interest rates to rising planned investment to rising national income.
The Keynesian hypothesis is that a government's deficit spending has an effect similar to that of a lower saving rate, increasing the amount of aggregate demand for national income at each individual interest rate. An increased deficit by the national government shifts the IS curve to the right. This raises the equilibrium interest rate and national income.
The LM curve, on the other hand, represents the money markets, equilibrium in the supply of and demand for money. As national income rises, the demand for money (liquidity preference ) rises. With a given and inelastic supply of money, this leads to a rise in interest rates. Thus, the LM curve is upward sloping, representing the positive relationship between national income and the interest rate.
The IS/LM model allows for the role of monetary policy. If the money supply is increased, that shifts the LM curve to the right, lowering interest rates and raising equilibrium national income.
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. He later presented it in "Mr. Keynes and the Classics: A Suggested Reinterpretation" (Econometrica, April 1937).
Hicks later agreed that the model missed important points from the Keynesian theory. The problem was that it presents the real and monetary sectors as separate, something Keynes attempted to transcend. In addition, an equilibrium model ignores uncertainty. A shift in the IS or LM curve will cause change in expectations, causing the other curve to shift. Hicks therefore created the new Hicks-Hansen IS-LM Model to resolve some of the problems.
- IS-MP Model
- AD-IA Model
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