IS-LM Model

John Hicks formalized the IS-LM model in 1937 as a compact mathematical reading of Keynes' General Theory. Alvin Hansen later popularized it through his textbook work in the 1940s and 1950s, embedding it in the standard graduate curriculum.

The model joins two equilibrium conditions: the IS curve (where planned investment equals planned saving in the goods market) and the LM curve (where liquidity preference equals money supply in the money market). Together they pin down the interest rate and output level that clear both markets simultaneously.

IS-LM still anchors policy discussions because it maps the transmission channels of fiscal and monetary action. A tax cut, a spending increase, or a change in the money supply each shift one curve, and the new intersection shows how interest rates and output adjust.

The IS curve slopes downward: higher interest rates raise the cost of borrowing, reducing investment spending, which through the multiplier lowers equilibrium income.

The LM curve slopes upward: higher income raises the transactions demand for money, and with a fixed money supply, the interest rate must rise to restore equilibrium in the money market.

Where the two curves cross is the only interest-rate and output pair consistent with both goods-market and money-market clearing. A fiscal or monetary shock shifts one curve, and the intersection slides to a new equilibrium.

Central banks trace monetary transmission through the LM curve. Reducing the money supply shifts LM left, pushing interest rates up and output down. The size of the output response depends on how sensitive investment is to the interest rate (the IS curve's slope).

Fiscal authorities trace spending and tax effects through the IS curve. A fiscal expansion shifts IS right, raising income - but the resulting interest-rate increase crowds out some private investment, so the net output gain is smaller than the raw multiplier suggests.

IS-LM is a fixed-price model: it says nothing about inflation. Central banks and treasuries embed its logic inside larger forecasting models that add price adjustment, expectations, and open-economy channels. The core transmission mechanisms - multiplier, crowding out, liquidity effect - carry over.