The IS-LM Model: Is There a Connection between Slopes and the Effectiveness of Fiscal and

Monetary Policy?
Author(s): David W. Findlay
Source: The Journal of Economic Education, Vol. 30, No. 4 (Autumn, 1999), pp. 373-382
Published by: Taylor & Francis, Ltd.
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 The IS-LM Model: Is There a
Connection Between Slopes
and the Effectiveness of
Fiscal and Monetary Policy?

David W. Findlay

The IS-LM model, as noted by Barron and Lowenstein (1996), continues to be

an important analytical tool in many money and banking and intermediate
macroeconomic textbooks.' The model is used, for example, to explain fluctua-
tions in output and interest rates and to illustrate the analytics of fiscal and mon-
etary policy.2 A number of textbooks also use the IS-LM model to examine how
the output effects of given changes in the money supply and government spend-
ing (or taxes) depend on the model's parameters and on the slopes of the IS
(investment-saving) and LM (liquidity preference-money supply) curves. This
has become a particularly important application of the model given recent poli-
cies and economic developments.3 In these textbooks, one often finds the fol-
lowing "slope rules": (1) monetary policy is more effective the flatter the IS
curve; (2) fiscal policy is more effective the flatter the LM curve; (3) monetary
policy is more effective the steeper the LM curve; and, less frequently; (4) fiscal
policy is more effective the steeper the IS curve.
The use of these slope rules creates at least two problems for an instructor (and
the student). First, whereas rules 1 and 2 are always correct, rules 3 and 4 are, at
best, misleading and, at worst, incorrect. Second, some students invariably mem-
orize such rules without being able to explain and to show how changes in the
underlying parameters of the IS-LM model affect the slopes of the IS and LM
curves and the effectiveness of fiscal and monetary policy.
Explanations of shifts of the IS curve generally focus on the size of the horizon-
tal distance between the two IS curves, but explanations of shifts of the LM curve
generally focus on the size of the vertical distance between the two LM curves. In
this article, I offer instructors a slightly different presentation of the IS-LM model.
Specifically, a number of benefits emerge if the instructor simply focuses on what
determines the size of both the horizontal and vertical distances between the IS
curves and between the LM curves. This approach can be easily incorporated into
any course that currently presents the IS-LM model. Students will be able to exam-
ine graphically how changes in the parameters alter the effectiveness of fiscal and

David W. Findlay is a professor of economics at Colby College (e-mail: dwfindla@colby.edu). The

author would like to thank William Becker and Peter Kennedy for helpful comments on an earlier ver-
sion of this article.

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monetary policy. In particular, they will be able to verify that (1) a change in the
slope of the IS curve could increase or decrease the effectiveness of fiscal policy;
and (2) a change in the slope of the LM curve could increase or decrease the effec-
tiveness of monetary policy. Finally, such a presentation can provide students with
a stronger understanding of the IS-LM model and its applications.

THE MODEL

I use the notation found in Gordon (1993).4 Equilibrium in the go

is given by

Y= k(Ao - br), (1)

where Y represents output; k represents the multiplier (which is a function of the

marginal propensity to consume, the tax rate, and the marginal propensity to
import); AO represents aggregate expenditures independent of both the interest
rate and output; r is the interest rate; and b represents the interest rate respon-
siveness of aggregate expenditures. Solving for r yields the IS equation

r = Aolb - (1/kb)Y. (1')

Equations (1) and (1'), in addition to any graphs the instructor presents, can be
used to explain all characteristics of the IS curve. First, the slope equals -(1/kb);
consequently, as k and b increase, the IS curve becomes "flatter." Second, a given
increase in AO causes the IS curve to shift to the right (holding r constant) by the
distance kAA0; the larger is k or AA0, the larger is the size of the shift as measured
horizontally. Students, therefore, should understand that the larger is k, the flat-
ter is the IS curve and the larger is the size of the shift (for a given change in A0)
of the IS curve as measured horizontally.5
To facilitate the discussion about what effect, if any, the slope of the IS curve
has on the effectiveness of fiscal policy and to avoid misleading presentations
that rely on the slope rules, instructors simply need to discuss the size of the shift
of the IS curve as measured vertically.6 Equation (1) can be used to illustrate
what determines the size of the horizontal and vertical shifts of the IS curve.
Specifically, the possible effects of changes in AO on output and/or the interest
rate can be obtained from the following: AY = kAAo - kbAr. For example, when
Ar = 0, AY = kAAo; most students know that this expression represents the dis-
tance as measured horizontally.
In addition to the standard explanation of shifts of the IS curve, instructors can
ask students what the vertical distance (assuming AY = 0) represents. For the
equilibrium in the market for nonmoney goods (the goods market) to be main-
tained at the initial level of Y, r must rise so that all of the initial increase in AO
is completely offset by the increase in r. What determines the size of this required
increase in r? Mathematically, Ar = AA/b. The size of the vertical shift, there-
fore, depends solely on AA0 and b; the parameter k has no effect on the size of
the vertical shift.
Virtually all money and banking and intermediate macroeconomic textbooks
focus on the horizontal shift of the IS curve. There are two benefits of discussing

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 the size of the vertical shift of the IS curve. First, students will have a better
understanding of what the IS curve represents. Second, students should be able
to prove that a steeper IS curve does not necessarily imply that fiscal policy is
less effective; I present this second issue in the next section.
Once the IS curve is presented, the same type of analysis of the LM curve fol-
lows. Equilibrium in the money market is given by

MIP = hY -fr, (2)

where MIP is the real supply of money; h represents the income responsiveness
of the demand for money; andfrepresents the interest-rate responsiveness of this
money demand. Solving for r yields the LM equation

r = (h/Jf)Y- (1/J)M/P. (2')

Equations (2) and (2'), in addition to the simple money market model, can be
used to explain all characteristics of the LM curve. First, the slope of the LM
curve equals (h/f). Second, an increase in h causes the LM curve to become
steeper, whereas an increase in fcauses the LM curve to become flatter.
Equation (2) can be used to illustrate the size of the horizontal and vertical
shifts of the LM curve. The possible effects of changes in MIP on output and/or
the interest rate can be obtained from the following: Ar = (h/f)AY - (1/f)A(M/P).
A given increase in M/P causes the LM curve to shift down. The vertical dis-
tance, -(1/f)A(M/P), represents how much r must fall, given the initial level of Y,
to maintain money market equilibrium. The larger the A(M/P) or the smaller the
f, the larger the size of the vertical shift; the parameter h has no effect on the size
of the vertical distance.
To facilitate the discussion of what effect, if any, the slope of the LM curve has
on the effectiveness of monetary policy and, once again, to avoid the use of the
misleading slope rules, the instructor can discuss the size of the horizontal shift
of the LM curve. For the money market to remain in equilibrium at the initial
interest rate, Y must increase so that all of the increase in the money supply is
completely offset by an equal income-induced increase in money demand; the
size of this required increase in Y equals (1/h)A(M/P). The larger is A(M/P), the
larger is the size of the horizontal shift. We also observe that the larger is h, the
smaller is the size of the horizontal shift because money demand is more respon-
sive to changes in Y. Students should now understand that an increase in h has
two effects on the LM curve: (1) the curve becomes steeper; and (2) the size of
the horizontal shift, for a given change in M/P, decreases.7

THE EFFECTIVENESS OF FISCAL AND MONETARY POLICY

A number of the money and banking and intermediate macroeconomic text-

book authors examine what factors influence the effectiveness of fiscal and mon-
etary policy. In most books and in the model presented here, there are four para-
meters: b, k, f, and h. The student should be able to explain how a change in the
parameters alters not only the slopes of the IS and LM curves but also the output
effects of (1) a given increase in government spending (the effectiveness of fis-
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cal policy), and (2) a given increase in the money supply (the effectiveness of
monetary policy).8
The effects of the money market parameters (h and f) on the effectiveness of
fiscal policy are straightforward. The effects of the goods market parameters (k
and b) on the effectiveness of monetary policy are also clear.9 However, textbook
presentations of the relationships between the slope of the IS curve and the effec-
tiveness of fiscal policy and between the slope of the LM curve and the effec-
tiveness of monetary policy are, at best, misleading. The analysis in the preced-
ing section can be used to show that the following slope rules are not always
correct: (1) Fiscal policy is more effective the steeper is the IS curve; and (2)
monetary policy is more effective the steeper the LM curve.'0 This analysis also
forces the student to explain the effects of changes in each parameter rather than
simply memorize potentially incorrect rules about slopes and effectiveness.

The Effectiveness of Fiscal Policy

The example found in those textbooks that examine the relationship between
the slope of the IS curve and the effectiveness of fiscal policy is included in
Figure 1. To reinforce the issues discussed in the last section and to illustrate the
effects of an increase in the interest rate responsiveness of expenditures on the
effectiveness of fiscal policy, I show two cases in the same graph beginning with
the same initial equilibrium E0. Including the two cases in the same graph makes
it easier for the student to observe how changes in the parameters alter the effec-
tiveness of macro policy.
The steeper IS curve IS(k,b)o reflects the less interest rate responsive aggregate
expenditures case where b' > b. For ease of exposition, the multiplier, k, is the
same for both curves." A given increase in government expenditures, G, causes
both IS curves to shift to the right. Because k is the same for both cases, the size
of the horizontal shift (given by the distance EoB or, equivalently, kAG) is the
same. By including the two cases in the same graph, students will observe that
two different equilibria occur, El and E '. Students can easily verify that fiscal
policy is more effective the less interest-rate responsive are aggregate expendi-
tures.'2 Those textbooks that examine this issue conclude that fiscal policy is
more effective the steeper the IS curve. This conclusion, as the next example
proves, is not always correct.
Changes in the size of the multiplier also cause changes in the slope of the IS
curve. In addition to the effects of changes in the size of structural parameters
(e.g., the marginal propensity to consume) on the multiplier, policymakers can
affect the size of the multiplier and, therefore, the slope of the IS curve by chang-
ing, for example, tax rates. In classes that examine the effectiveness of macro
policy, some students will likely want to examine the effects of a change in the
tax rate on the effectiveness of fiscal policy. In Figure 2, I again show two cases
in the same graph. The steeper IS curve, IS(k,b)0, now reflects a smaller multi-
plier where k' > k. In this example, the interest rate responsiveness of expendi-
tures is the same for both cases. To examine what effect the size of the multipli-
er and what effect, if any, the slope of the IS curve have on the effectiveness of

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 FIGURE 1
The Effectiveness of Fiscal Policy and the Interest-Rate
Responsiveness of Aggregate Expenditures (b' > b)

SD LM

I S(k,b) IS(k,b)

0_ _1

YO Y

fiscal policy, I exam

expenditures.
The results of this e
LM model does not in
izontal and vertical s
shift further to the r
dent could conclude
steeper the IS curve.1
Because b is the sam
curves (given by E0B
student to pinpoint
much the curves shif
the two equilibria (E,
er is the multiplier-a
ition. In this case and
effective the flatter t

The two examples in

of the IS curve, with
tiveness of fiscal po
about the relationshi
fiscal policy, such a r

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 FIGURE 2
The Effectiveness of Fiscal Policy and the Multiplier (k' > k)

BLM

C D
r

IS(k ,,b)

IS (kP9b)

IS(k,b) IS(k,b)

yo y

they are expected t

curve (rather than
the students under
selves the analysis
develop.14

The Effectiveness of Monetary Policy

Those textbooks that examine the relationship between the slope of the LM
curve and the effectiveness of monetary policy focus solely on the interest rate
responsiveness of money demand. Separate graphs are generally used, each rep-
resenting a different level of interest rate responsiveness of money demand,
(Ritter and Silber [1993] is the exception) to show that monetary policy becomes
more effective as money demand becomes less interest rate responsive. Because
this example is familiar to many instructors, I will only briefly discuss it here.
Two different LM curves that yield the same initial equilibrium at Eo are shown
in Figure 3. The steeper LM curve, LM(fh)o, reflects a less interest-rate respon-
sive money demand relation where f' > f. The level of income responsiveness of
money demand, h, is the same for both cases.
An equal increase in the money supply causes both curves to shift down. To
pinpoint the exact size of the shift, we know that the horizontal distances between

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 FIGURE 3
The Effectiveness of Monetary Policy and the
Interest-Rate Responsiveness of Money Demand (f' > f)

LM(f,h) LM(fh)
0 1

LM(f ,h)
0

O LM(f',h)

IS

y0y

the two sets of LM curve

comparison of El and E', c
less interest rate responsi
force the student's under
presents this example con
effective the steeper the
is not always correct.
Two different LM cur
LM(f h')o, reflects a more
h; the interest rate respon
An equal increase in the m
the same vertical distanc
and EoD, differ because t
values of h and h'. Once t
of the LM curves, the rem
E'r indicates that monetar
money demand. In this ca
policy is more effective t
The two examples in Fig
of the LM curve, withou
effectiveness of monetary
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 FIGURE 4
The Effectiveness of Monetary Policy and
the Income Responsiveness of Money Demand (h' > h)

LM(fh ')
0

LM(fh h')

LM(f h)
E O

C D LM(h)
r1

IS

o Yo Y

stronger understanding of these issues if they are expected to explain how

changes in the underlying parameters of the LM curve (and not its slope) alter
the effectiveness of monetary policy.

CONCLUSION

Hansen (1986) offers a list of proficiencies we might expect of econ

majors. One of the skills would require that students use "existing know
explore issues." I have provided instructors with a simple, alternative e
of shifts of the IS and LM curves.16 Students equipped with this know
(1) explain and show how changes in the model's parameters alter the ef
ness of monetary and fiscal policy; and, therefore, (2) conclude, in contr
current treatment found in textbooks, that the relationship between th
the IS and LM curves and the effectiveness of macro policy is weak."7

NOTES

1. The following textbooks use the IS-LM model: Baily and Friedman (1995), Blanchard
Dornbusch and Fischer (1994), Froyen (1996), Gordon (1993), Hall and Taylor (1993),
(1989), Mankiw (1996), Mayer, Duesenberry, and Aliber (1993), Miller and VanHoose
Mishkin (1995), and Ritter and Silber (1993)
2. There is debate about the usefulness of the IS-LM framework. For example, Mankiw
1645) notes that "[t]he IS-LM model, augmented by the Phillips curve, continues to prov

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 best way to interpret discussions of economic policy in the press and among policy makers."
Views similar to those of Mankiw were more recently expressed by Blanchard (1997a) and
Blinder (1997). However, King (1993, 68) argues that the IS-LM model "is a hazardous base on
which to build positive theories of business fluctuations and to undertake policy analysis." The
purpose of this note is not to resolve this debate but to offer an alternative presentation of the IS-
LM model that will improve the student's understanding of it.
3. For example, reductions in income tax rates in the early 1980s affected the multiplier and, there-
fore, the IS curve while financial market innovations, as described by Gordon (1993, 464-65)
and others, affected money demand and the LM curve.
4. I also use the beginning-of-period version of the IS-LM model rather than the end-of-period
model developed by Barron and Lowenstein (1996). Although the end-of-period version, as
noted by Barron and Lowenstein (p. 167), "is an attractive alternative to the beginning-of-peri-
od model," I use the beginning-of-period version because most money and banking and inter-
mediate macroeconomics textbooks use it.
5. To illustrate in more detail the effects of changes in the parameters b and k on the IS curve, one
can obtain values of the two intercepts of the IS curve. Although the analysis included here (and
in note 7) might be more mathematical than some instructors prefer, it does show the student
exactly what happens to the IS curve as the parameters of the model change. For the IS curve,
the vertical intercept (i.e., when Y = 0) is Ao/b and the horizontal intercept (i.e., when r = 0) is
kA0. An increase in b causes the IS curve to become flatter as it pivots around the fixed horizon-
tal intercept. In the IS-LM model, an increase in b, all else fixed, would cause Y and r to fall; this
is a result that might initially surprise the students. An increase in k causes the IS curve to
become flatter as the IS curve pivots around the fixed vertical intercept. The discussion in this
note, however, is not needed to examine the effectiveness of fiscal policy.
6. Hereafter, I will refer to the size of any shift as measured vertically (horizontally) as the vertical
(horizontal) shift.
7. To illustrate in more detail the effects of changes in h andfon the LM curve, one can obtain the
expressions that represent the two intercepts of the LM curve. The horizontal intercept (i.e.,
when r = 0) is (1/h)M/P; the vertical intercept (i.e., when Y = 0) is - (1/f)M/P. The purpose of
presenting these two intercepts is not to emphasize their economic interpretation but to explain
precisely what happens to the LM curve when h and f change. An increase in h causes the LM
curve to become steeper as it pivots around the fixed vertical intercept. Students will then notice
that the LM curve becomes steeper and appears to shift to the left as h increases. An increase in
fcauses the LM curve to become flatter as the LM curve pivots around the fixed horizontal inter-
cept. The discussion in this note is not needed to examine the effectiveness of monetary policy.
8. Ritter and Silber (1993) and Dornbusch and Fischer (1994), in addition to several other text-
books, derive algebraically the fiscal and monetary policy multipliers that are functions of the
four parameters.
9. An increase in h or a reduction in f (both of which cause the LM curve to become steeper) will
reduce the effectiveness of fiscal policy. An increase in b or k (both of which cause the IS curve
to become flatter) will increase the effectiveness of monetary policy.
10. The coverage of these two claims varies across textbooks. Virtually all of the books explain how
the interest rate responsiveness of expenditures and the interest rate responsiveness of money
demand affect the slope of the IS and LM curves. Only a few (e.g., Froyen 1996, 151-52) dis-
cuss how the slopes of the IS and LM curves depend on the remaining two parameters, k and h.
Unfortunately, even in those cases where the effects of all four parameters on the slopes of the
IS and LM curves are discussed, the textbook authors ignore the effects of the parameter k (h)
on the effectiveness of fiscal (monetary) policy, emphasizing the misleading slope rules.
11. It might be helpful to point out to students that the initial levels of A0 associated with each IS
curve must be different to achieve the same, initial equilibrium.
12. Students, based on their understanding of the material, should be able to explain why the different
vertical distances, given by line segments EoD and EoC, occur. To keep this figure (and others) as
clear as possible, I have omitted the horizontal and vertical lines associated with E, and E'.
13. This potential ambiguity might explain why this example is ignored in most textbooks.
14. An example of such an exercise is available from the author upon request.
15. Once again, given the discussion, students should be able to explain the different vertical dis-
tances represented by the line segments EoD and EoC.
16. I wrote this article for instructors of intermediate macroeconomics courses and money and bank-
ing courses. Given this intended audience, I have used algebra to help illustrate what effects
changes in the size of the model's parameters have on the slopes and size of shifts of the IS and
LM curves. Algebra, however, is not needed to explore these issues. In fact, instructors can (and

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 some believe should) explain these same issues without the use of algebra. Some of these issues
have been previously examined by Kennedy and Worrell (1975) and Kennedy (1984) who use a
rule to explain shifts in the IS and LM curves. For example, Kennedy (1984, 155) explains that
"When the slope of the IS or the LM curve has changed because of a change in the sensitivity of
something to changes in the interest rate, move the two curves equidistantly in the horizontal
direction; if the slope has changed because of a change in the sensitivity of something to changes
in the level of income, shift the two curves equidistantly in the vertical direction." Regardless of
how one presents these issues, it is important that students be able to explain intuitively what fac-
tors determine the slopes and the size of shifts measured both vertically and horizontally. Once
students accomplish this, they will be able to use the model to examine the effectiveness of
macroeconomic policy under different conditions.
17. An additional advantage of the graphical treatment presented here is that students will not need
to base their understanding of the effects of changes in the model's parameters on algebraically
derived monetary and fiscal policy multipliers. This analysis could also be used to examine the
determinants of the aggregate price level responsiveness of aggregate demand. Students will
understand that increases in k and b will yield a more aggregate price level responsive aggregate
demand curve. Students should also understand, for reasons similar to those presented above,
that the slope of the LM curve by itself does not determine the extent to which output increases
(in the IS-LM model) as a result of a given reduction in the aggregate price level.

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