The IS-LM model is a macroeconomic tool that shows the relationship between interest rates and real

output in the goods and services and money markets. Developed independently by Sir John Hicks and
Alvin Hansen in 1937, it is based on the ideas of John Maynard Keynes presented in his work "The
General Theory of Employment, Interest, and Money." The model is used to analyze economic policies
and equilibrium.

### IS Curve (Investment-Saving)

- **Definition**: The IS curve represents the equilibrium in the market for goods and services, where
investment equals saving.

- **Derivation**: It is derived from the Keynesian cross analysis of aggregate expenditure. A higher
interest rate decreases investment, lowering aggregate demand and output.

- **Position**: A change in autonomous spending (like government spending) shifts the IS curve.
Increase in autonomous spending shifts it right; a decrease shifts it left.

### LM Curve (Liquidity Preference-Money Supply)

- **Definition**: The LM curve represents money market equilibrium, where the demand for money
equals the supply.

- **Derivation**: It comes from the theory of liquidity preference, where people prefer liquidity to
either bonds or goods at different interest rates.

- **Position**: Factors affecting money supply or demand, like changes in banking policy or preferences
for liquidity, shift the LM curve. Increased money supply shifts it right; decreased supply shifts it left.

### Interaction of IS and LM Curves

- **Equilibrium**: The intersection of the IS and LM curves shows the general equilibrium in both goods
and money markets.

- **Economic Policies**: Fiscal policy (government spending, taxes) shifts the IS curve, while monetary
policy (changing money supply, interest rates) shifts the LM curve.

### Policy Analysis

- **Expansionary Fiscal Policy**: Increases government spending or decreases taxes, shifting the IS
curve right. This can lead to higher output and interest rates.
- **Contractionary Fiscal Policy**: Decreases government spending or increases taxes, shifting the IS
curve left, potentially lowering output and interest rates.

- **Expansionary Monetary Policy**: Increases money supply, shifting LM curve right, which can lower
interest rates and increase output.

- **Contractionary Monetary Policy**: Decreases money supply, shifting LM curve left, increasing
interest rates and potentially decreasing output.

### Limitations and Critiques

- **Assumptions**: Assumes constant price level, fixed exchange rates, and no capital flows, which is
often unrealistic.

- **Liquidity Trap**: At very low interest rates, the LM curve becomes horizontal, making monetary
policy ineffective (Keynes’s liquidity trap).

- **Dynamic Analysis**: The IS-LM model is static and doesn't account for expectations or time lags in
policy effects.

### Applications

- **Recession Analysis**: Used to evaluate policies to counteract recessions.

- **Interest Rate Predictions**: Helps predict the effects of fiscal and monetary policy on interest rates.

- **Macroeconomic Teaching**: A foundational tool in macroeconomic education.

### Evolution

- **Extensions**: The model has been extended to include the foreign sector (IS-LM-BP model) and to
account for price level changes (AD-AS model).

- **Contemporary Relevance**: While criticized, it remains a fundamental tool in macroeconomic

theory and policy analysis.

Understanding the IS-LM model provides insights into the functioning of the economy and the impact of
different policy measures on output and interest rates. However, it's important to consider its
limitations and the context of its application.