Definition
IS-LM Analysis is a macroeconomic tool developed by John Maynard Keynes used to evaluate the interaction between the goods market (Investment-Saving or IS) and the money market (Liquidity preference-Money supply, or LM). The model illustrates how interest rates and aggregate income levels (domestic production) are determined and how they adjust in response to different economic policies.
IS Curve
The IS curve represents the combinations of interest rates and GDP (output) where the goods market is in equilibrium, meaning total spending equals total output. It shows the tradeoff between investment and spending.
LM Curve
The LM curve represents the combinations of interest rates and GDP where the money market is in equilibrium, meaning the demand for money equals the supply. It illustrates how changes in the money supply influence the demand for money.
Interaction
The point where the IS and LM curves intersect signifies the equilibrium in both the goods and the money market simultaneously. This point determines the equilibrium levels of interest rates and aggregate income.
Examples
- Fiscal Policy Impact: An increase in government spending shifts the IS curve to the right, indicating a higher level of aggregate income for any given interest rate.
- Monetary Policy Impact: An increase in the money supply shifts the LM curve to the right, indicating a lower interest rate for any given level of aggregate income.
Frequently Asked Questions
What does IS-LM stand for?
IS stands for Investment-Saving, and LM stands for Liquidity preference-Money supply.
Who developed the IS-LM model?
John Maynard Keynes is credited with the development of the IS-LM model as part of his examination of macroeconomic activity.
What does the IS curve represent?
The IS curve describes the relationship between interest rates and output in the goods market where total spending equates total output.
What does the LM curve represent?
The LM curve illustrates the relationship between interest rates and GDP in the money market where the demand for money equals the supply of money.
How does an increase in government spending affect the IS-LM model?
An increase in government spending shifts the IS curve to the right, indicating higher output for any given interest rate and leading to a new equilibrium with higher GDP and generally higher interest rates.
Related Terms with Definitions
- Fiscal Policy: Government policies related to taxation and spending aimed at influencing economic activity.
- Monetary Policy: Central bank actions involving the management of interest rates and money supply to influence economic activity.
- Aggregate Demand: The total demand for goods and services within the economy at a given overall price level and in a given period.
- Macroeconomics: The branch of economics dealing with the performance, structure, and behavior of an economy as a whole.
Online References
- Investopedia on IS-LM Model
- Wikipedia on IS-LM Model
- Federal Reserve Education on Monetary and Fiscal Policy
Suggested Books for Further Study
- “The General Theory of Employment, Interest, and Money” by John Maynard Keynes
- “Macroeconomics” by N. Gregory Mankiw
- “Advanced Macroeconomics” by David Romer
- “Macroeconomics: Theory and Policy” by William H. Branson
Fundamentals of IS-LM Analysis: Macroeconomics Basics Quiz
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