What is IS-LM Analysis?
The term IS stands for Investment, Savings, and LM stands for Liquidity Preference, Money Supply. Therefore, the term IS-LM model is known as Investment Savings – Liquidity preference money Supply. This model was introduced by a Keynesian macroeconomic theory which shows the relationship between the economic goods market and loanable funds market or money market. In other words, it shows how the market for real goods interacts with the financial markets to strike a balance between the interest rate and total output in the macroeconomy. This particular model is designed in the form of a graphical representation of the Keynesian economic theory principle. The output and money are the two important factors in an economy.
The IS-LM model shows the relationship between interest rates and the money market as well as real output in the goods and services market. It is the analysis of goods and money market. The short-run GDP in the economy is determined through IS-LM analysis.
The graph indicated the relationship between IS and LM. The horizontal curve represents Gross Domestic Products, and the vertical curve represents interest rates. IS shows levels of interest rates and GDP. Here total investment = total savings. Investment is high at lower interest rates. The IS curve slopes downwards. The LM curve slopes upward, which indicates a high GDP rate. This indicates that demand for money is increased to hold the balance of money transactions.
The point at which both IS and LM intersects, the point of equilibrium. This indicates that the money market and economy are in balance.
The IS-LM model has three external variables, namely investment, liquidity, and consumption. While liquidity depends upon the money supply, investment and consumption are determined by marginal decisions of the individuals.
LM Curve represents the relationship between the income and the interest rate where money Supply is equal to the demand of money. The demand for money decreases with the increase in the interest rate because of the opportunity cost involved in holding the money.
IS Curve indicating the relationship between gross domestic product and real interest rate. The spending decreases if the interest rate increases in the economy.
The graph indicates the demand and supply of assets in an economy. The horizontal curve shows the price of an asset, and the vertical axis shows the quantity of assets traded. The intersection point shows the equilibrium where the demand and supply of the asset are matched in the economy.
Aggregate demand mainly arises when there is the intersection of IS and LM curves at a particular price. When the level of price is high, then the supply of money would be less. Hence aggregate demand will be less when the LM curve moves higher.
The graph indicates the relationship between money supply and demand and nominal interest rates. The intersection point indicates the equilibrium rate at the money market. Money demand is shifted to the right at a higher level of income; when money demand is shifted to the right, the interest rate increases at this point. This is done to ensure the equilibrium between money demand and supply.
Liquidity Preference Theory
According to liquidity preference theory, the demand does not imply borrowing of money but mainly remains liquid. Liquidity preference theory is the theory that was created by John Maynard Keynes. According to him, the demand for money is divided into three major categories, namely transitionary demand, precautionary demand, and speculative demand.
- Transitionary demand: The amount of liquidity depends upon the income level. Higher the income more would be the amount of money required for spending purposes. This is because people give priority to the concept of liquidity these days. This is known as transitionary demand.
- Precautionary demand: This is also the concept of liquidity in which it is always essential to ensure that there must be adequate money to cover unforeseen expenses like accidents or any emergency reasons.
- Speculative demand: This type of demand mainly aims to take advantage of changing interest rates or bond prices. Higher interest rates lower the speculative demand for money and vice versa.
Following are some of the features of the IS-LM graph
- The IS-LM graph has two curves, namely gross domestic product, which is placed on the horizontal axis, and interest rate lies on the vertical axis.
- All levels of interest rates are depicted by the curve. The curve would move downward and to the right when the interest rate is less and investment is high.
- The curve would move upwards because of high levels of GDP, which increases the demand to hold money for transactions requiring high rates of interest to keep money supply and demand at equilibrium.
- The varying positions and shapes show the changing preferences for liquidity, investment, and consumption.
IS-LM curve is important for the following reasons
- The IS-LM curve helps in determining how interest rates and aggregate output are calculated when there is a fixed price level.
- The IS-LM can be used as an apparatus to increase the level of aggregate output when the level of unemployment is too high in the economy.
Limitations of IS-LM analysis
One of the serious limitations of the IS-LM analysis is that it fails to deal explicitly with the supply side of the economy.
Implications of the IS-LM Model
The IS-LM model has major implications in the case of monetary policy. When there is instability in the IS curve, the target money supply will result in greater stability in the output. On the other hand, instability in the LM curve will make the interest rate target create higher macro stability.
One more implication of the curve is that the central bank may act with care to shift the monetary aggregates when the IS curve becomes more stable than the LM curve.
Context and Applications
This topic is significant in the professional exams for both undergraduate and graduate courses, especially for
- B. Com
- BA Economics
- MA Economics
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