The IS-LM Model

The IS-LM model also referred to as the Hicks-Hansen model is used as a Keynesian macroeconomic tool to explain the relationship between asset markets and the interest rates. It was first developed by John Hicks in 1937 and later improved by Alvin Hansen to incorporate the Keynesian macroeconomic elements.  It is graphically expressed by the investment –saving (IS) curve and the liquidity preference-money supply (LM) curve.  The IS curve indicates variation in market interest rates, that reflect demand, and the model of income-expenditure. On the other hand, the LM curve represents the supply of money for investment purposes. The point of intersection of these two curves indicates short-run equilibrium of the interest rates and the asset market. This means that the amount available for investment is equal to the amount invested.

This model is mostly used in policy analysis and expounding the macroeconomic applications. The interrelationship between output and interest rates is used to show the aggregate demand in an economy. In the money market, the demand for quantity of money increases when the interest rates decrease and the aggregate income increases. On the other hand, in a closed economy, an increase in interest rates will result to decrease in aggregate demand in investment and goods. Therefore, the output levels decrease and the quantity produced moves to match the quantity demanded. This condition equates that of the savings equating invested. It should be noted that the IS-LM model is mostly applied when prices are considered sticky and there is no inflation in the short run. However, its major role in application is acting as a sub-model of larger models which have flexibility of price levels, for instance the Aggregate Demand- Aggregate Supply model.