IS–LM model

The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates (ordinate) and assets market (also known as real output in goods and services market plus money market, as abscissa). The intersection of the 'investment–saving' (IS) and 'liquidity preference–money supply' (LM) curves models 'general equilibrium' where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift.Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies. The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates (ordinate) and assets market (also known as real output in goods and services market plus money market, as abscissa). The intersection of the 'investment–saving' (IS) and 'liquidity preference–money supply' (LM) curves models 'general equilibrium' where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift.Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies. The model was developed by John Hicks in 1937, and later extended by Alvin Hansen, as a mathematical representation of Keynesian macroeconomic theory. Between the 1940s and mid-1970s, it was the leading framework of macroeconomic analysis. While it has been largely absent from macroeconomic research ever since, it is still a backbone conceptual introductory tool in many macroeconomics textbooks. By itself, the IS–LM model is used to study the short run when prices are fixed or sticky and no inflation is taken into consideration. But in practice the main role of the model is as a path to explain the AD–AS model. The IS–LM model was first introduced at a conference of the Econometric Society held in Oxford during September 1936. Roy Harrod, John R. Hicks, and James Meade all presented papersdescribing mathematical models attempting to summarize John Maynard Keynes' General Theory of Employment, Interest, and Money. Hicks, who had seen a draft of Harrod's paper, invented the IS–LM model (originally using the abbreviation 'LL', not 'LM'). He later presented it in'Mr. Keynes and the Classics: A Suggested Interpretation'. Hicks later agreed that the model missed important points of Keynesian theory, criticizing it as having very limited use beyond 'a classroom gadget', and criticizing equilibrium methods generally: 'When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect.' The first problem was that it presents the real and monetary sectors as separate, something Keynes attempted to transcend. In addition, an equilibrium model ignores uncertainty—and that liquidity preference only makes sense in the presence of uncertainty 'For there is no sense in liquidity, unless expectations are uncertain.' A shift in one of the IS or LM curves will cause a change in expectations, which shifts the other curve. Although generally accepted as being imperfect, the model is seen as a useful pedagogical tool for imparting an understanding of the questions that macroeconomists today attempt to answer through more nuanced approaches. As such, it is included in most undergraduate macroeconomics textbooks, but omitted from most graduate texts due to the current dominance of real business cycle and new Keynesian theories.