The IS-LM Model
● How output and the interest rate are determined in the short run in goods and
financial markets
● Called the IS-LM model by John Hicks and Alvin Hansen
The goods market and IS relation
● Along the IS curve:
○ Planned expenditure = actual expenditure
○ Planned expenditure = income
○ There are no unplanned changes in inventories
● Investment is not exogenous, it depends on production (Y) and the interest
rate (i)
○ An increase in the interest rate increases the cost of capital and
reduces investment
● Equilibrium in the goods market is Y = C(Y-T) + I(Y,i) + G (the IS relation)
○ In the short run, inflation = 0 so nominal interest is used
● Demand is an increasing function of output
○ Upward sloping because an increase in output increases demand (via
consumption and investment) for a given interest rate
○ A curve because we have not assumed consumption and investment
are linear
○ Flatter than 45° because an increase in output leads to a less than 1
for 1 increase in investment
● Equilibrium means demand for goods = output
● An increase in the interest rate decreases the demand for goods, decreasing
output
○ Causes the IS curve to be downward sloping - higher interest
decreases output
● A change in the interest rate or output causes a movement along the IS curve
● A change in the variable not on the axis causes a shift in the IS curve for a
given level of interest
○ Lower taxes / higher government spending causes the IS curve to shift
right
○ Higher taxes / lower government spending causes the IS curve to shift
left
● How output and the interest rate are determined in the short run in goods and
financial markets
● Called the IS-LM model by John Hicks and Alvin Hansen
The goods market and IS relation
● Along the IS curve:
○ Planned expenditure = actual expenditure
○ Planned expenditure = income
○ There are no unplanned changes in inventories
● Investment is not exogenous, it depends on production (Y) and the interest
rate (i)
○ An increase in the interest rate increases the cost of capital and
reduces investment
● Equilibrium in the goods market is Y = C(Y-T) + I(Y,i) + G (the IS relation)
○ In the short run, inflation = 0 so nominal interest is used
● Demand is an increasing function of output
○ Upward sloping because an increase in output increases demand (via
consumption and investment) for a given interest rate
○ A curve because we have not assumed consumption and investment
are linear
○ Flatter than 45° because an increase in output leads to a less than 1
for 1 increase in investment
● Equilibrium means demand for goods = output
● An increase in the interest rate decreases the demand for goods, decreasing
output
○ Causes the IS curve to be downward sloping - higher interest
decreases output
● A change in the interest rate or output causes a movement along the IS curve
● A change in the variable not on the axis causes a shift in the IS curve for a
given level of interest
○ Lower taxes / higher government spending causes the IS curve to shift
right
○ Higher taxes / lower government spending causes the IS curve to shift
left
