The document provides an overview of the IS-LM model, which is a macroeconomic model that shows the interaction between the goods market (IS curve) and money market (LM curve). The IS curve depicts combinations of interest rates and output where investment equals savings. The LM curve shows combinations where money supply equals money demand. The equilibrium point is where the two curves intersect, indicating balanced rates and output. The document discusses the development of the model, its graphical representation, assumptions, limitations, and how it can be used to analyze macroeconomic policy scenarios.

1. What is the IS-LM Model?
The IS-LM model, which stands for "investment-savings" (IS) and "liquidity preference-
money supply" (LM) is a macroeconomic model that shows how the market for economic
goods (IS) interacts with the loanable funds market (LM) or money market.
 The IS-LM model describes how aggregate markets for real goods and financial
markets interact to balance the rate of interest and total output in the macroeconomy.
 IS-LM can be used to describe how changes in market preferences alter the equilibrium
levels of GDP and market interest rates, but the model lacks the precision and realism
to be a useful prescription tool for economic policy.
Understanding IS-LM Model
British economist John Hicks first introduced the IS-LM model in 1937, just one year after
fellow British economist John Maynard Keynes published The General Theory of Employment,
Interest, and Money. Hicks's model served as a formalized graphical representation of Keynes's
theories, though it is used mainly as a heuristic device today.
The three critical exogenous – i.e. external – variables in the IS-LM model are liquidity,
investment, and consumption. According to the theory, liquidity is determined by the size and
velocity of the money supply. The levels of investing and consumption are determined by the
marginal decisions of individual actors.
The IS-LM graph examines the relationship between output, or GDP, and interest rates. The
entire economy is boiled down to just two markets, output and money, and their respective
supply and demand characteristics push the economy towards an equilibrium point.
Characteristics of the IS-LM Graph

2. The IS-LM graph consists of two curves, IS and LM. Gross domestic product (GDP), or (Y),
is placed on the horizontal axis, increasing to the right. The interest rate, or (i or R), makes up
the vertical axis.
The IS curve depicts the set of all levels of interest rates and output (GDP) at which total
investment (I) equals total saving (S).
At lower interest rates investment is higher, which translates into more total output (GDP) so
the IS curve slopes downward and to the right.
The LM curve depicts the set of all levels of income (GDP) and interest rates at which money
supply equals money (liquidity) demand.
The LM curve slopes upward because higher levels of income (GDP) induce increased demand
to hold money balances for transactions, which requires a higher interest rate to keep money
supply and liquidity demand in equilibrium.
The intersection of the IS and LM curves shows the equilibrium point of interest rates and
output when money markets and the real economy are in balance. Multiple scenarios or points
in time may be represented by adding additional IS and LM curves. In some versions of the
graph, curves display limited convexity or concavity. Shifts in the position and shape of the IS
and LM curves, representing changing preferences for liquidity, investment, and consumption,
alter the equilibrium levels of income and interest rates.
Limitations of the IS-LM Model
Many economists, including many Keynesians, object to the IS-LM model for its simplistic
and unrealistic assumptions about the macroeconomy. In fact, Hicks later admitted model's
flaws were fatal, and it was probably best used as "a classroom gadget, to be superseded, later

3. on, by something better." Subsequent revisions have taken place for so-called "new" or
"optimized" IS-LM frameworks.
The model is a limited policy tool, as it cannot explain how tax or spending policies should be
formulated with any specificity. This significantly limits its functional appeal. It has very little
to say about inflation, rational expectations, or international markets, although later models do
attempt to incorporate these ideas. The model also ignores the formation of capital and labor
productivity.
THE IS – LM MODEL
IS – LM analysis aims to find the level of income and rate of interest at which both the
commodity market and money market will be in equilibrium.
There IS curve is locus of points representing all the different combinations of interest rates
and income levels consistent with equilibrium in the goods or commodity market.
The IS curve is shown in the diagram below:
Interest
Rate
(i)

4. IS curve
0 National Income (Y)
Figure: The IS curve
The IS curve is a linear function in the two variables Yand I.
The LM curve is a locus of points representing all the different combinations of interest rates
and income levels consistent with equilibrium in the money market. The LM curve is shown
in the following diagram.
Interest
Rate LM curve
(i)
National Income (Y)
Figure: The LM Curve
The LM curve is also a function which is linear in the two variables I and Y.

5. IS – LM analysis aims at obtaining simultaneous equilibrium in both the commodity and the
money markets. Graphically, this situation can be represented as follows:

6. Interest
Rate IS – curve LM - curve
(i)
_
i
_
Y National income (Y)
Figure: Equilibrium in both the commodity and money markets.
The equilibrium in the two markets is represented graphically by the intersection of the IS and
LM curves.
The commodity market for a simple two – sector economy is in equilibrium when

7. Y = C + I. The money market, on the other hand, is in equilibrium when the supply of money
(Ms) equals the demand for money (Md). The demand for money is in turn made up of the
transaction – precautionary demand (MDT) and speculative demand for money (MDS).
Numerical example.
Assume that:
C = 178 + 0.6 Y
I = 240 – 300 i
MS = 550
MDT = 0.2 Y
MDS = 480 – 500i
Commodity market equilibrium (IS) exists where;
Y = C + I

8. = 178 + 0.6Y + 240 – 300i
Y – 0.6Y = 418 – 300 i
0.4Y + 300 i – 418 = 0
Monetary equilibrium (LM) exists where
MS = MDT + MDS
550 = 0.2y + 480 – 500 i
0.2Y – 500 i – 70 = 0
Simultaneous equilibrium in both markets requires that :
0.4Y + 300 i – 418 = 0 …………… (i)
0.2Y + 500i – 70 = 0 …………… (ii)
Multiply (i) by 5 and (ii) by 3 in order to eliminate i.
2 Y+ 1500 i – 2,090 = 0
0.6Y + 1500 i - 210 = 0
2.6Y _= 2,300

9. Y =2,300
= 885
_
substitute Y = 885 into (i) or (ii)
0.4 (885) + 300i – 418 = 0
354 + 300i – 418 = 0
300 i = 64
i = 0.21
REINFORCING QUESTIONS:
1. State clearly the meaning of Liquidity Preference as applied to an individual and a
commercial bank.
2. How does a commercial bank reconcile the need for security, liquidity and profitability in
distribution of the assets?
Check your answers with those given in Lesson 9 of the Study Pack.