Finance:IS–LM model

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Short description: Macroeconomic model relating interest rates and asset market
The IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y)

IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market (also known as real output in goods and services market plus money market). The intersection of the "investmentsaving" (IS) and "liquidity preferencemoney supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets.[1] Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when the price level is fixed in the short-run; second, the IS–LM model shows why an aggregate demand curve can shift.[2] Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.[3]

The model was created, developed and taught by Keynes.[4] However, it is often believed that John Hicks invented it in 1937,[5] and was later extended by Alvin Hansen,[6] as a mathematical representation of Keynesian macroeconomic theory. Between the 1940s and mid-1970s, it was the leading framework of macroeconomic analysis.[7] While it has been largely absent from macroeconomic research ever since, it is still a backbone conceptual introductory tool in many macroeconomics textbooks.[8] 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.[2]

History

Keynes created, developed,improved and taught his original IS-LM model to his students from 1933 to 1935.[9] Later the IS–LM model was introduced at a conference of the Econometric Society held in Oxford during September 1936. Roy Harrod, John R. Hicks, and James Meade all presented papers describing mathematical models attempting to summarize John Maynard Keynes' General Theory of Employment, Interest, and Money.[5][10] 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".[5]

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.Cite error: Closing </ref> missing for <ref> tag In his original IS–LM model, Hicks assumed that the price level was fixed, reflecting John Maynard Keynes' belief that wages and prices do not adapt quickly to clear markets.

The introduction of an adjustment to Hicks' loose assumption of a fixed price level requires allowing the price level to change. Allowing the price level to change necessitates the addition of a third component, the full equilibrium (FE) condition.[11] When this component is added to the IS–LM model, a new model called IS–LM–FE emerges. The IS–LM–FE model is widely used in cyclical fluctuations analysis, forecasting, and macroeconomic policymaking.[11] There are many advantages to using the IS–LM–FE model as a framework for both classical and Keynesian analyses: First, rather than learning two different models for classical and Keynesian analyses, a single model can be used for both.[11] Second, using a single framework highlights the many areas of agreement between the Keynesian and classical approaches while also emphasizing the differences between them. Furthermore, since various versions of the IS–LM–FE model (along with its ideas and terminology) are frequently used in economic and macroeconomic policy analyses, studying this framework will help to understand and engage in contemporary economic debates. Three approaches are used when analyzing this economic model: graphical, numerical, and algebraic.

Reinventing IS-LM: the IS-LM-NAC model

In the IS-LM-NAC model, the long-run effect of monetary policy depends on the way people form beliefs.[12] Roger Farmer and Konstantin Platanov study a case they call 'persistent adaptive beliefs' in which people believe, correctly, that shocks to asset values are permanent. The important innovation in this work is a model of the labor market in which there can be a continuum of long-run steady state equilibria.

See also


References

  1. Gordon, Robert J. (2009). Macroeconomics (Eleventh ed.). Boston: Pearson Addison Wesley. ISBN 9780321552075. 
  2. 2.0 2.1 Mankiw, N. Gregory (2012). Macroeconomics (Eighth ed.). New York: Worth Publishers. ISBN 9781429240024. 
  3. Sloman, John; Wride, Alison (2009). Economics (Seventh ed.). Prentice Hall. ISBN 9780273715627. 
  4. Brady, Michael Emmett (2020). "Investopedia Needs to Heavily Revise Its 'IS-LM Model' Paper". SSRN Electronic Journal. doi:10.2139/ssrn.3656347. 
  5. 5.0 5.1 5.2 Hicks, J. R. (1937). "Mr. Keynes and the 'Classics': A Suggested Interpretation". Econometrica 5 (2): 147–159. doi:10.2307/1907242. 
  6. Hansen, A. H. (1953). A Guide to Keynes. New York: McGraw Hill. ISBN 9780070260467. https://archive.org/details/guidetokeynes0000hans. 
  7. Bentolila, Samuel (2005). "Hicks–Hansen model". An Eponymous Dictionary of Economics: A Guide to Laws and Theorems Named after Economists. Edward Elgar. ISBN 978-1-84376-029-0. 
  8. Colander, David (2004). "The Strange Persistence of the IS-LM Model". History of Political Economy 36 (Annual Supplement): 305–322. doi:10.1215/00182702-36-suppl_1-305. http://muse.jhu.edu/journals/history_of_political_economy/v036/36.5colander.pdf. 
  9. Brady, Michael Emmett (2020). "Investopedia Needs to Heavily Revise Its 'IS-LM Model' Paper". SSRN Electronic Journal. doi:10.2139/ssrn.3656347. 
  10. Meade, J. E. (1937). "A Simplified Model of Mr. Keynes' System". Review of Economic Studies 4 (2): 98–107. doi:10.2307/2967607. 
  11. 11.0 11.1 11.2 Cite error: Invalid <ref> tag; no text was provided for refs named acemoglu_etal_2018
  12. Farmer, Roger E. A. (2012). "Confidence, crashes, and animal spirits". The Economic Journal 122 (559): 155–172. doi:10.1111/j.1468-0297.2011.02474.x. 

Further reading

External links

  • Krugman, Paul. There's something about macro – An explanation of the model and its role in understanding macroeconomics.
  • Krugman, Paul. IS-LMentary – A basic explanation of the model and its uses.
  • Wiens, Elmer G. IS–LM model – An online, interactive IS–LM model of the Canadian economy.