Lecture 10 - Keynesian Economics and the ISLM Model Claude

Before proceeding, it is worth acknowledging the pedagogical position of the IS-LM model within this course. The model serves as a foundational framework for understanding short-run macroeconomic equilibrium, and whilst the subsequent lecture will derive the Aggregate Demand (AD) curve through the AD-AS framework rather than directly through IS-LM, the model remains intellectually indispensable. A great many practising economists, policymakers, and central bankers continue to reason in IS-LM terms, making fluency with it a prerequisite for engaging with macroeconomic discourse at any serious level.

The IS-LM model is a short-run macroeconomic framework that simultaneously characterises equilibrium in two markets: the goods market and the money market. Its central purpose is to jointly determine two endogenous variables: the interest rate () and the level of national income ().

The model is composed of two curves:

When plotted together, the intersection of IS and LM identifies the unique pair that clears both markets simultaneously — what may be termed a general equilibrium of the short-run economy.

The key assumption of the IS-LM model is that the general price level is held constant. This transforms the model into a purely quantity-and-interest-rate framework: neither firms nor households can adjust prices to restore equilibrium. Instead, only real quantities (output ) and the nominal interest rate () adjust.

This assumption is most defensible over very short time horizons. In the very short run, many prices are sticky: firms face costs of changing price lists (menu costs), wages are set by contracts, and expectations may be anchored. As the time horizon lengthens, the price rigidity assumption becomes less tenable, which is why the IS-LM model is explicitly a short-run tool.

The starting point for the goods market block is the familiar national income identity:

In the IS-LM framework, the left-hand side () represents actual production — the volume of output that firms produce and wish to sell. The right-hand side () is reinterpreted as planned expenditure — the total spending that households, firms, the government, and the foreign sector intend to undertake.

Equilibrium in the goods market requires that these two quantities be equal: firms produce exactly what agents plan to buy. If planned expenditure exceeds actual production, firms will unintentionally run down their inventories and subsequently increase output; the reverse holds if production exceeds planned spending. This self-correcting inventory mechanism is the Keynesian adjustment process.

A central concept here is the marginal propensity to consume (MPC): the fraction of each additional unit of income that households spend on consumption. Because planned expenditure is increasing in income (via the MPC), the planned expenditure schedule is upward-sloping when plotted against .

Planned expenditure is not determined solely by income; it also depends on the interest rate . The interest rate enters through two principal channels:

Consumption (): Households face an intertemporal trade-off between spending today and saving for tomorrow. A higher interest rate raises the return to saving, inducing households to defer consumption, thereby reducing current planned expenditure. This is the classical substitution effect in intertemporal consumption choice.

Investment (): Firms evaluate investment projects by comparing the expected return on capital with the cost of borrowing. A higher interest rate raises the hurdle rate of return required for a project to be profitable. Marginal investment projects that were previously viable become unprofitable, so aggregate investment falls. This is the standard neoclassical investment mechanism, formalised in the concept of the marginal efficiency of capital.

Both channels thus imply a negative relationship between the interest rate and planned expenditure. For a given level of income, a rise in shifts the planned expenditure schedule downward, reducing the equilibrium level of output in the goods market.

This diagram illustrates the derivation of the IS curve from the Keynesian cross. The left panel shows the goods market: for a given high interest rate , planned expenditure is , yielding equilibrium income (point ). When the interest rate falls to , investment and consumption rise, shifting planned expenditure upward to and equilibrium income rises to (point ). The right panel maps these two pairs onto a new diagram. Connecting points and traces out the IS curve, which slopes downward from left to right.

The negative slope of the IS curve embodies the following causal chain: a lower interest rate raises planned expenditure via increased investment and consumption, which — through the Keynesian multiplier — raises equilibrium output by more than the initial increase in spending.

The money market block is built upon Keynes's theory of liquidity preference. Money demand depends on two distinct motives:

The money demand curve thus slopes downward in space: for a given level of income, higher interest rates reduce the quantity of real money balances demanded.

Money supply () is treated as exogenous — it is set by the central bank and does not depend on or . In the standard IS-LM framework, money supply is represented as a vertical line.

Money market equilibrium requires that the quantity of real money balances demanded equals the exogenous real money supply:

where is the liquidity preference (money demand) function, increasing in and decreasing in . Because is held fixed, changes in the nominal money supply translate one-for-one into changes in real balances.

This diagram shows the derivation of the LM curve. Panel (a) depicts the money market: the vertical line is the fixed money supply , and and are money demand curves corresponding to income levels respectively. A higher income level raises money demand, shifting rightward; with a fixed supply, equilibrium in the money market requires a higher interest rate to dampen demand back to the level of supply. Points (at ) and (at ) in panel (a) map onto points and in panel (b), tracing the upward-sloping LM curve.

The positive slope of the LM curve reflects a straightforward mechanism: as income rises, the transactions demand for money increases; with a fixed supply, the interest rate must rise to clear the money market by reducing the speculative demand for money.

This diagram combines the IS and LM curves in a single space. The downward-sloping IS curve and the upward-sloping LM curve intersect at the unique point , which represents the simultaneous equilibrium of both the goods market and the money market. At this point, planned expenditure equals actual output and money demand equals money supply.

The analytical power of IS-LM lies precisely in this simultaneity. The goods market alone (the IS curve) cannot determine and independently — it only tells us that for any given , there is a corresponding equilibrium . Similarly, the money market alone (the LM curve) cannot determine both variables. Only the joint solution pins down the economy's short-run position.

The IS-LM model can be used to derive the Aggregate Demand (AD) curve, which maps the relationship between the general price level and the equilibrium level of national output .

The derivation proceeds as follows. For a given initial price level , the IS-LM model delivers an equilibrium . Now consider a rise in the price level to . Because the nominal money supply is fixed by the central bank, a higher price level reduces the real money supply :

This reduction in real money balances shifts the LM curve to the left: at every level of income, a higher interest rate is now required to equate the reduced real supply with money demand. The new equilibrium has a higher interest rate and lower output: where .

Plotting against and against in space yields two points on the AD curve. The AD curve slopes downward because a higher price level reduces real money balances, tightens financial conditions via a higher interest rate, crowds out investment and consumption, and therefore lowers equilibrium output. This monetary transmission channel (sometimes called the Keynes effect) is the IS-LM explanation for the negative slope of the AD curve.

The IS-LM model, formalised by Hicks (1937) as an interpretation of Keynes's General Theory (1936), captures the essence of Keynesian macroeconomics in a tractable two-equation framework. Its enduring relevance lies in the central proposition that prices are rigid in the short run. This rigidity means that the economy need not automatically self-correct following a negative demand shock; output and employment can remain below their natural levels for a sustained period, providing the theoretical case for discretionary stabilisation policy.

The model also formalises a key distinction between fiscal and monetary policy transmission. Fiscal expansion (higher government spending or lower taxes ) shifts the IS curve rightward, raising both and . The rise in partially offsets the fiscal stimulus by crowding out private investment — the extent of this crowding-out effect depends on the slopes of both curves. Monetary expansion (a rise in ) shifts the LM curve rightward, lowering and raising — the classic mechanism of monetary stimulus.

Hicks, J.R. (1937) 'Mr. Keynes and the Classics: A Suggested Interpretation', Econometrica, 5(2), pp. 147–159.
Keynes, J.M. (1936) The General Theory of Employment, Interest and Money. London: Macmillan.
Mankiw, N.G. (2019) Macroeconomics. 10th edn. New York: Worth Publishers.
Blanchard, O. (2021) Macroeconomics. 8th edn. Harlow: Pearson Education.
Carlin, W. and Soskice, D. (2015) Macroeconomics: Institutions, Instability, and the Financial System. Oxford: Oxford University Press.