Lecture 10 - Keynesian Economics and the ISLM Model

These notes introduce the IS-LM model, one of the central frameworks of short-run macroeconomics. The model describes how output (income) and the interest rate are simultaneously determined through interactions between the goods market and the money market.

The framework originates from Keynesian macroeconomics and attempts to explain short-run economic fluctuations when prices are slow to adjust. While modern macroeconomics often uses more advanced models, the IS-LM framework remains an essential conceptual tool for understanding monetary policy, fiscal policy, and aggregate demand.

Definition

IS-LM Model
A macroeconomic framework describing equilibrium in the goods market and money market simultaneously. It determines the equilibrium interest rate () and national income/output () in the short run.

The lecture introduces the model briefly, but it remains important because much economic reasoning about policy still uses the IS-LM framework.

1. Core Structure of the IS-LM Model

The IS-LM model combines two equilibrium conditions:

  1. Goods market equilibrium
  2. Money market equilibrium

Together these determine the general equilibrium of the short-run economy.

Goods Market

The goods market concerns equilibrium between production and planned spending.

Money Market

The money market concerns equilibrium between money supply and money demand.

The intersection of these two conditions determines:

  • Equilibrium income/output ()
  • Equilibrium interest rate ()

Key Assumption: Fixed Prices

A fundamental assumption of the model is that the general price level () is fixed in the short run.

Definition

Price rigidity
A situation where prices adjust slowly or are costly to change, meaning that short-run economic adjustments occur mainly through quantities (output and employment) rather than prices.

Because prices are fixed:

  • The real money supply is constant
  • Markets clear through changes in interest rates and output
Theoretical Interpretation

The IS-LM model is essentially a short-run general equilibrium model with sticky prices. Instead of price adjustments equilibrating markets, adjustment occurs through income changes and interest rate movements. This reflects Keynes's argument that insufficient demand can generate recessions.

2. The National Income Identity and Planned Expenditure

The starting point is the national income identity:

$Y = C + I + G + (X-M) \text{ or } NX$

Where:

  • = national income or output
  • = consumption
  • = investment
  • = government spending
  • = net exports

This identity can be interpreted as:

Concept Interpretation
Actual production/output
Planned expenditure (aggregate demand)
Definition

Planned expenditure
The total amount households, firms, government, and foreigners intend to spend on goods and services.

Economic equilibrium occurs when:

Meaning:

  • Firms produce exactly what agents plan to buy.

Consumption and the Marginal Propensity to Consume

Consumption typically depends on income.

Definition

Marginal Propensity to Consume (MPC)
The fraction of an additional unit of income that households spend on consumption.

Example:

  • If MPC = 0.8, households spend 80% of additional income.
Economic Intuition

When income rises, households increase spending. This generates the multiplier effect, where additional spending leads to further rounds of income and consumption.

3. The Keynesian Cross

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_set1(ISLM)/Slide10.png

The Keynesian Cross illustrates equilibrium in the goods market.

The diagram typically shows:

  • Actual output () on the horizontal axis
  • Planned expenditure on the vertical axis
  • A 45-degree line representing points where expenditure equals output

Equilibrium occurs where:

  • Planned expenditure equals actual output.

If expenditure exceeds output:

  • Firms increase production.

If output exceeds expenditure:

  • Firms accumulate inventories and reduce production.
Economic Intuition

The Keynesian Cross demonstrates that aggregate demand determines output in the short run. Firms respond to unexpected demand changes through adjustments in production rather than price changes.

Exam Insight

When explaining the Keynesian cross:

  • Highlight planned vs actual expenditure
  • Explain the inventory adjustment mechanism
  • Mention the multiplier process.

4. Interest Rates and the Goods Market

Planned expenditure depends on the interest rate ().
The interest rate affects two major components of spending.

Consumption

Higher interest rates encourage saving.

  • Households receive higher returns on savings
  • Consumption tends to fall.

Investment

Investment decisions depend strongly on borrowing costs.
Higher interest rates imply:

  • Higher cost of borrowing
  • Fewer profitable investment opportunities.

Therefore:

Investment declines when interest rates rise.

Theoretical Interpretation

Firms invest when the expected return on capital exceeds the cost of borrowing. Rising interest rates increase the required rate of return, reducing the number of profitable investment projects.

5. The Investment-Saving (IS) Curve

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_set1(ISLM)/Slide10.png

The IS curve represents combinations of:

  • income ()
  • interest rate ()

for which the goods market is in equilibrium.

Definition

IS Curve
The relationship between the interest rate and output such that planned expenditure equals output.

Key Property

The IS curve slopes downward.

Reason:

  • Higher interest rates reduce investment
  • Lower investment reduces aggregate demand
  • Output must fall to restore equilibrium.
Economic Intuition

When borrowing becomes expensive, investment and consumption decline. This reduces aggregate demand and forces output downward.

6. Money Market and Liquidity Preference

The money market equilibrium depends on money demand and money supply.

Money demand depends on two factors.

Transactions Demand

Higher income leads to:

  • More transactions
  • Higher demand for money.

Portfolio Choice

Households allocate wealth between:

  • money (liquid but no return)
  • bonds or other interest-bearing assets.

When interest rates rise:

  • bonds become more attractive
  • money demand falls.
Definition

Liquidity preference
Keynes's theory describing how individuals choose between holding money and interest-bearing assets.

7. The Liquidity-Money (LM) Curve

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_set1(ISLM)/Slide12.png

The LM curve represents combinations of income and interest rates where the money market is in equilibrium.

Definition

LM Curve
The relationship between interest rate and income such that money demand equals money supply.

Why the LM Curve Slopes Upward

When income increases:

  • transactions increase
  • money demand rises.

Because the money supply is fixed:

  • interest rates must rise to reduce money demand.

Thus:

Higher income → higher interest rates.

Economic Intuition

When the economy expands, people require more money for transactions. With a fixed supply of money, interest rates increase to balance money demand with money supply.

8. IS-LM General Equilibrium

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_set1(ISLM)/Slide13.png

The intersection of the IS curve and the LM curve determines the economy's short-run equilibrium.

This equilibrium gives:

  • Output:
  • Interest rate:

At this point:

  • the goods market clears
  • the money market clears.
Theoretical Interpretation

The IS-LM framework is essentially a two-market general equilibrium model linking financial markets and real economic activity. The IS curve captures equilibrium in the goods market, while the LM curve captures equilibrium in the money market.

Exam Insight

In policy analysis questions:

  • Fiscal policy shifts the IS curve
  • Monetary policy shifts the LM curve
  • The new intersection determines the change in output and interest rates.

9. From IS-LM to the Aggregate Demand Curve

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_set1(ISLM)/Slide15.png

The Aggregate Demand (AD) curve describes the relationship between:

  • the price level ()
  • output ().

The IS-LM model helps derive this relationship.

Step 1: Initial Price Level

The IS-LM model determines equilibrium output for a given price level .

Step 2: Increase in Price Level

When prices increase:

  • real money supply decreases

because:

falls.

Step 3: Effect on LM Curve

Lower real money supply shifts the LM curve left.

Step 4: New Equilibrium

The new equilibrium involves:

  • higher interest rates
  • lower output.

This generates the downward-sloping aggregate demand curve.

Economic Intuition

Higher prices reduce the purchasing power of money balances, tightening financial conditions and reducing spending.

Summary

Mechanism linking price level to output:

  • Higher → lower
  • LM shifts left
  • Interest rates increase
  • Investment falls
  • Output declines.

10. Importance of the IS-LM Model

Although modern macroeconomics often uses more advanced models, the IS-LM framework remains valuable because it captures the core ideas of Keynesian economics.

Key insights include:

  • Short-run price rigidity
  • Demand-driven fluctuations in output
  • Interaction between financial markets and real activity
  • Effects of monetary and fiscal policy
Summary

Core takeaways:

  • IS curve: goods market equilibrium
  • LM curve: money market equilibrium
  • Intersection determines income and interest rate
  • Policy changes shift these curves
  • The framework explains the aggregate demand curve

References

Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning EMEA.

Jensen, M.K. (2026) Keynesian Economics and the IS-LM Model. ECON1002 Lecture Slides, University of Nottingham.