IS-LM Model

The IS-LM model is a two-curve diagram used to analyze short-run macroeconomic equilibrium in a closed economy. It was developed by John Hicks in his 1937 article "Mr. Keynes and the Classics: A Suggested Interpretation" in Econometrica, as a formal reading of Keynes's General Theory (1936). Alvin Hansen popularized it in U.S. textbooks during the 1940s and 1950s, after which it became the standard teaching tool of the neoclassical synthesis.

The model has two relationships, both plotted with the interest rate (i) on the vertical axis and real output (Y) on the horizontal axis:

• IS curve ("investment–saving"): combinations of i and Y at which the goods market clears, i.e., planned investment equals saving. It slopes downward because lower interest rates raise investment and, via the multiplier, output.
• LM curve ("liquidity preference–money supply"): combinations of i and Y at which money demand equals a fixed real money supply. It slopes upward because higher income raises transactions demand for money, which must be offset by a higher interest rate.

Their intersection pins down short-run equilibrium output and the interest rate. Fiscal expansion (higher G or lower T) shifts IS right, raising both Y and i, and may "crowd out" private investment. Monetary expansion shifts LM right, raising Y while lowering i. The relative slopes determine the potency of each policy: a steep LM (money demand insensitive to interest) makes fiscal policy weak and monetary policy strong, and vice versa.

The framework was extended to open economies as the Mundell–Fleming model in the early 1960s. It has been criticized — notably by Hicks himself in 1980 — for assuming a fixed price level, ignoring expectations, and lacking explicit microfoundations. Modern graduate macroeconomics largely replaces it with DSGE models, but IS-LM remains a staple of undergraduate teaching and policy commentary because it conveys the basic logic of demand management compactly.