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IS-LM Model

Keynesian macroeconomics — goods & money market equilibrium, fiscal & monetary policy effects

Macroeconomics Keynesian Fiscal Policy Monetary Policy
Y* = — r* = — % Fiscal multiplier = — Crowding-out = —

IS-LM Framework (Hicks, 1937)

The IS curve (Investment-Saving) represents goods market equilibrium: all (Y, r) where planned expenditure equals output. rIS = (A − Y·(1−c₁)) / b where A = C₀ − c₁T + I₀ + G (autonomous spending), c₁ = MPC, b = investment sensitivity.

The LM curve (Liquidity-Money) represents money market equilibrium: money demand L = kY − hr equals real money supply M/P. rLM = (kY − M/P) / h. Equilibrium Y*, r* is where both curves intersect.

Use the shock buttons or drag the sliders to see how fiscal and monetary policy shift each curve and move the equilibrium point.

About IS-LM Economic Model

The IS-LM model, developed by John Hicks and Alvin Hansen in 1937 as a formalisation of Keynes's General Theory, depicts the simultaneous equilibrium of two markets: the goods market (IS curve) and the money market (LM curve). The IS curve traces combinations of real interest rate and GDP where investment equals saving; the LM curve traces combinations where money demand equals money supply. Their intersection determines the short-run equilibrium level of output and the interest rate.

The IS curve slopes downward: higher interest rates reduce investment spending, lowering equilibrium output. Fiscal policy (government spending or tax cuts) shifts the IS curve rightward, raising output and interest rates. The LM curve slopes upward: higher output increases money demand; with fixed money supply, interest rates must rise to restore money market equilibrium. Monetary policy (increasing money supply) shifts the LM curve rightward, lowering interest rates and raising output.

The IS-LM model is a simplified Keynesian macroeconomic framework used to analyse policy interactions. It highlights the crowding-out effect: fiscal expansion raises interest rates, which partially offsets the stimulus by reducing private investment. It also shows the liquidity trap: when interest rates reach zero (LM is flat), monetary policy cannot lower them further, making fiscal policy the only effective demand stimulus. The model was extended to the open economy by Mundell and Fleming.

Frequently Asked Questions

What does the IS curve represent?

The IS curve represents combinations of the real interest rate and GDP at which the goods market is in equilibrium (investment equals saving, or equivalently, aggregate expenditure equals output). It slopes downward because lower interest rates stimulate investment, raising equilibrium output.

What shifts the IS curve?

The IS curve shifts rightward with: increased government spending, tax cuts, higher consumer confidence (more consumption), increased investment optimism, or higher export demand. It shifts leftward with fiscal consolidation, lower confidence, or a fall in exports. Each shift changes the equilibrium output at every interest rate level.

What is the liquidity trap?

A liquidity trap occurs when interest rates are at or near zero and monetary policy loses its effectiveness. At very low rates, people prefer to hold money (liquidity) rather than bonds because they expect interest rates to rise (bond prices to fall). In this situation, increasing the money supply does not lower interest rates further, and monetary stimulus has no effect on output — a situation Keynes described and that reoccurred during the 2008 crisis and the COVID-19 recession.

What is the crowding-out effect?

When fiscal policy raises government spending (shifting IS right), equilibrium output and interest rates both rise. The higher interest rates reduce private investment and consumption, partially offsetting the fiscal stimulus. This is crowding out — government borrowing displaces private spending. In the extreme classical case (vertical LM), full crowding out occurs and fiscal policy has no net effect on output.

How does the IS-LM model apply to open economies?

The Mundell-Fleming model extends IS-LM to an open economy with international capital flows and a balance of payments constraint. Under fixed exchange rates and perfect capital mobility, fiscal policy is very effective (no crowding out because the exchange rate is fixed) while monetary policy is ineffective (money supply changes are offset by capital flows). Under floating rates, monetary policy is effective and fiscal policy is largely crowded out by exchange rate appreciation.

About this simulation

The diagram plots two schedules in interest-rate/output space: the IS curve, where planned spending equals output, and the LM curve, where money demand equals money supply. Wherever the curves cross gives the short-run equilibrium output Y* and interest rate r*, recalculated live as you adjust spending, taxes, the money supply, or the sensitivity parameters. Moving a slider redraws both curves and slides the equilibrium dot to its new position, whilst the previous curves briefly show dashed so the shift is visible.

🔬 What it shows

How goods-market equilibrium (the IS curve) and money-market equilibrium (the LM curve) combine to determine output and the interest rate together, alongside the fiscal multiplier and crowding-out readouts below the graph.

🎮 How to use

Drag the Gov. Spending G, Money Supply M, Tax T, Investment sensitivity b, Money demand h and Price level P sliders, or click Fiscal Expansion, Monetary Expansion or Tax Cut for a preset shock; Reset restores the baseline (G=200, M=800, T=150, b=30, h=40, P=1.0).

💡 Did you know?

John Hicks sketched the IS-LM apparatus in his 1937 paper "Mr. Keynes and the Classics", written months after Keynes's General Theory appeared; he later shared the 1972 Nobel Memorial Prize in Economic Sciences.

Frequently asked questions

Why does the IS curve slope downward here?

A lower interest rate cuts the cost of borrowing, raising investment and equilibrium output. The Investment sensitivity slider b sets the steepness: a larger b flattens the curve.

Why does the LM curve slope upward?

Higher output raises money demand; with supply and prices fixed, the rate must rise to keep demand equal to the fixed real money stock, so LM slopes upward.

What happens when I click Fiscal Expansion?

Gov. Spending jumps higher, shifting IS rightward. The new equilibrium shows higher output and a higher rate, and Crowding-out reports how much extra spending is offset by that rate rise.

What does the Crowding-out figure mean?

It estimates how much the equilibrium rate rises per unit of extra spending, after the fiscal multiplier. A larger rise means private investment is displaced more, partly cancelling the stimulus.

How would a liquidity trap show here?

Push Money demand h very high and LM turns flat, so raising Money Supply barely moves the rate or output — showing why monetary policy loses traction near zero rates.