Is Lm Model Definition Explained Macroeconomic Assumptions

IS-LM Model Definition

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The intersection of the IS and LM curves signifies equilibrium. From IS-LM Model, two interpretations emerge; first, it explains changes in national income at a fixed price level. Second, it explains why the aggregate demand curve moves. It is also used to study economic swings and find pertinent stabilization policies.

Key Takeaways

The IS-LM model is a macroeconomic tool that illustrates the link between interest rates and real production in the money and goods and services markets.The IS-LM model is an acronym for “investment-savings” (IS) and “liquidity preference-money supply (LM).Examining the models facilitates comprehension of the fluctuations in national income and the changes in the demand curve. This aids in the formulation of economic policies that stabilize economic swings.A significant shortcoming of the model is that it disregards the crucial time lag when analyzing the implications of economic policy changes.

IS-LM Model In Macroeconomics Explained

IS-LM Model is also called as Hicks-Hansen model. The “IS-LM Model” depicts the relationship between interest rates and the asset market (also known as actual output in goods and services and money markets). Higher the interest rate, the lesser the demand for money. This principle is utilized to model money and income in an economy.

The models are used to determine equilibrium or balance points. Or to locate values where the amount of money required and the amount of cash available for investment coincide. The analyses derived from the models are utilized to make macroeconomic policy decisions.

IS-LM BP model and IS-LM PC model are further applications of the LM model in macroeconomics. IS-LM PC model examines the output and inflation dynamics. The IS-LM model in open economy works as IS-LM BP model, which is an extension of the original one.

In the original IS-LM model, the vertical axis shows interest rates, whereas the horizontal axis shows total nominal income. The downward-sloping IS curve represents the area where investment (a function of interest rates) and savings (a function of income) are equal. Whereas, the upward-sloping LL curve illustrates the locations where the money stock matches the amount necessary to satisfy liquidity preference. Also, it is worth noting that the original diagrams included “LL” rather than “LM.”

IS-LM Model Assumptions

All businesses make similar products, which are utilized for consumption and residential investment.There is no influence of aggregate supply on the equilibrium level of income, defined by aggregate demand.The only assets in the financial-market are money and bonds.

IS-LM Graph

Two intersecting lines graphically represent the model. The horizontal axis Y represents national-income, often known as a real gross domestic product . Similarly, ‘i’ denotes the real interest rate on the vertical axis ‘X.’

IS refers to the investment and savings equilibrium. Implying total expenditure equals total output. Where total expenditure can include consumer spending, planned private investment, government purchases, and net-exports . Total output implies real-income or GDP Each point reflects equilibrium in savings and investment. Consequently, every interest rate level creates a particular amount of anticipated fixed investment and consumption.

The IS LM curve illustrates real income levels and interest rate combinations (when the money market is in equilibrium). An upward sloping curve depicts the relationship between finance and the economy. Each point on the curve represents a specific equilibrium position in the money market based on a certain income level.

The IS LM curve swings to the right as the liquidity preference function changes in response to an increase in GDP. IS LM curve adjustments are studied to anticipate a rise in interest rates. Therefore, the slope of the LM function is positive.

Since this model is non-dynamic, the nominal and real-interest-rate have a fixed connection. In addition to the predicted inflation rate, which is exogenous in the near run, both numbers are identical. Similarly, money demand relies on the nominal interest rate. This junction signifies a short-term balance in the real and financial industries. Hence, this circumstance produces a unique combination of the interest rate and real GDP (where both the money and product markets are in equilibrium).

Limitation

The IS-LM model serves as the conceptual foundation for the vast majority of governmental and commercial macro-econometric models. However, every model has certain limitations. Consequently, those of IS-LM Model are listed below:

Earlier models did not consider inflation. The model did not anticipate conditions in which prices would exhibit long-term upward or downward movements.The IS-LM model is predominantly static. It disregards the crucial time lag when analyzing the implications of economic policy changes. As a result, the use of the “Phillips-curve,” is done to address the model’s flaws.