IS–LM model

The IS- LM model ( Investment Saving / Liquidity preference Money supply) is a model from the economics and describes the overall economic balance that by combining the equilibrium models to the real sector ( IS curve, goods market ) and to monetary sector ( LM curve, money market ) is created. In the extension of the model to the balance of payments (ZZ curve) one speaks of the Mundell- Fleming model (also IS -LM -ZZ model). For an extension of the model to an equilibrium in the labor market, the AS- AD model was developed.

History

The idea for the IS- LM model was born at a conference of the Econometric Society in Oxford in September 1936, ie eight months after the publication of the General Theory of Employment, Interest and Money by John Maynard Keynes. John R. Hicks published his paper to this conference in April 1937 under the title Mr. Keynes and the " Classics": A Suggested Interpretation. In 1937, appointed to Harvard Alvin Hansen also contributed to the IS- LM model and it was taught as a Hicks -Hansen synthesis in the USA and by Paul A. Samuelson in 1948 in his best-selling textbook Economics: An Introductory Analysis popularized. John Hicks himself later explained his dissatisfaction with the IS -LM model, which was rejected by students of Keynes as Joan Robinson, and described it as "a classroom gadget".

Hicks had stressed from the outset that the money supply must not be assumed to be constant in the LM function, because those in charge of monetary policy would prefer to expand the money supply in order to prevent a rise in interest rates. Thus, the elasticity of the LM curve rather depends on the elasticity of monetary policy.

Although the IS- LM model is taught at the universities as Keynesian model, it has not really the knowledge and insights of Keynes, but it is an officially so designated Neoclassical synthesis and reduces the theories of Keynes on a general equilibrium model. Because after the global economic crisis, the reputation of classical and neoclassical economics was ruined, some approaches to the criticism of Keynes have been taken, such as that money is not neutral and the labor market does not take a long time to equilibrate to incorporate them into the neoclassical ideas and then as Keynesian model to present to the audience. Franco Modigliani even claimed in his article Liquidity Preference and the Theory of Interest and Money ( Econometrica, 1944), the only difference between Keynes and the classical economists would be the rigidity of wages.

Joan Robinson called the representatives of the so-called neo-Keynesianism, ie the neoclassical synthesis and the IS-LM model, as a bastard Keynesians who would are wrong to rely on Keynes.

The model is currently being criticized because the central banks no longer pay attention to the money supply and the model does not treat the key areas for investment real interest rate. As a new standard model, a Keynesian consensus model is discussed, in which the central bank no money supply controls, but according to the Taylor rule determines the interest rate.

Background

The IS- LM model is concerned with the total size of an economy. The decisive factors are the equilibrium in the goods market ( aggregate demand for goods = total economic supply of goods = national income ) as well as the money market ( money demand = money supply ). The IS curve represents a goods market equilibrium curve. As such, it represents all combinations of interest rate ( i) and national income (Y), for which the goods market is in equilibrium. The LM curve is a money market equilibrium curve and indicates all combinations of interest rate ( i) and national income (Y ), an equilibrium exists for those on the money market. The intersection of the IS curve with the LM curve, there is a simultaneous equilibrium of the goods market and the money market and thus overall economic balance.

This equilibrium point is reached, however, only in theory, because in practice it is constantly changes according to Keynes, which lead to a shift of the equilibrium point. In the IS - LM model is therefore investigated the effects of various imbalances.

Definitions

The IS- LM model is considered in the neoclassical context, that is, it is assumed that flexible wages.

Market Equilibrium (IS Curve):

• C: Private Consumption
• Y: national income
• I: investment in the formulas is often called " IS " is used
• I: interest rate
• G: government consumption

The IS curve has a negative slope because the investment ( I) with increasing interest rate ( i) remove, so the goods market only at a lower national income (Y) may be in equilibrium.

Money market equilibrium ( LM curve ):

• L: Demand for money ("L " stands for Liquidity preference )
• Y: national income
• I: interest rate
• M: nominal money supply ("M " stands for money supply)
• P: price level
• Real money supply

The LM curve is upward sloping because the demand for money (L ) with increasing national income (Y ) increases. With the increased demand for money, however, the money market can only be at a higher interest rate ( i) in equilibrium.

Effect chains

If the state appears on the goods market itself as a consumer, then the IS curve shifts to the right. Depending on the position of the LM curve, this may mean an increase in national income Y. This kind of expansive fiscal policy can be initiated via deficit spending.

Hold down the households increased speculation fund ( which is the holding money to fall back with a favorable interest rate and security price on these can ) then affects the deficit spending as an initial ignition of the economy. This is justified by the fact that the multiplier is set ( in this case the government spending multiplier ) in motion.

The operation of the multiplier is simple: Any increase in demand (in this case by the state ) in the goods market, then of course also increases the production. If production increases, then the entrepreneurs need more workers. They will get a salary that they consume partially (depending on the marginal propensity to consume ). The resulting additional consumption initiates a further expansion of production, which means that workers will be needed again again, which in turn relate to a konsumierendes content.

This idea of ​​government debt is not, as is often assumed to Keynes, but Abba P. Lerner on back. However, Keynes called for reserves previously formed. Since deficit spending ( the rightward shift of the IS curve ) represents a debt of the State, should this when the economy is flourishing, the debt back pay due to increased tax revenues ( Surplus saving ). The state thus operates a counter-cyclical economic policy to smooth the business cycle fluctuations. Hold down the households, however, only cash transactions (that is the amount of money that is needed to purchase goods ), then this policy has due to the vertical position of the LM curve means that only the interest rate rises and the national income remains the same. This condition is called crowding-out ( crowding out of private demand, which may occur as a result of increase in government spending ).

Hicks Chart

In the presentation of the IS-LM functions in the first quadrant is the so-called Hicks - diagram is named after John R. Hicks.

Model extension

The traditional IS- LM model explains macroeconomic equilibria only for closed economies and without taking into account the labor market. Taking account of balance of payments contexts, the model can also model more open economies. For this purpose, it is a third curve, the so-called extended ZZ curve. This represents all combinations of interest rate and income for which there is a balanced balance of payments.

Criticism

In the current economics, the IS / LM model as well as the AS / AD model is now viewed as an outdated model structure, but which is still found in many textbooks. It is now believed that a central bank sets the interest rate for central bank money, while respecting its inflation target is anxious without cause with its monetary policy a larger output gap by a recession or even depression. The central bank does not conduct monetary policy and interest rate for central bank money is not an equilibrium interest rate on a money market, but is determined by the central bank. Demand and investment are negatively affected by interest rates. The assumption is that the real interest rate, while the IS / LM model knew no difference between nominal interest rate and real interest rate.

Early on the economic application of the model has been criticized. Thus, it remains questionable whether a government demand policy actually leads to more economic growth and reduce unemployment. This effect will be weaker when parts of the additional income will be saved from the households, or when goods are consumed, resulting from the few new jobs. This problem also recognized Keynes and therefore advocated the increase of government consumption, which can be steered in labor-intensive sectors.

A politico -economic problem results, provided that the willingness to save in boom times fails too low, because these can not convey politically. In this case, the model often leads in practice to ever-increasing national debt.

Milton Friedman criticized lags according to his theory of the so-called Time that so much time between the decline in consumption and the workings of government demand programs vanishing, that the economy has already recovered most of its own and is in a boom phase. The additional government consumption, the economy will overheat and it comes to inflation.

A more fundamental criticism of the model assumptions was formulated in recent years by John B. Taylor and David Romer. These two economists point out that the real interest rates and nominal interest rates are not relevant to investors. Therefore, the IS curve is not removed correctly in the model (or should be moved with the rate of inflation). In particular, however, they criticize the assumption of a fixed money supply by the central bank. To describe the central bank through an interest rate rule, the so-called Taylor rule is reality closer. The central bank can control this with the help of their lending to the banks of the nominal and real interest rate of the economy. She is acting with the aim of stabilizing the economy and increases the real interest rate in the boom or when inflation is high and lowers it in the recession or deflation. Fluctuations in the money supply are only a concomitant of the modeling in this analysis. The critique can thereby be taken into account in the model that the LM curve, which describes an equilibrium in the money market, is replaced by a policy rule.