Introduction: Why Should You Care About IS-LM?
Imagine that you want to take an education loan for your master’s degree. The bank tells you that the interest rate on your loan has increased. Suddenly, your monthly EMI becomes more expensive. You may decide to borrow less, delay your studies, or look for a cheaper option.
Now imagine a family planning to buy a house. If interest rates fall, home loans become cheaper. More people may decide to buy houses. Builders receive more orders. Construction companies hire more workers. Cement, steel and other industries also become busier.
At the same time, suppose the government announces a large infrastructure programme. It spends more money on roads, railways and bridges. This creates demand for goods and services and can increase employment.
So we have two important questions: What happens to national income when government spending changes? And what happens when interest rates or the money supply change?
This is where the IS-LM model becomes extremely useful.
The IS-LM model is one of the most important models in introductory macroeconomics. It brings together two markets: the goods market, where total spending and production interact, and the money market, where money demand and money supply determine the interest rate.
Think of these as two gears in the same machine. The economy reaches equilibrium only when both gears are working together.
By the end of this article, you should be able to:
Understand what IS and LM actually mean.
Derive the IS curve.
Derive the LM curve.
Explain why IS slopes downward and LM slopes upward.
Draw and interpret IS-LM diagrams.
Solve IS-LM numerical questions.
Understand fiscal and monetary policy.
Explain crowding out.
Understand liquidity traps.
Connect the model with RBI policy, government spending and real-life economic events.
1. What Is the IS-LM Model and Why Was It Created?
The basic idea
The IS-LM model explains how the interest rate and national income are jointly determined by conditions in the goods market and the money market.
IS stands for Investment = Saving. LM stands for Liquidity preference = Money supply. The names come from the equilibrium conditions used to describe the two markets.
The model is associated with the work of John Maynard Keynes, and its formal development is strongly associated with John Hicks and later Alvin Hansen. Hicks developed the IS-LM framework as an interpretation of Keynes’s ideas, while Hansen helped popularise and develop the framework.
The model is useful for understanding the Keynesian idea that changes in aggregate demand can affect output and employment, especially when the economy has unused resources.
What question does IS-LM answer?
Suppose the government increases spending. Will output increase? Probably yes. But will the interest rate also change? Yes. And if the interest rate rises, private investment may fall. Therefore, we cannot study government spending in isolation.
Similarly, suppose the central bank increases the money supply. The interest rate may fall. Lower interest rates can encourage investment. Investment increases demand. Demand increases output. So the goods market and money market interact.
Where does it fit into the DU syllabus?
For students of B.A. (Hons.) Economics at Delhi University and similar undergraduate programmes, IS-LM is commonly connected with Keynesian macroeconomics and topics such as:
Keynesian income determination
Consumption and investment
Multiplier
Money demand
Liquidity preference
Monetary policy
Fiscal policy
Aggregate demand
AD-AS analysis
Always match the discussion with your specific college and semester syllabus because course structures can change.
Quick check: What two markets are studied in the IS-LM model?
Answer: The goods market and the money market.
2. The Goods Market and the IS Curve
Let’s start with the goods market. Imagine the entire economy as a giant shop. Firms produce goods and services. Households buy them. Firms invest. The government spends. The value of total production must eventually be related to total expenditure.
2.1 Expenditure equation
Y = C + I + G
Y is national income/output, C is consumption, I is investment, and G is government expenditure.
The important point is: the goods market is in equilibrium when output equals planned expenditure.
2.2 Consumption function
People generally consume more when their income increases, but they do not usually spend every additional rupee they earn.
C = C̄ + c(Y − T)
C̄ is autonomous consumption, c is the marginal propensity to consume (MPC), Y is income and T is taxes.
Autonomous consumption means consumption that does not depend directly on current disposable income. Even when current income is temporarily low, households still need food, electricity and transport.
The marginal propensity to consume tells us how much of an additional rupee of disposable income people spend. If MPC = 0.75, an extra ₹1 of disposable income leads to ₹0.75 of additional consumption.
2.3 Investment and the interest rate
Investment usually falls when the interest rate rises. Imagine a company wants to borrow ₹10 crore to build a new factory. If the interest rate is 5%, borrowing is relatively cheaper. If it becomes 10%, some projects may no longer be profitable.
Therefore: higher interest rate → lower investment; lower interest rate → higher investment.
I = Ī − br
Ī is autonomous investment, b is interest sensitivity of investment, and r is the interest rate.
2.4 Deriving the IS curve
Start with goods-market equilibrium:
Y = C + I + G
Substitute the consumption and investment functions:
Y = C̄ + c(Y − T) + Ī − br + G
Rearranging:
(1 − c)Y = C̄ − cT + Ī + G − br
Therefore:
Y = [C̄ − cT + Ī + G − br] / (1 − c)
This is the IS equation. It gives combinations of income and interest rate that keep the goods market in equilibrium.
2.5 Why does IS slope downward?
Suppose the interest rate falls. Investment increases. Total expenditure increases. Firms increase production. Income rises. Therefore, lower interest rates are associated with higher equilibrium income. Hence the IS curve slopes downward.
2.6 What shifts the IS curve?
Increase in government spending → IS shifts right.
Tax cut → disposable income and consumption rise → IS shifts right.
Increase in autonomous consumption → IS shifts right.
Increase in business confidence/autonomous investment → IS shifts right.
2.8 What changes the slope of IS?
The slope depends mainly on the multiplier and the interest sensitivity of investment. The multiplier tells us how much total income changes after an initial change in autonomous expenditure.
Multiplier = 1 / (1 − c)
If MPC is high, the multiplier is large. If investment responds strongly to interest rates, IS tends to be flatter. If investment barely responds to interest rates, IS tends to be steeper.
Quick check: Why does the IS curve slope downward?
Answer: Because a lower interest rate increases investment, which increases planned expenditure and therefore equilibrium income.
3. The Money Market and the LM Curve
The money market asks: how much money do people want to hold, and how much money is available? There are two sides: money supply and money demand.
3.1 Money supply
Money supply is the quantity of money available in the economy. In the basic IS-LM model, the central bank is treated as controlling the nominal money supply. Real money balances are represented by M/P, where M is nominal money supply and P is the price level.
3.2 Why do people demand money?
Keynes discussed three motives for holding money.
Transactions motive
People need money for everyday purchases. As income rises, transactions generally increase, so transactions demand for money also rises.
Precautionary motive
People hold money for unexpected situations such as medical emergencies, repairs or temporary income loss.
Speculative motive
People may hold money instead of bonds because they are concerned about future interest rates and bond prices. When interest rates are very low, they may expect rates to rise later and prefer holding liquid money.
This broader desire to hold money is called liquidity preference.
3.3 Money demand function
L = kY − hr
L is demand for real money balances; k measures income sensitivity; h measures interest sensitivity. Money demand increases with income and decreases with the interest rate.
3.4 Deriving the LM curve
Money-market equilibrium occurs when real money supply equals real money demand:
M/P = L(Y,r)
Using L = kY − hr:
M/P = kY − hr
r = (k/h)Y − (1/h)(M/P)
This is the LM curve. It shows combinations of income and interest rate that keep the money market in equilibrium.
3.5 Why does LM slope upward?
Suppose income increases. People conduct more transactions and want to hold more money. If money supply is fixed, the interest rate must rise to reduce money demand and restore equilibrium. Therefore higher income is associated with a higher interest rate.
What shifts the LM curve?
An increase in money supply shifts LM downward/rightward because more money is available at each level of income. A decrease in money supply shifts LM upward/leftward.
The slope also depends on how strongly money demand responds to income and interest rates. If money demand is highly interest-sensitive, LM tends to be flatter.
Quick check: Why does LM slope upward?
Answer: Higher income increases money demand. With money supply fixed, the interest rate must rise to maintain money-market equilibrium.
4. Putting IS and LM Together: Equilibrium
The economy must satisfy both the goods-market and money-market conditions simultaneously. Therefore, equilibrium occurs where IS and LM intersect.
How to draw this: Draw a downward-sloping IS and an upward-sloping LM. Mark their intersection E. Draw dashed guides to Y* and r* if desired.
At the intersection, goods-market equilibrium and money-market equilibrium occur together. The coordinates give equilibrium income Y* and equilibrium interest rate r*.
What happens away from equilibrium?
To the right of IS, output can be too high relative to planned expenditure, causing inventories to build and firms to cut production. To the left of IS, planned expenditure can exceed output, inventories fall and firms have an incentive to increase production.
Below LM, the interest rate is too low for money-market equilibrium at that income, so there is excess demand for money and upward pressure on the interest rate. Above LM, money demand is relatively low and there is downward pressure on the interest rate.
Quick check: What does the intersection of IS and LM represent?
Answer: Simultaneous equilibrium in the goods market and money market.