The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates and real output, in the goods and services market and the money market (also known as the assets market). The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves is the "general equilibrium" where there is simultaneous equilibrium in both markets.
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- The IS-LM model appears to describe well the behavior of the economy in the short run. In particular, the effects of monetary policy appear to be similar to those implied by the IS-LM model once dynamics are introduced in the model. An increase in the interest rate due to a monetary contraction leads to a steady decrease in output, with the maximum effect taking place after about eight quarters.
- Olivier Blanchard, Macroeconomics, 7th ed. (2017), Chap. 5: Goods and Financial Markets; The IS-LM Model
- Yes, IS-LM simplifies things a lot, and can’t be taken as the final word. But it has done what good economic models are supposed to do: make sense of what we see, and make highly useful predictions about what would happen in unusual circumstances. Economists who understand IS-LM have done vastly better in tracking our current crisis than people who don’t.