IS-LM

IS-LM is the graphical apparatus introduced by John Hicks in his 1937 Econometrica paper “Mr. Keynes and the Classics” — a translation of Keynes’s General Theory into a two-curve diagram on output / interest-rate axes. Alvin Hansen’s 1953 A Guide to Keynes developed it pedagogically; Paul Samuelson’s Economics (1948 onward) put it in front of a generation of undergraduates; by the late 1950s it was the canonical graphical statement of the Keynesian system in English-speaking academic macroeconomics. It remained the dominant teaching device through the 1970s and survives in modified form in contemporary intermediate-macro texts. Substantively, it is the framework against which the monetarist policy debate of the 1960s and 1970s was conducted, against which the Lucas critique was directed, and out of which the modern New Keynesian 3-equation model was reconstructed.

The two curves

The IS curve plots combinations of output (Y) and the interest rate (r) at which the goods market is in equilibrium — investment equals saving in the closed-economy version. Higher interest rates reduce investment; reduced investment reduces aggregate demand; reduced aggregate demand reduces equilibrium output. The IS curve is therefore downward-sloping in (Y, r) space.

The LM curve plots combinations of output and the interest rate at which the money market is in equilibrium — money demand equals money supply. Higher output increases transactions demand for money; with money supply fixed by the central bank, this requires a higher interest rate to clear the money market by reducing speculative demand. The LM curve is therefore upward-sloping.

Their intersection determines simultaneous equilibrium in goods and money markets. Fiscal expansion shifts the IS curve right; monetary expansion shifts the LM curve right. The framework allows immediate graphical analysis of the relative effectiveness of fiscal and monetary policy, the consequences of liquidity traps (flat LM at very low interest rates), and the comparative statics of various shocks.

What it captures

• Joint determination of output and the interest rate by goods- and money-market equilibrium. Pre-Keynesian classical theory had treated the interest rate as determined in the loanable-funds market and output as supply-determined. IS-LM showed that under Keynesian assumptions the interest rate is jointly determined with output, with money-market conditions playing a role classical theory had denied.

• The relative effectiveness of fiscal vs monetary policy. Steeply-sloping LM (high money-demand interest sensitivity, the “liquidity trap” extreme) makes fiscal policy more effective. Steeply-sloping IS (low investment interest-sensitivity) makes monetary policy less effective. The 1960s “fiscalist vs monetarist” debate was largely conducted as a dispute over which slope was empirically larger.

• Stabilisation policy as routine practice. The framework supports continuous calibration of fiscal and monetary instruments to stabilise output near full employment — the operating intuition of 1960s Old Keynesian policy advice.

What it does not capture

• Inflation, prices, and expectations. The standard IS-LM diagram is in nominal interest-rate / output space and treats the price level as fixed. Extending it to handle inflation requires the further AD-AS apparatus or an explicit Phillips-Curve appendage; expectations enter only awkwardly. The framework’s inability to handle the inflation-expectations dynamics of the 1970s was central to its postwar reputation breaking.

• Microfoundations. The behavioural equations (consumption function, investment function, money-demand function) are aggregate empirical regularities, not derivations from explicit individual optimising behaviour. The Lucas critique argued — with substantial force — that this is a methodological vice, not just a missing derivation.

• Financial-system structure. The “money market” of the LM curve abstracts entirely from the financial-intermediation system that actually sets interest rates and creates credit. Bank balance sheets, leverage, fire-sale dynamics, and the entire macro-prudential dimension are absent. The 2008 crisis exposed the cost of this abstraction.

• Open-economy mechanics. The basic IS-LM is closed-economy. The Mundell-Fleming extension (IS-LM-BP) adds an external balance, with sharp implications for fiscal-vs-monetary effectiveness under fixed and floating exchange rates — but the extensions are stylised and have not been the framework of choice for serious open-economy work since the late 1980s.

Standard criticisms

• Hicks’s own reservations. In a 1980 Journal of Post Keynesian Economics paper “IS-LM: An Explanation,” Hicks distanced himself from the apparatus he had originated, arguing it had been over-identified with Keynes’s actual position and had outlived its usefulness as a framework for thinking about a fundamentally non-equilibrium economy. The textbook tradition substantially ignored this reservation.

• The Phelps-Friedman natural-rate critique. IS-LM does not generate a natural-rate constraint on output; the framework as standardly used implies that monetary stimulus can produce sustained reductions in unemployment. The natural-rate hypothesis of Friedman 1968 and Phelps 1967 was, in part, a critique of the policy intuition IS-LM had supplied.

• The Lucas critique. Estimated IS-LM coefficients (the slopes of the two curves, the multiplier estimates) are functions of the prevailing policy regime. Using IS-LM to evaluate alternative policy regimes is, on Lucas’s argument, methodologically invalid. This is the deepest critique the framework received and the one that ended its run as an active research apparatus.

• Post-Keynesian objections. Post-Keynesians — particularly Davidson, Robinson, and the Cambridge UK tradition — argue that IS-LM systematically misrepresents Keynes by treating the interest rate as a market-clearing variable. Keynes’s actual position was that the interest rate is a monetary phenomenon set by liquidity preference and convention, not an equilibrium variable; IS-LM’s market-clearing framing reconciles Keynes with classical equilibrium analysis at the cost of the substantive Keynesian position.

Descendants

The contemporary New Keynesian 3-equation model is recognisably an IS-LM descendant. The Euler-equation IS curve replaces the static IS with a forward-looking optimising version; the central-bank Taylor rule replaces the LM curve with an explicit interest-rate reaction function (eliminating the need for money-market equilibrium altogether); the New Keynesian Phillips Curve adds an inflation-output link the original IS-LM lacked. The skeleton — output and interest rates jointly determined, with explicit roles for fiscal and monetary instruments — survives. The microfoundations and the expectations apparatus are wholly new.

Pedagogy and current status

IS-LM remains in the standard intermediate-macroeconomics curriculum at most universities, typically presented with explicit caveats about its limitations and as a stepping-stone to the New Keynesian 3-equation model. As a research tool it is dead and has been since the late 1980s. As a teaching tool it is contested: pedagogical conservatives argue that it builds the joint-equilibrium intuitions students need before they can reason about more sophisticated frameworks; reformers argue that teaching IS-LM at all in the 2020s is teaching students to think with an apparatus the field has rejected. The dispute is unresolved and largely a matter of departmental choice.