Is–Lm Model

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Is–Lm Model

FROM HICKS’S IS-LL MODEL TO THE TEXTBOOK IS-LM MODEL

Macroeconomics is a subfield of economic theory that is concerned with the study of economies as a whole. It bears on aggregate variables and is geared toward providing policy advice. The IS-LM model was the prevailing macroeconomic model from the 1950s to the 1970s.

FROM KEYNES TO HICKS

The origin of the IS-LM model is to be found in The General Theory of Employment, Interest, and Money (1936) by John Maynard Keynes (1883–1946). This book was written in the aftermath of the Great Depression of the 1930s, a time of great disarray, with unemployment reaching peak levels while no remedy seemed to be available to fix the ailing economic system. The general confusion did not spare academic economists, who were torn between their expertise and their gut instincts. According to economic theory, unemployment must have been caused by real wages being too high, so decreasing them should be the remedy. Yet the economists’ instincts told them that this was untrue, and the remedy lay in state-induced demand activation. Keynes’s book aimed at solving this contradiction by providing a theoretical basis for the economists’ gut feelings. The proposed path was to generalize Marshallian theory, which was exclusively concerned with partial equilibrium analysis, so as to enable it to address issues related to interdependency across markets. Keynes’s hunch was that unemployment was due to deficient aggregate demand, the cause of which had its roots in the money market or finance.

Keynes’s book was kaleidoscopic, mingling several threads of reasoning. Its central message was clarified when three young economists—James Meade (1907–1995), Roy Harrod (1900–1978), and John Hicks (1904–1989)—presented their interpretations of Keynes’s book at the European meeting of the Econometric Society in Oxford in September 1936 (see Young [1987] for a vivid account of the event). Of the three papers, Hicks’s (1937) came to prominence. It contained the first version of what was to become the IS-LM model. Hicks succeeded in transforming Keynes’s convoluted reasoning into a simple system of simultaneous equations comprehensible to working economists. Hicks’s paper also included an ingenious graph, allowing the outcome of two distinct markets to be represented in one simple two-dimensional diagram. At the time, Hicks could not have imagined the success his model would later encounter. In effect, it became the organizing theoretical apparatus of the emerging discipline of macroeconomics, in spite of the fact that its ability to capture the central message of the General Theory has been questioned by several interpreters of Keynes’s work. Hicks’s original diagram is shown in Figure 1.

This diagram resembles the Marshallian scissorlike representation of the matching of supply and demand in a given market, but its content is totally different. First, it

does not relate to a single market. Second, the two functions it displays are not supply and demand. Instead, it sets the interest rate on the vertical axis, and the aggregate nominal income on the horizontal axis. The downward-sloping IS curve is the combination of income (I, to become Y in the subsequent literature) and the interest rate (r ), for which investment (a function of interest rates) and saving (a function of income) are equal. It is assumed that investment varies inversely with the rate of interest and that saving increases with income. Higher income implies higher saving. As a result, in order for investment to equal saving, the rate of interest must be lower. This explains the inverse relationship between income and the interest rate. The upward-sloping LL curve represents the combination of income and the interest rate that keeps the demand for and the supply of money equal. In the money market, a given supply of money faces a demand for money, which is a function of income and the interest rate. As income increases, the transaction demand for money increases. The other component of the demand for money is liquidity preference. Holding money entails the opportunity cost of foregoing interest on bonds. Hence, the higher the interest rate, the lower this second component of the demand for money. Assuming a fixed supply of money, an increase in income involves a higher transaction demand for money. In order for the total demand for and supply of money to match, the liquidity preference part of the total demand must decrease. This requires a higher interest rate. Hence the upward slope of the LL curve.

Hicks located the essential difference between Keynes and the classical economists in the shape of the LL curve. According to Hicks, Keynes’s system becomes “completely out of touch with the classical world” (1937, p. 154) whenever the LL curve exhibits a horizontal section with the IS and the LL curves intersecting on this section. In this situation, which came to be called the liquidity trap, monetary expansion—unlike fiscal policy—is unable to increase employment.

FROM HICKS’S IS-LL MODEL TO THE TEXTBOOK IS-LM MODEL

Hicks’s model was not to become the canonical IS-LM model. Franco Modigliani (1918–2003) was the economist responsible for the transition from the Hicks’s model to the IS-LM formulation (Modigliani 1944). Another influential economist in this move was Alvin Hansen (1887–1975) (1949, 1953). While dismissing the role of liquidity preference, Modigliani argued that a Keynesian outcome was sure to arise whenever two factors were jointly present: a particular shape of the labor supply curve (supposed to capture the sociological elements that affected the labor supply) and some form of money disturbance, in particular, an insufficient quantity of money. In this recasting, the classical and the Keynesian submodels become more sharply opposed than they had been in Hicks’s original paper (see De Vroey 2000). The classical model now featured flexible wages and generalized market clearing, the Keynesian model’s downward-rigid wages, and (possibly) involuntary unemployment. According to Modigliani, the Keynesian model is characterized less by a lack of investment than by a maladjustment between the quantity of money and the money wage, the latter being too high relative to the quantity of money. The proper remedy for this situation is an increase in the money supply.

For some twenty-five years after the end of World War II (1939–1945), the IS-LM model dominated macroeconomics. By degrees, standard textbooks adopted the IS-LM model as their framework. It was enriched in various ways by the consideration of open economies, the integration of the Phillips curve, and attempts at giving microfoundations to the consumption function, portfolio decisions, and investment schedules. The success of the IS-LM model can also be explained by its adaptability to econometric modeling.

As the model became more dominant theoretically, it lost its Keynesian character with respect to practical policy issues. That is, non-Keynesians could simply state that only its classical variant was valid, its Keynesian variant being flawed by its ad hoc assumption of rigid wages. Thus, friends and foes of Keynes alike could use the model to promote or refute Keynesian policy prescriptions.

There are several reasons for the success of the IS-LM model. First, it made Keynes’s theory tractable. Second, it provided a simplified account of interdependency across markets, allowing the interrelationships between fundamental macroeconomic variables such as income, interest rate, saving, investment, and the supply and demand for money to be studied. Third, the model prompts interesting comparative statics exercises. For example, an increase in the propensity to invest shifts the IS curve to the right, and an increase in the money supply moves the LM curve to the right. Fourth and finally, it has proven to be resilient in the face of criticism.

THE DEMISE OF THE IS-LM MODEL

In the 1970s the dominance of the IS-LM model was strongly challenged as part of a broader offensive against Keynesian theory led by new classical economists, such as Robert E. Lucas and Thomas Sargent. The model’s demise accompanied the dethroning of Keynesian macroeconomics, centered on the study of unemployment, and its replacement by dynamic stochastic Walrasian macroeconomics in which the issue of unemployment has only a minor place.

Flaws in the IS-LM model that had until then been overlooked were now fully exposed: the sloppy microfoundations of the model, its lack of consideration for expectations, its lack of connection with long-period analysis, and the inability of macroeconometric models to guide the choice between alternative economic policies.

However, the IS-LM model lives on. While no longer central to the graduate training of most macroeconomists or to cutting-edge macroeconomic research, it continues to be a mainstay of undergraduate textbooks, finds wide application in areas of applied macroeconomics away from the front lines of macroeconomic theory, and lies at the conceptual core of most governmental and commercial macroeconometric models.

SEE ALSO Hicks, John R.; Keynes, John Maynard; Macroeconomics; Mundell-Fleming Model