Political Economy Keynesian Economics Questions Medium
The IS-LM model is a key framework in Keynesian economics that analyzes the relationship between interest rates, output, and the goods and money markets in an economy. It was developed by John Hicks and Alvin Hansen in the 1930s as a way to understand the impact of fiscal and monetary policies on aggregate demand and economic equilibrium.
The IS curve represents the equilibrium in the goods market, showing the combinations of interest rates and output levels where total spending (aggregate demand) equals total production (aggregate supply). It is derived from the Keynesian cross diagram, which shows the relationship between aggregate demand and income. The IS curve slopes downward, indicating that as interest rates decrease, investment increases, leading to higher output and vice versa.
The LM curve represents the equilibrium in the money market, showing the combinations of interest rates and income levels where the demand for money equals the supply of money. It is derived from the liquidity preference theory, which states that individuals hold money for transactional and speculative purposes. The LM curve slopes upward, indicating that as income increases, the demand for money increases, leading to higher interest rates and vice versa.
The intersection of the IS and LM curves determines the equilibrium interest rate and output level in the economy. This point represents the level of aggregate demand that is consistent with the supply of money and goods. If the economy is below this equilibrium point, there is a deficiency in aggregate demand, leading to unemployment and a recession. In this case, expansionary fiscal or monetary policies can be used to shift the IS or LM curve, increasing aggregate demand and stimulating economic growth.
Conversely, if the economy is above the equilibrium point, there is excess aggregate demand, leading to inflationary pressures. In this case, contractionary fiscal or monetary policies can be used to shift the IS or LM curve, reducing aggregate demand and controlling inflation.
Overall, the IS-LM model provides a framework for understanding the interaction between interest rates, output, and the goods and money markets in Keynesian economics. It helps policymakers analyze the impact of fiscal and monetary policies on the economy and make informed decisions to stabilize economic conditions.