IS-LM Model

Summary

Keynes could be thought of as a special theory of Hick's IS-LM model where S(Y), investment is relatively interest inelastic and liquidity preference rules interest rates.

Assumptions

Classicals 3 equations to determine unknowns Y, I & i

  1. M=kY - Y is income, M is demand for money
  2. I=K(i) where I is investment and K demand for capital
  3. I=S(i,Y) where S is savings

Keynes 3 equations: 

  1. M=L(i)
  2. I=K(i)
  3. I=S(Y)

Model/Theory

Hicks 3 equations:

  1. M=L(Y,i)
  2. I=K(Y,i)
  3. I=S(Y,i)

CC-curve = demand for investment

SS-curve = supply of savings

IS-curve = investment-savings eq. 

LM-curve = income-->interest rate curve.

Note: L-L is LM (for liquidity preference =money supply) and Y rather than I for income, Ix rather than I.

Predictions

  • Keynes view M--> i, Classical view M--> Y
  • Keynes view increase in inducement to invest or propensity to consumer will not raise rate of interest but only increase employment.

Evidence

Evaluation

  • Couldn't solve the liquidity preference vs loanable funds debate because IS-LM is an equilibrium model and the two theories are identical in equilibrium.
  • If L-M curve is vertical than you have Keynes
  • S-R bonds r < L-R bonds r in line with liquidity preference --> Theory of the term structure of interest rates + assumption of risk aversion --> positively sloped yield curve. However recently downward slope yield curves are not uncommon - where long-term rates are an average of the expected short-term rates over the same period (tho slightly biased because of liquidity preference)