Origins
The year after Keynes's General Theory (1936) appeared, John Hicks (1937), in "Mr. Keynes and the 'Classics'," summarized Keynes's central argument as two equilibrium conditions. Alvin Hansen (1953) spread it through textbooks, so it is also called the Hicks–Hansen model, and Modigliani (1944) extended it with nominal wage rigidity. For decades IS-LM became the standard framework for macroeconomics teaching and policy analysis and the core of the neoclassical synthesis that compared Keynesian and classical economics within a single framework.
The two curves and equilibrium
The IS (investment–saving) curve shows combinations of interest rate and income at which the goods market clears. A lower interest rate raises investment and, through the multiplier, income, so the IS curve slopes downward; higher government spending or tax cuts shift it right. The LM (liquidity preference–money supply) curve shows combinations at which the money market clears. Higher income raises transactions demand for money, so with a given money supply the interest rate must rise: the LM curve slopes upward, and a larger money supply shifts it right. Their intersection sets equilibrium interest rate and output. Expansionary fiscal policy raises income but also the interest rate, reducing some private investment: crowding out. In a liquidity trap, where LM is flat, monetary policy is powerless and fiscal policy is most effective; in the classical case of a vertical LM, fiscal policy is fully crowded out. This dispute over slopes was at the heart of the 1960s Keynesian–monetarist debate (Friedman, 1970).
Extensions, critiques and today
Poole (1970) used IS-LM to derive a theory of instrument choice, showing that an interest-rate target beats a money-supply target when IS shocks are large, and the open-economy extension is the Mundell–Fleming model. Critiques abound. Leijonhufvud (1968) argued that IS-LM distorted Keynes's treatment of uncertainty and expectations, and Hicks (1980) himself acknowledged its reliance on equilibrium concepts. After the Lucas critique of the 1970s it was faulted for lacking microfoundations, and at the research frontier it was replaced by dynamic stochastic general equilibrium (DSGE) models. Yet Krugman (1998) revived the liquidity trap by analyzing Japan's prolonged slump with IS-LM, and the model regained attention at the zero lower bound after the 2008 financial crisis. David Romer (2000) proposed an IS-MP model that replaces LM with a monetary policy rule, reflecting that central banks set interest rates rather than the money supply. De Vroey and Hoover (2004) called this its strange persistence.
FAQ
- What is the IS-LM model in simple terms?
- It is a short-run macro model in which interest rates and national income are set where the goods market and the money market are both in balance, used to analyze fiscal and monetary policy.
- What is crowding out?
- When government spending rises, higher income raises money demand and pushes up interest rates, which reduces private investment and partly offsets the stimulus.
Sources reviewed: 2026-10-26
References
- Hicks, J. R. (1937). Mr. Keynes and the "Classics": A suggested interpretation. Econometrica, 5(2), 147–159.
- Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. London: Macmillan.
- Hansen, A. H. (1953). A Guide to Keynes. New York: McGraw-Hill.
- Modigliani, F. (1944). Liquidity preference and the theory of interest and money. Econometrica, 12(1), 45–88.
- Hicks, J. R. (1980). IS-LM: An explanation. Journal of Post Keynesian Economics, 3(2), 139–154.
- Poole, W. (1970). Optimal choice of monetary policy instruments in a simple stochastic macro model. Quarterly Journal of Economics, 84(2), 197–216.
- Friedman, M. (1970). A theoretical framework for monetary analysis. Journal of Political Economy, 78(2), 193–238.
- Romer, D. (2000). Keynesian macroeconomics without the LM curve. Journal of Economic Perspectives, 14(2), 149–169.
- Krugman, P. R. (1998). It's baaack: Japan's slump and the return of the liquidity trap. Brookings Papers on Economic Activity, 1998(2), 137–205.
- Leijonhufvud, A. (1968). On Keynesian Economics and the Economics of Keynes. New York: Oxford University Press.
- De Vroey, M., & Hoover, K. D. (Eds.). (2004). The IS-LM Model: Its Rise, Fall, and Strange Persistence. Durham: Duke University Press.
- Mankiw, N. G. (2022). Macroeconomics (11th ed.). New York: Worth Publishers.
- Blanchard, O. (2021). Macroeconomics (8th ed.). Boston: Pearson.