From various theories like classical theory, loanable-fund theory, neo-classical theory of Pigou, and determining the rate of interest put forward from time to time, we have seen that all these theories suffer from various drawbacks and are indeterminate. The Keynesian theory considered only the monetary factors and the classical theory only the real factors as determining rate of interest. Modern economists have considered both types of factors, monetary and real. The economists like Prof. Hicks and Hansen have made a synthesis between these various theories and have given an adequate and determinate theory of interest. Prof. Hansen asserts that the classical and the Keynesian theories of Interest are indeterminate. Because according to this theory Interest rate determination depends on savings.

Prof. Hansen asserts that the classical or loanable fund formulation and the Keynesian formulation taken together, do supply us with an adequate theory of the rate of interest. The three critical exogenous (or external) variables in the IS-LM model are liquidity, investment, and consumption. Accordingly, liquidity is determined by the size and velocity of the money supply. The levels of investment and consumption are determined by the marginal decisions of individual actors.

The Hicks–Hansen synthesis, or IS-LM model, which stands for “investment-saving” (IS) and “liquidity preference-money supply” (LM), is a Keynesian macroeconomic model that shows how the market for economic goods interacts with the loanable funds market or money market. The IS-LM model describes how aggregate markets for real goods and financial markets interact to balance the rate of interest and total output in the macro-economy. It is represented as a graph in which the IS and LM curves intersect to show the short-run equilibrium between interest rates and output.

The IS-LM graph examines the relationship between output, or gross domestic product (GDP), and interest rates. The entire economy is summarized into two markets, output, and money, and their respective supply and demand characteristics push the economy toward an equilibrium point. IS-LM can be used to describe how changes in market preferences alter the equilibrium levels of gross domestic product (GDP) and market interest rates.

The IS Curve

The IS curve portrays the set of all levels of interest rates and output (GDP) at which total investment (I) equals total saving (S). At lower interest rates, investment is higher, which translates into more total output (GDP), so the IS curve slopes downward and to the right. Here, the interest rate is the independent variable, while income is the dependent variable. Notably, the curve is downward-sloping. The IS also shows the locus point where total income equals total spending.

The LM Curve

The LM curve portrays all levels of income (GDP) and interest rates at which money supply equals money (liquidity) demand. The LM curve slopes upward because higher levels of income (GDP) bring increased demand to hold money balances for transactions, which requires a higher interest rate to keep money supply and liquidity demand in equilibrium. In this case, the independent variable is income, while the dependent variable is interest rates. This curve represents the money market equilibrium. Also, it represents the set of points at equilibrium between liquidity preference (demand for money) and the money supply function. The LM curve depicts multiple equilibria in the asset market (money supplied equals money demanded) at various real interest rates and real output combinations.

The Intersection of the IS and LM Curves

The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when money markets and the real economy are in balance.

Adding additional IS and LM curves may represent multiple scenarios or points in time. In some versions of the graph, curves display limited convexity or concavity. Shifts in the position and shape of the IS and LM curves, representing changing preferences for liquidity, investment, and consumption, alter the equilibrium levels of income and interest rates.

Limitations of the IS-LM Model

Many economists, including Keynesians, object to the IS-LM model for its simplistic and unrealistic assumptions about the macroeconomy. It cannot account for simultaneous high unemployment and inflation in the economy. It is also undercut by the change by central banks to use an interest-rate rule rather than targeting the money supply. Even Hicks later admitted that the model’s flaws were fatal, and it was probably best used as “a classroom gadget, to be superseded, later on, by something better.”

Related Posts:

- THE CLASSICAL THEORY OF THE RATE OF INTEREST
- KEYNES’ LIQUIDITY PREFERENCE AND OTHER THEORIES OF INTEREST