# Understanding the IS-LM Model: Curves, Characteristics, and Limitations

![The Marriner S. Eccles Federal Reserve building during a renovation in Washington, DC, US, on Tuesday, Oct. 24, 2023. The Federal Reserve chair last week suggested the US central bank is inclined to hold interest rates steady again at its next meeting while leaving open the possibility of a future hike if policymakers see further signs of resilient economic growth. ](https://www.investopedia.com/thmb/jofAvpUrfjRW-KeIQa6WO7Cp8aU=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/GettyImages-1744774231-0619428be7b642fcb78d7559a7a67345.jpg)

*— Valerie Plesch / Bloomberg via Getty Images*

## What Is the IS-LM Model?

The IS-LM model, standing for "investment-saving" (IS) and "liquidity preference-money supply" (LM), is a foundational Keynesian [macroeconomic](https://www.investopedia.com/terms/m/macroeconomics.asp) concept. It illustrates the interaction between the goods market and the [money market](https://www.investopedia.com/terms/m/moneymarket.asp), using IS and LM curves to determine the short-run equilibrium of [interest rates](https://www.investopedia.com/terms/i/interestrate.asp) and output. British economist John Hicks introduced this model in 1937 as a formal representation of John Maynard Keynes' earlier theories on employment, interest, and money.

### Key Takeaways

*   The IS-LM model, introduced by economist John Hicks, illustrates the interactions between the real economy and financial markets to determine equilibrium interest rates and economic output.
*   The IS curve represents the relationship between interest rates and GDP where investment equals savings, with lower interest rates promoting higher investment and output.
*   The LM curve shows how money supply and demand balance at varying income levels and interest rates, with higher GDP increasing money demand and raising interest rates.
*   While the IS-LM model is a useful educational tool, its simplistic assumptions and inability to address issues like inflation and unemployment limit its practical application in modern economics.
*   Hicks himself regarded the model as a "classroom gadget," and it has been largely dismissed for policy-making due to its lack of specificity and relevance to current economic complexities.

## Origins and Development of the IS-LM Model

British economist [John Hicks](https://www.investopedia.com/terms/j/john-r-hicks.asp) first introduced the IS-LM model in 1937, not long after fellow British economist [John Maynard Keynes](https://www.investopedia.com/terms/j/john_maynard_keynes.asp) published "The General Theory of Employment, Interest, and Money" in 1936. Hicks' model was a formal graph of Keynes' theories but is mostly used as a tool for understanding today.

The three critical exogenous (or external) variables in the IS-LM model are [liquidity](https://www.investopedia.com/terms/l/liquidity.asp), [investment](https://www.investopedia.com/terms/i/investing.asp), and consumption. According to the theory, liquidity is determined by the size and [velocity](https://www.investopedia.com/terms/v/velocity.asp) of the [money supply](https://www.investopedia.com/terms/m/moneysupply.asp). The levels of investment and consumption are determined by the marginal decisions of individual actors.

The IS-LM graph examines the relationship between output, or [gross domestic product (GDP)](https://www.investopedia.com/terms/g/gdp.asp), and [interest rates](https://www.investopedia.com/terms/i/interestrate.asp). The model simplifies the [economy](https://www.investopedia.com/terms/e/economy.asp) to two markets—output and money—where [supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp) find [equilibrium](https://www.investopedia.com/terms/e/equilibrium.asp).

## Structure and Dynamics of the IS-LM Graph

The IS-LM graph consists of two curves: IS and LM. GDP is placed on the horizontal axis, increasing to the right. The interest rate makes up the vertical axis.

### Exploring the IS Curve: Investment and Savings Balance

The IS curve shows the interest rates and GDP levels where investment equals saving. Lower interest rates lead to more investment and higher GDP, making the IS curve slope down and to the right.

### Analyzing the LM Curve: Income and Liquidity Connection

The LM curve shows income and interest rates where money supply equals liquidity demand. The LM curve slopes up because higher income boosts money demand, needing higher interest rates for balance.

### IS-LM Equilibrium: Achieving Economic Balance

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. Multiple scenarios or points in time may be represented by adding additional IS and LM curves.

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.

## Criticisms and Limitations of the IS-LM Model

Many economists, even [Keynesians](https://www.investopedia.com/terms/k/keynesianeconomics.asp), criticize the IS-LM model for being too simplistic and unrealistic. It cannot account for simultaneous high [unemployment](https://www.investopedia.com/terms/u/unemployment.asp) and [inflation](https://www.investopedia.com/terms/i/inflation.asp) in the economy. It is also undercut by the change by [central banks](https://www.investopedia.com/terms/c/centralbank.asp) to using an interest-rate rule rather than targeting the [money supply](https://www.investopedia.com/terms/m/moneysupply.asp).

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.” Subsequent revisions have taken place for so-called “new” or “optimized” IS-LM frameworks.

The model is a limited policy tool because it can't clearly guide [tax or spending policy](https://www.investopedia.com/terms/f/fiscalpolicy.asp)decisions. This significantly limits its functional appeal. It has very little to say about inflation, rational expectations, or international markets, although later models do attempt to incorporate these ideas. The model also ignores the formation of capital and [labor productivity](https://www.investopedia.com/terms/l/labor-productivity.asp).

## Is the IS-LM Model Actually Used?

The IS-LM model has limited use as a shortcut that enables quick decision-making. Because it is too simplistic, it is not useful for formulating tax or spending policies. Even its creator, John Hicks, called it “a classroom gadget” and expected it to be eventually replaced by something more sophisticated.

## Why Does the LM Curve Slope Upward?

The LM curve slopes upward because a higher gross domestic product (GDP) causes greater demand to hold money for transactions. This, in turn, raises interest rates, so that money supply and liquidity can stay in equilibrium.

## Who Developed the IS-LM Model?

A British economist named John Hicks developed the IS-LM model in 1936, basing it on theories published by another British economist, John Maynard Keynes, only a few months earlier.

## The Bottom Line

The IS-LM model is a tool for looking at how the market for economic goods intersects with the loanable funds market. It depicts the short-term equilibrium point between interest rates and output, with its three variables being liquidity, investment, and consumption.

Because it is a highly simplistic device, it is only useful when snap decisions must be made, as it lacks the sophistication necessary for setting tax and spending policies.  

> **Article Sources**
>
> 1.  John Hicks, via JSTOR. “[Mr. Keynes and the ‘Classics’; A Suggested Interpretation](https://www.jstor.org/stable/1907242?origin=crossref&seq=1).” _Econometrica_, Vol. 5, No. 2 (April 1937), Pages 147–159.
>     
> 2.  John Maynard Keynes, via Internet Archive. “[The General Theory of Employment, Interest, and Money](https://archive.org/details/generaltheoryofe00keyn_0).” Harcourt Brace Jovanovich, 1953.
>     
> 3.  Duke University, Department of Economics. “[Introduction: Seven Decades of the IS-LM Model](http://public.econ.duke.edu/~kdh9/Source%20Materials/Research/IS-LM%20Introduction.pdf),” Pages 3–4 of PDF.
>     
> 4.  Bartleby. “[What Is IS-LM Analysis?](https://www.bartleby.com/subject/business/economics/concepts/is-lm-analysis)”
>     
> 5.  Journal of Young Investigators. “[Can the IS/LM Model Truly Explain Macroeconomic Phenomena?](https://www.jyi.org/2007-september/2017/11/10/can-the-islm-model-truly-explain-macroeconomic-phenomena-1#)”
>     
> 6.  Steven Kates, via Google Books. “[Macroeconomic Theory and Its Failings](https://books.google.com/books?id=YQsCAQAAQBAJ&pg),” Page 130. Edward Elgar, 2010.