The IS-LM Model in Words

How a classic model links the market for goods with the market for money to show how interest rates and output are determined together.

In 1937, the British economist John Hicks summarised key ideas from John Maynard Keynes in a simple model known as IS-LM. For decades it was the workhorse of macroeconomics teaching and still helps explain how fiscal and monetary policy work.

The IS side: goods

IS stands for investment and saving. It describes the market for goods and services. When interest rates are lower, borrowing is cheaper, so businesses invest more and households buy more on credit. This raises total spending and output. So lower interest rates go with higher output in the goods market.

The LM side: money

LM stands for liquidity preference and money supply. It describes the market for money. When output and incomes are higher, people need more money for transactions. With a fixed money supply, this extra demand pushes interest rates up. So higher output goes with higher interest rates in the money market.

Putting them together

The economy settles where both markets are in balance: a combination of output and interest rate consistent with both goods and money markets.

Using the model

Fiscal policy: if the government increases spending, total demand rises, shifting the IS side. Output rises, but interest rates also rise, which can reduce private investment, called crowding out.
Monetary policy: if the central bank increases the money supply, interest rates fall, shifting the LM side. Output rises as investment increases.

Limits

IS-LM is simplified. It assumes fixed prices in the short run and does not address inflation directly. Modern central banks usually set interest rates rather than the money supply, so economists often use updated versions in which the central bank sets the interest rate directly. Still, the core insight, that goods and financial markets interact, remains useful.

A spending boost

The government builds new roads, increasing demand for construction and materials. Incomes rise, and people and firms want to hold more money for transactions. Interest rates rise, and some businesses postpone investments. Output rises overall, but by less than the extra spending alone would suggest, because higher interest rates crowd out some private investment.

Thinking IS-LM describes how central banks work today

Modern central banks mostly target interest rates rather than money quantities, so textbooks increasingly use updated models. IS-LM remains useful for understanding how goods and money markets interact.

Key takeaways

IS-LM, developed by John Hicks in 1937, links the goods market and the money market.
In the goods market, lower interest rates raise output.
In the money market, higher output raises interest rates for a fixed money supply.
The model shows how fiscal policy can crowd out investment and how monetary policy lowers rates.