IS-LM Framework

Background

• IS → Commodity or Goods market
• LM → Loanable funds market or Money market

It is an extension of the Keynesian framework, which forms its basis.

Restriction

Closed Economic Market

Goal

How is the equilibrium obtained? How does interest rates affect equilibrium?

Abbv.	Meaning
$I$	Investments: How much are the firms willing to invest in production
$S$	Savings: How much are the consumers willing to hold back (that reduces consumption but also provides opportunity for lending)
$L$	Liquidity Preference: (Money Demand) How much do I need to carry in cash form to meet my daily demands.
$M$	Money Supply

When is goods market in equilibrium?

If $I=S$ (absolute values), if both are in equilibrium we say that the goods market in equilibrium.

When is money market in equilibrium?

$M_d$ = $M_s$

We derive the $IS$ curve using the four quadrant approach. And we do the same for the $LM$ curves.

The ISLM framework is also used to understand the policies¹

• $IS$ → Fiscal policy (revenue and expenditure of the government)
• $LM$ → Monetary policy (money supply)

Footnotes

1. No policy is useless, it depends on the state of the economy. ↩