Ch 39. The IS-LM Model: Policy Scenarios

When analyzing the effects of policy in macroeconomics, the IS-LM model is the first tool economists reach for. Formalized by British economist John Hicks as a diagram of Keynes’s General Theory, this model shows how the real economy (goods market) and the financial economy (money market) are connected.

1. The IS Curve (Investment-Saving)

Represents equilibrium in the goods market. As income (Y) rises, saving increases, and for investment to remain in balance, the interest rate (r) must fall. The curve is therefore downward-sloping.

Shift factors: Moved by fiscal policy — an increase in government spending (G) or a decrease in taxes (T).

2. The LM Curve (Liquidity Preference–Money Supply)

Represents equilibrium in the money market. As income (Y) rises, transaction demand for money increases, and with a fixed money supply, the interest rate (r) must rise to restore equilibrium. The curve is therefore upward-sloping.

Shift factors: Moved by changes in the money supply (M) from the central bank.

3. Interactive Policy Simulator

Adjust the sliders in the simulator below to see how each policy affects the economy’s overall income and interest rate.

인터랙티브 IS-LM 모델 시뮬레이터

* 재정정책(G)은 IS곡선을, 통화정책(M)은 LM곡선을 이동시킵니다.

재정 지출 (G)기본

통화 공급 (M)기본

균형 분석 (Equilibrium)

균형 소득 (Y*)84.6

균형 이자율 (r*)32.3%

Crowding-Out Effect: When government spending (G) increases and shifts the IS curve to the right, income (Y) rises — but so does the interest rate (r). The higher interest rate suppresses private investment, partially offsetting the impact of the fiscal expansion. This is known as the crowding-out effect.

4. Policy Scenario Analysis

Effects of Policy on Equilibrium
Policy	Curve Shift	Income (Y)	Interest Rate (r)
Expansionary Fiscal Policy (G↑)	IS shifts right	Increases (↑)	Rises (↑)
Expansionary Monetary Policy (M↑)	LM shifts right	Increases (↑)	Falls (↓)

The IS-LM model is the most powerful framework for understanding modern macroeconomic policy. Use the simulator to make the intuitive dynamics behind complex equations your own.

Economics Ch39. The IS-LM Model — How Macroeconomic Policies Interact