The IS-LM Model and Macroeconomic Equilibrium
The IS-LM model is the central analytical framework for understanding the interactions between the market for goods and services and the money market in the short run. Mankiw devotes two full chapters to it (ch. 11-12, 9th ed.) and presents it as the most influential interpretation of Keynesian thought, indispensable for analyzing the effects of monetary and fiscal policy.
Last updated: 9 July 2026
Definition
DefinitionThe IS-LM model, developed by John Hicks (Nobel Prize 1972) and Alvin Hansen, formalizes the simultaneous equilibrium in two markets:
The IS curve (Investment-Saving) represents the set of combinations of interest rate (r) and income (Y) for which the market for goods and services is in equilibrium — that is, where planned investment equals planned saving. Its slope is negative: a lower interest rate stimulates investment and raises equilibrium income.
The LM curve (Liquidity preference-Money supply) represents the set of combinations of r and Y for which the money market is in equilibrium — that is, where money demand equals the money supply set by the central bank. Its slope is positive: a rise in income increases money demand and pushes the interest rate up.
The intersection of the two curves determines the short-run equilibrium interest rate and national income.
Why it matters
Mankiw presents the IS-LM model as "the dominant interpretation of Keynesian theory" and the main tool of short-run macroeconomics. It makes it possible to understand:
Why an expansionary fiscal policy raises income but also raises interest rates (and why the full multiplier of the Keynesian cross is an overestimate)
Why monetary policy is generally more effective than fiscal policy in normal times
Why the two policies become complementary in extreme situations (liquidity trap)
The fiscal multiplier formula in IS-LM is:
ΔY/ΔG = 1 / [1 − MPC × (1 − t) + (h × k / l)]
where MPC is the marginal propensity to consume, t the marginal tax rate, h the sensitivity of investment to the interest rate, k the sensitivity of money demand to income, and l the sensitivity of money demand to the interest rate. The h × k / l term captures crowding out: the larger h and k (highly sensitive investment and money demand), the stronger the crowding out; the larger l (money demand very sensitive to the rate), the weaker the crowding out. This multiplier is always smaller than the simple multiplier 1/(1 − MPC) due to crowding out.
Key points
Fiscal policy (shift of IS) is more effective when the LM curve is flat (high sensitivity of money demand to the interest rate, extreme case: liquidity trap where l → ∞) and less effective when LM is steep (classical case, strong crowding out)
Monetary policy (shift of LM) is more effective when the IS curve is flat (high sensitivity of investment to the interest rate) and ineffective when the interest rate is at its floor (liquidity trap)
The Mundell-Fleming model extends the analysis to the open economy and shows that the exchange rate regime determines the relative effectiveness of policies. For a eurozone member, the situation is hybrid: vis-à-vis its eurozone partners the exchange rate is fixed (unified), so no exchange-rate crowding out — the main crowding out of an isolated national fiscal stimulus comes from intra-zone import leakage, with partner countries supplying a substantial share of the additional demand. Vis-à-vis the rest of the world (dollar, yen) the rate floats, so a stimulus aggregated at zone level could appreciate the euro and crowd out the extra-zone share of exports — but this channel activates only for a coordinated zone-wide stimulus, not for an isolated stimulus by a single member state. The ECB's monetary policy remains fully effective at the aggregate level
The U.S. 2009 stimulus plan ($787 bn) combined with the Fed's zero-rate policy illustrates a classical IS-LM policy mix: simultaneous shift of IS (fiscal stimulus) and LM (QE) to maximize the effect on Y
Concrete example
ExamplesThe response to the 2008 crisis perfectly illustrates the IS-LM model. The Fed first used conventional monetary policy (shifting LM rightward by cutting rates from 5.25% to 0-0.25%). Once at the rate floor (liquidity trap), it resorted to QE (an attempt to shift LM through quantities rather than prices). In parallel, the Obama administration launched the American Recovery and Reinvestment Act (ARRA) of $787 billion (shifting IS rightward). The IS-LM model correctly predicts that, in this liquidity-trap situation, fiscal policy is particularly effective because the crowding-out effect is zero.
Mankiw anecdote
MankiwMankiw notes that the IS-LM model, although developed in 1937 by John Hicks in "Mr. Keynes and the Classics — A Suggested Interpretation" (Econometrica, vol. 5, no. 2, April 1937, pp. 147-159) as an interpretation of Keynes's General Theory (1936), remains "the starting point of most macroeconomic policy analyses." Historical note on the notation — Hicks used in the 1937 article the notation IS-LL (the IS curve for the goods market, the LL curve — later renamed LM — for the money market), later converted to IS-LM by subsequent textbooks, notably those of Alvin Hansen at Harvard ("A Guide to Keynes", McGraw-Hill, 1953) which helped popularize the tool in the United States in its modern form. He acknowledges, however, that the model has its limits — it assumes fixed prices (short run), ignores rational expectations, and does not account for wealth effects related to variations in asset prices.
📊 Modèle IS-LM
Market impact
MarketsThe IS-LM model is implicitly used by market analysts to anticipate the impact of economic policies. When a government announces a massive stimulus plan (IS shift), bond markets anticipate a rise in rates (movement along LM) and adjust yields accordingly. When a central bank announces QE (LM shift), markets anticipate a fall in rates and risky assets rise. Understanding the policy mix makes it possible to anticipate the joint movements of equity, bond, and currency markets.