Annexes—The IS-LM Model and Macroeconomic Equilibrium

founding article of the IS-LM model by John R. Hicks, "Mr.

Keynes and the Classics

A Suggested Interpretation" (Econometrica, vol. 5, no. 2, April 1937, pp. 147-159), which proposes a diagrammatic formalization of Keynes's General Theory (1936) accessible to students and practitioners.

Founding article

Hicks is a young researcher at Cambridge (Gonville and Caius College, after his years at the London School of Economics until 1935) when he writes this text in response to the General Theory, at age 32. The article follows a September 1936 Oxford seminar at which Roy Harrod, James Meade, and Hicks himself present their interpretations of Keynes's book. It is Hicks's version, by virtue of its graphical clarity, that will dominate macroeconomic teaching for half a century.

Hicks's self-critique (1980)

rarely taught historiographical detail. John Hicks publishes in 1980, at age 76, an article titled "IS-LM — An Explanation" (Journal of Post Keynesian Economics, vol. 3, no. 2, Winter 1980-1981, pp. 139-154), in which he distances himself from his own model. Hicks acknowledges that IS-LM "tends to presuppose that one is already at equilibrium" and that the model lacks a genuine temporal dimension — useful for pedagogy but problematic for understanding dynamic adjustment. Hicks faults his framework for having omitted radical uncertainty and expectations, dimensions nevertheless central to Keynes (notably in chapter 12 of the General Theory on animal spirits).

Hicks's conclusion

IS-LM is "a useful classroom device" but "not an adequate instrument for thinking about real macroeconomics". This partial repudiation is rarely mentioned in textbooks, which continue to teach IS-LM as a settled achievement.

Pedagogical importance

for a hard-level explanation, it is essential to flag that the author of the model himself ended up qualifying its scope, which opens the discussion of the limits already mentioned in this explanation (fixed prices, absence of rational expectations, absence of wealth effects) and bridges to post-1980 developments — DSGE models, New Keynesians, and the modern neo-Keynesian synthesis.

rigorous reformulation of the IS-LM framework integrating real balance effects, published by Don Patinkin as "Money, Interest, and Prices — An Integration of Monetary and Value Theory" (Harper & Row, 1st edition 1956, 2nd revised edition 1965).

Central ambition

to resolve the "classical dichotomy dilemma" (separation between real and monetary spheres) that made it inconsistent to integrate the Keynesian model into a Walrasian general-equilibrium framework. Patinkin formally demonstrates that the dichotomy can only hold under very restrictive assumptions.

Real balance effect (Pigou effect)

mechanism whereby a fall in the general price level P raises the purchasing power of nominal money holdings held by households (M/P increases), which stimulates consumption and shifts IS rightward. Originally formulated by Arthur Cecil Pigou ("The Classical Stationary State", Economic Journal, vol. 53, no. 212, December 1943, pp. 343-351) as an argument against the Keynesian thesis of durable underemployment equilibrium.

Patinkin effect

formal extension of the Pigou effect in a rigorous general-equilibrium framework. Patinkin shows that real balances enter as an argument in the goods and money demand functions themselves, and that the equilibrium of the system requires their explicit treatment.

Theoretical consequence

the standard IS-LM version without real balance effects is only an approximation valid at given prices (short run). In an analysis including price adjustment, full price flexibility theoretically guarantees a return to full-employment equilibrium, which contradicts the Keynesian conclusion of persistent involuntary unemployment — except in the special case of the liquidity trap or downwardly rigid prices.

Position in the literature

pivot of the "neoclassical synthesis" that dominated post-war macroeconomics until the rational-expectations revolution. Don Patinkin (Hebrew University of Jerusalem) trained an entire generation of Israeli macroeconomists.

major methodological critique addressed to economic-policy analysis based on IS-LM (and more generally on structural macroeconometric models), formulated by Robert E. Lucas Jr. in "Econometric Policy Evaluation — A Critique" (Carnegie-Rochester Conference Series on Public Policy, vol. 1, January 1976, pp. 19-46).

Central thesis

the behavioral parameters of IS-LM (MPC, h sensitivity of investment to rates, k sensitivity of money demand to income, l sensitivity of money demand to rates) are not invariant structural constants. They depend on the economic-policy regime in place, because they summarize the optimizing behaviors of agents who form expectations about future policy.

Mechanism

rational agents anticipate economic policies and adjust their behavior accordingly. If the central bank changes its rule (for example, switching from money-stock targeting to inflation targeting), agents recalibrate their expectations and hence their consumption, investment, and money demand. Parameters estimated on the historical sample of the old regime no longer correctly predict the effects of the new regime.

Consequence for IS-LM

using the multiplier ΔY/ΔG = 1 / [1 − MPC×(1−t) + h×k/l] to predict the effect of a stimulus plan presupposes that all these parameters remain stable even though fiscal policy is changing. The Lucas critique shows that this is precisely false.

Proposed solution

base macroeconometric analysis on the deep parameters of preferences and technologies, which are themselves policy-invariant. This is the intellectual matrix of modern DSGE models (Real Business Cycle then New Keynesians) that have dominated macroeconomics since the 1980s. Lucas receives the 1995 Nobel Prize "for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy".

Contemporary status

the Lucas critique has profoundly destabilized the use of IS-LM in economic-policy analysis, but the model remains widely taught for its pedagogical simplicity. Contemporary economists use it with explicit awareness of this limit — it is precisely Hicks's self-critique (previous entry) that meets the Lucas critique here by a different route.

pedagogical redesign of the IS-LM model proposed by David Romer in "Keynesian Macroeconomics without the LM Curve" (Journal of Economic Perspectives, vol. 14, no. 2, Spring 2000, pp. 149-169).

Starting observation

since the 1980s-1990s, no major central bank steers the money supply M. They all directly target a policy interest rate (Fed funds rate in the United States, refi rate at the ECB, etc.). The LM curve as taught — which assumes M fixed and r endogenous — describes a monetary policy that has not existed in the practice of major economies since the abandonment of Volcker-era monetarism.

Substitution of LM by MP

Romer proposes to replace the LM curve with an MP (Monetary Policy) curve that directly represents the policy rule followed by the central bank.

Generic form

r = r̄ + a·(π − π*) + b·(Y − Ȳ)/Ȳ, where r̄ is the neutral rate, π inflation, π* the inflation target, Y income, Ȳ full-employment income. This form is the Taylor rule (1993) applied as a positive rather than normative description.

Pedagogical consequences

(1) monetary policy is no longer represented by a shift of LM due to a change in M, but by a change in the MP rule (for example a fall in the neutral rate r̄ or a rise in the inflation target π*) ; (2) the monetary transmission mechanism becomes direct, the central bank sets r which determines investment and income via IS ; (3) the monetary channel runs through the central bank's reaction function, much closer to contemporary institutional reality.

Status in teaching

IS-MP has replaced IS-LM in several reference macroeconomic textbooks post-2000, notably Frederic Mishkin ("Macroeconomics — Policy and Practice", 2012), Charles Jones ("Macroeconomics", 2008-2024) and several recent editions of Mankiw himself, who now presents the policy-rate approach as a complement to the classical IS-LM framework.

Critique of the critique

IS-MP inherits the other limits of IS-LM (fixed prices, absence of expectations, comparative statics), and the Lucas critique (previous entry) remains applicable. IS-MP is an institutional improvement, not a response to the deeper methodological problems.

academic successor to IS-LM in contemporary frontier macroeconomics, synthesized by Richard Clarida, Jordi Galí and Mark Gertler in "The Science of Monetary Policy — A New Keynesian Perspective" (Journal of Economic Literature, vol. 37, no. 4, December 1999, pp. 1661-1707). The model articulates three equations derived from microeconomic optimization and rational expectations.

Dynamic New Keynesian IS equation

y_t = E_t y_{t+1} − (1/σ) × (i_t − E_t π_{t+1} − r̄), where y_t is the output gap, i_t the nominal rate, π_t inflation, E_t the rational expectations operator, and σ the intertemporal elasticity of substitution. Consumption is forward-looking and derived from a representative household's optimization (Euler equation).

New Keynesian Phillips curve

π_t = β × E_t π_{t+1} + κ × y_t, derived from Calvo pricing (Calvo 1983) in which a fraction of firms adjusts prices each period. The NKPC links current inflation to expected future inflation and the output gap, unlike the Phillips curve with adaptive expectations.

Taylor rule

i_t = r̄ + π* + φ_π × (π_t − π*) + φ_y × y_t, where the central bank adjusts the policy rate in response to the inflation gap and the output gap.

Taylor principle

for the equilibrium to be determinate and stable, φ_π > 1 — the central bank must adjust its nominal rate by more than one point for each additional point of inflation.

Conceptual break with IS-LM

explicit microfoundations derived from household and firm optimization satisfying the Lucas critique, rational expectations integrated at the core of the model, explicit temporal dynamics rather than comparative statics, monetary policy represented by a policy-rate rule consistent with modern central-bank practice.

Position in the discipline

intellectual foundation of New Keynesian DSGE models (Dynamic Stochastic General Equilibrium) that dominate monetary policy analysis in central banks around the world (Fed, ECB, BoE, BoJ) and in frontier academic macroeconomics since the 2000s. Mark Gertler pursues this line with Bernanke toward the financial accelerator (see C10 explanation "Business cycles and crises", Bernanke-Gertler-Gilchrist annex).

article by Paul Krugman, "It's Baaack — Japan's Slump and the Return of the Liquidity Trap" (Brookings Papers on Economic Activity, vol. 1998, no. 2, 1998, pp. 137-205), which brings the concept of the liquidity trap back to the center of the macroeconomic debate after several decades of neglect.

Japanese context

since the bursting of the real-estate and stock-market bubble of 1989-1990, Japan has experienced prolonged stagnation. The Bank of Japan cuts its policy rate to practically 0% by the mid-1990s without managing to restart activity or inflation. The situation directly contradicts the monetarist consensus of the 1980s according to which a central bank can always create inflation by raising the money supply.

Krugman's diagnosis

Japan has entered a genuine liquidity trap in the modern Keynesian sense. The nominal rate hits its zero floor and conventional monetary policy (open-market operations) no longer affects the real rate or aggregate demand.

Theoretical originality

Krugman integrates the concept into a New Keynesian model with rational expectations, which was impossible within the static IS-LM framework. He demonstrates that exiting the trap requires a credible commitment from the central bank to maintain a zero nominal rate even after inflation returns, in other words to tolerate inflation above its target for a certain time. This is the first modern formulation of forward guidance.

Influence

the article reshaped central-bank thinking even before the 2008 crisis. When the Fed hits its zero floor in December 2008, the tools proposed by Krugman (forward guidance, QE, price-level targeting rather than inflation-rate targeting) enter the standard toolkit of central banks worldwide. Krugman receives the 2008 Nobel "for his analysis of trade patterns and location of economic activity", not specifically for this article, but he is widely recognized as a pivotal macroeconomist in contemporary thinking on the zero lower bound.

foundational article by Gauti Eggertsson and Michael Woodford, "The Zero Bound on Interest Rates and Optimal Monetary Policy" (Brookings Papers on Economic Activity, vol. 2003, no. 1, 2003, pp. 139-211), which rigorously formalizes the optimal conduct of monetary policy when the policy rate is constrained by the zero lower bound.

Analytical framework

New Keynesian three-equation model (Clarida-Galí-Gertler 1999, previous entry) augmented with the constraint i_t ≥ 0 on the policy rate. The central bank's problem becomes a constrained optimization with a nominal bound.

Central result

optimal policy in the presence of a nominal bound is not equivalent to a purely discretionary policy that would simply set i_t = 0 during the crisis and revert to the Taylor rule afterward. The optimal commitment policy consists of promising to maintain low rates longer than the present state of the economy would justify, creating expected inflation slightly above target which reduces the real rate and stimulates demand today. This is the rigorous theorization of forward guidance intuitively proposed by Krugman (1998, previous entry).

Optimal forward guidance

the central bank must publicly communicate its future rate path and commit to it even when the economy has returned to normal. This is precisely what the Fed did with its calendar-based and state-contingent forward guidance between 2008 and 2015.

Justification of QE

Eggertsson and Woodford show within the theoretical framework that asset purchases (QE) have effect only insofar as they signal the central bank's commitment to maintain low rates (signaling channel), not through a direct effect on market portfolios (portfolio-balance channel, which they reject as negligible in the model). This interpretation is debated empirically today, with some authors (notably Krishnamurthy-Vissing-Jorgensen 2011, Bauer-Rudebusch 2014) finding measurable portfolio effects.

Institutional influence

the article has become the standard theoretical reference for the conduct of monetary policy at the zero bound. The Fed under Bernanke (2008-2014) and Yellen (2014-2018), the ECB under Draghi (2011-2019), and the Bank of Japan under Kuroda (2013-2023) all implemented policies that fall within this theoretical framework. Michael Woodford ("Interest and Prices", Princeton University Press, 2003) also published the same year the reference treatise on modern neo-Wicksellian monetary macroeconomics.

central banks and frontier academic macroeconomics replaced IS-LM with DSGE (Dynamic Stochastic General Equilibrium) models from the 2000s-2010s onwards.

Smets-Wouters (2003, 2007)

Frank Smets and Raf Wouters publish "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area" (Journal of the European Economic Association, vol. 1, no. 5, September 2003, pp. 1123-1175) then "Shocks and Frictions in US Business Cycles" (American Economic Review, vol. 97, no. 3, June 2007, pp. 586-606). These two articles become the reference DSGE models at the ECB and the Fed respectively. They extend the New Keynesian three-equation framework (entry 5) with nominal rigidities (Calvo prices and wages), habit formation in consumption, investment adjustment costs, past-price indexation and identify seven structural shocks (productivity, risk premium, investment, monetary, price-push, wage-push, government).

Current institutional models

Federal Reserve Board of the United States (FRB/US, semi-structural large-scale model in use since 1996, complemented by the DSGE models EDO and SIGMA), European Central Bank (NAWM, direct heir of Smets-Wouters 2003), Bank of England (COMPASS since 2011, successor to BEQM), Bank of Japan (Q-JEM), Banque de France (FR-BDF), IMF (GIMF and GEM).

Methodological advances over IS-LM

(1) explicit microfoundations derived from household and firm optimization ; (2) rational expectations ; (3) Bayesian econometric estimation over long series ; (4) accounting for multiple identified structural shocks ; (5) integration of financial frictions via the Bernanke-Gertler-Gilchrist 1999 extensions and post-2008 models such as Gertler-Karadi 2011 on QE.

Limits revealed by the 2008 crisis

pre-crisis DSGE did not adequately model the financial sector. Olivier Blanchard acknowledges in "The State of Macro" (Annual Review of Economics, vol. 1, 2009, pp. 209-228) that the profession had underestimated the complexity of the financial sector.

Post-2008 responses

integration of collateral, leverage constraints and bank defaults in models such as Gertler-Kiyotaki 2010 and Christiano-Motto-Rostagno 2010-2014.

Position of IS-LM today

IS-LM survives in textbooks for its pedagogical role and graphical intuition, but no central bank or top-tier academic journal uses it in research. It is an introductory teaching tool, not a scientific production tool.

foundational article by James Tobin, "A General Equilibrium Approach to Monetary Theory" (Journal of Money, Credit and Banking, vol. 1, no. 1, February 1969, pp. 15-29), which proposes a microeconomic theory of investment directly linking financial markets to capital accumulation.

Definition of Tobin's q

q = (market value of the firm) divided by (replacement cost of capital). When q > 1, the market values the firm above the replacement cost of its capital and the firm has an incentive to invest because each euro of installed capital creates more than one euro of stock-market value. When q < 1, the firm destroys value by investing and should divest or repurchase its own shares. In the long run, arbitrage brings q back toward 1.

Monetary transmission mechanism

a cut in the policy rate stimulates equity prices (financial assets are revalued when discounting decreases). This rise pushes q upward, hence productive investment by firms. The Tobin channel complements the classical IS-LM channel (fall in r entails rise in I) with a wealth channel running through financial markets.

Connection with portfolio theory

Tobin received the 1981 Nobel "for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices". This contribution follows the Tobin separation theorem ("Liquidity Preference as Behavior Towards Risk", Review of Economic Studies, vol. 25, no. 2, February 1958, pp. 65-86) and Tobin-Markowitz portfolio theory which show that households diversify their wealth between a risk-free asset and a portfolio of risky assets.

Empirical application

measuring q requires an approximation.

Marginal q versus average q

Fumio Hayashi ("Tobin's Marginal q and Average q", Econometrica, vol. 50, no. 1, January 1982, pp. 213-224) demonstrates that under certain assumptions (constant returns to scale, perfect competition, rational expectations), the marginal q relevant for the investment decision equals the observable average q, which makes the theory operational.

Empirical limits

"Investment = f(q)" regressions have low explanatory power (R² typically between 0.1 and 0.2). Cash-flow variables turn out to be significant in addition to q, which is inconsistent with a perfectly informative q. Fazzari, Hubbard & Petersen ("Financing Constraints and Corporate Investment", Brookings Papers on Economic Activity, vol. 1988, no. 1, pp. 141-206) interpret this through financial constraints (information asymmetries, agency costs) which make investment depend on both q and available cash.

Influence

Tobin's q has inspired the investment models with adjustment costs and financial frictions used in modern DSGE (previous entry), notably via Bernanke-Gertler-Gilchrist 1999 (see C10 explanation "Business cycles and crises", Bernanke-Gertler-Gilchrist annex) and Christiano-Eichenbaum-Evans ("Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy", Journal of Political Economy, vol. 113, no. 1, February 2005, pp. 1-45).