Why is lm model

Shifts in the position and shape of the IS and LM curves, representing changing preferences for liquidity, investment, and consumption, alter the equilibrium levels of income and interest rates. Many economists, including many Keynesians, object to the IS-LM model for its simplistic and unrealistic assumptions about the macroeconomy. In fact, Hicks later admitted that the model's flaws were fatal, and it was probably best used as "a classroom gadget, to be superseded, later on, by something better.

The model is a limited policy tool, as it cannot explain how tax or spending policies should be formulated with any specificity. This significantly limits its functional appeal. It has very little to say about inflation, rational expectations, or international markets, although later models do attempt to incorporate these ideas. The model also ignores the formation of capital and labor productivity. John Hicks. Keynes and the 'Classics'; A Suggested Interpretation.

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Forgot password? Don't have an account? Sign in via your Institution. You could not be signed in, please check and try again. Sign in with your library card Please enter your library card number. Hicks — economist John Maynard Keynes — economist macroeconomics See all related overviews in Oxford Reference ».

IS—LM Diagram. All rights reserved. Sign in to annotate. Money demand increases when output rises because money also serves as a medium of exchange. When output is larger, people have more income and so want to hold more money for their transactions. The supply of money is chosen by the monetary authority and is independent of the interest rate.

Thus it is drawn as a vertical line. The equilibrium in the money market is shown in Figure When the money supply is chosen by the monetary authority, the interest rate is the price that brings the market into equilibrium. Sometimes, in some countries, central banks target the money supply.

Alternatively, central banks may choose to target the interest rate. This was the case we considered in Chapter 25 "Understanding the Fed". Figure To trace out the LM curve, we look at what happens to the interest rate when the level of output in the economy changes and the supply of money is held fixed.

At the higher level of income, money demand is shifted to the right; the interest rate increases to ensure that money demand equals money supply. At each point along the LM curve, money supply equals money demand. We have not yet been specific about whether we are talking about nominal interest rates or real interest rates. In fact, it is the nominal interest rate that represents the opportunity cost of holding money.

When we draw the LM curve, however, we put the real interest rate on the axis, as shown in Figure The simplest way to think about this is to suppose that we are considering an economy where the inflation rate is zero.

In this case, by the Fisher equation, the nominal and real interest rates are the same. In a more complete analysis, we can incorporate inflation by noting that changes in the inflation rate will shift the LM curve.

Changes in the money supply also shift the LM curve. It incorporates both the dependence of spending on the real interest rate and the fact that, in the short run, real GDP equals spending. The IS curve is shown in Figure The IS curve is downward sloping: as the real interest rate increases, the level of spending decreases.

The dependence of spending on real interest rates comes partly from investment. As the real interest rate increases, spending by firms on new capital and spending by households on new housing decreases. Consumption also depends on the real interest rate: spending by households on durable goods decreases as the real interest rate increases. The connection between spending and real GDP comes from the aggregate expenditure model.

Given a particular level of the interest rate, the aggregate expenditure model determines the level of real GDP. Now suppose the interest rate increases. This reduces those components of spending that depend on the interest rate. In the aggregate expenditure framework, this is a reduction in autonomous spending. The equilibrium level of output decreases. Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and output.