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The IS-LM model describes the joint equilibrium of the goods market (IS curve: combinations of output and interest rate where investment equals saving) and the money market (LM curve: combinations of output and interest rate where money demand equals money supply). The IS curve slopes downward (higher rates reduce investment and output); the LM curve slopes upward (higher output raises money demand and thus rates). Their intersection determines the short-run equilibrium real interest rate and output level. Fiscal policy shifts IS; monetary policy shifts LM. The model reveals why fiscal stimulus can be partially offset by higher interest rates (crowding out).
Derive each curve from its underlying market condition. Then work through the four standard policy experiments: expansionary fiscal policy (IS right), contractionary fiscal policy (IS left), expansionary monetary policy (LM right), contractionary monetary policy (LM left). Identify equilibrium changes in output and interest rates.
You have studied the goods market and the money market separately. IS-LM asks: what happens when they must reach equilibrium at the same time? The answer is a pair of curves in (output, interest rate) space, and their intersection is the short-run macroeconomic equilibrium.
The IS curve traces all combinations of output (Y) and the interest rate (r) where the goods market clears — where investment equals saving, or equivalently where total spending equals total output. It slopes downward because higher interest rates reduce investment, which reduces output. Think of it as the goods market's constraint on (Y, r): only points on IS are consistent with spending equilibrium. Fiscal policy (government spending or taxes) shifts IS: more government spending means more output is demanded at every interest rate, so IS moves right.
The LM curve traces all combinations of Y and r where the money market clears — where money demand equals money supply. It slopes upward because higher output means more transactions, which raises money demand, which (with a fixed supply) pushes interest rates up. Think of LM as the money market's constraint. Monetary policy shifts LM: when the central bank increases the money supply, the interest rate needed to clear the money market is lower at every output level, so LM moves right (and down).
The intersection of IS and LM simultaneously satisfies both constraints. This is powerful: it shows that fiscal and monetary policy interact. Expansionary fiscal policy shifts IS right, raising output — but also raising interest rates, which crowds out some private investment. The net output gain is less than the simple multiplier predicts, precisely because the higher interest rate dampens investment. This "crowding out" is invisible if you analyze the goods market alone.
One important boundary case is the liquidity trap: when interest rates hit zero (or the zero lower bound), the LM curve becomes flat. People hold money and bonds interchangeably because both pay nothing. In this case, expanding the money supply cannot push rates any lower, so it has no effect — LM shifts but the intersection doesn't move. Fiscal policy, however, still works: shifting IS right moves equilibrium output along the flat LM without raising rates. This is exactly the situation many countries faced after 2008 and again during 2020, and it is why central banks turned to unconventional tools (quantitative easing, forward guidance) when their primary lever was exhausted.