Hicks-Hansen Synthesis: IS-LM Curve Model

The Hicks-Hansen synthesis, also known as the IS-LM curve model, is a macroeconomic model that combines John Maynard Keynes’ theory of liquidity preference and John Hicks’ interpretation of Keynes’ theory in terms of the IS (Investment-Saving) and LM (Liquidity Preference-Money Supply) curves. The model shows the relationship between interest rates, output, and prices in the short run.

The IS-LM model is based on the assumption that the economy is in equilibrium when the goods market and the money market are both in equilibrium. The goods market is in equilibrium when aggregate demand (AD) equals aggregate supply (AS), and the money market is in equilibrium when the demand for money equals the supply of money.

The IS curve shows the combinations of interest rates and output levels that ensure equilibrium in the goods market. It is derived from the Keynesian cross diagram, which shows that aggregate demand (AD) equals output (Y) when AD = C + I + G + NX = Y, where C is consumption, I is investment, G is government spending, and NX is net exports. The IS curve represents the combinations of interest rates and output levels that make investment equal to savings, or I = S. In other words, it shows the level of output that can be sustained at a given interest rate.

The LM curve shows the combinations of interest rates and output levels that ensure equilibrium in the money market. It is derived from the liquidity preference theory, which states that the demand for money depends on the interest rate and income. The LM curve represents the combinations of interest rates and output levels that equate the demand for money and the supply of money. In other words, it shows the level of interest rate that can be sustained at a given level of income.

The intersection of the IS and LM curves represents the equilibrium point of the economy. At this point, the goods market and the money market are both in equilibrium, and there is no tendency for output or interest rates to change. The equilibrium point determines the level of output and interest rates in the short run.

Changes in economic policies or external factors can shift the IS and LM curves, leading to changes in the equilibrium level of output and interest rates. For example, an increase in government spending shifts the IS curve to the right, increasing the equilibrium level of output and interest rates. A decrease in the money supply shifts the LM curve to the left, decreasing the equilibrium level of output and interest rates.

The IS-LM model is a useful tool for policymakers to analyze the short-run effects of economic policies, such as fiscal and monetary policies, on output and interest rates. It has been widely used in macroeconomic analysis and has been adapted to incorporate other factors, such as expectations and exchange rates.