The Hicks–Hansen synthesis, commonly known as the IS–LM curve model, is an important macroeconomic framework that combines the ideas of classical economics with Keynesian theory. It was developed by Sir John Hicks and later refined by Alvin Hansen to explain how the real sector and the monetary sector of the economy interact to determine the level of income and the rate of interest.
The IS–LM model is called a synthesis because it brings together the classical focus on interest rate determination with the Keynesian emphasis on income and employment. It shows how equilibrium in the goods market and money market occurs simultaneously.
Meaning of IS and LM Curves
The IS curve represents equilibrium in the goods market. The term “IS” stands for Investment equals Saving. It shows all combinations of income and interest rate at which planned investment equals planned saving. In other words, at any point on the IS curve, the goods market is in equilibrium.
The LM curve represents equilibrium in the money market. The term “LM” stands for Liquidity preference equals Money supply. It shows all combinations of income and interest rate at which the demand for money equals the supply of money. At any point on the LM curve, the money market is in equilibrium.
The point where the IS and LM curves intersect shows the simultaneous equilibrium of both markets. This intersection determines the equilibrium level of national income and the equilibrium rate of interest in the economy.
IS Curve and Its Explanation
The IS curve shows an inverse relationship between the rate of interest and the level of income. When the rate of interest falls, investment becomes cheaper, leading to higher investment spending. This increase in investment raises aggregate demand, resulting in higher income and output. Conversely, when the rate of interest rises, investment declines, reducing income and output.
The slope of the IS curve is downward sloping due to this inverse relationship. Changes in factors such as government expenditure, taxation, and autonomous investment cause the IS curve to shift. For example, an increase in government spending or a reduction in taxes raises aggregate demand, shifting the IS curve to the right. Similarly, a decrease in government spending or an increase in taxes shifts the IS curve to the left.
It is important to note that the IS curve reflects the impact of fiscal policy on income and interest rates.
LM Curve and Its Explanation
The LM curve shows a direct relationship between income and the rate of interest. As income increases, demand for money rises because people need more money for transactions. Given a fixed money supply, an increase in money demand leads to a rise in the rate of interest. Therefore, higher income levels are associated with higher interest rates, resulting in an upward sloping LM curve.
The position of the LM curve depends on the money supply and liquidity preference. If the central bank increases the money supply, the LM curve shifts to the right, leading to a lower interest rate at each level of income. On the other hand, a decrease in money supply shifts the LM curve to the left.
The LM curve highlights the role of monetary policy in influencing interest rates and income.
Determination of Equilibrium Income and Interest Rate
The equilibrium in the IS–LM model occurs at the point where the IS curve intersects the LM curve. At this point, both the goods market and money market are in equilibrium simultaneously. The corresponding level of income and rate of interest are the equilibrium values for the economy.
If the economy is not at this equilibrium point, forces within the system push it toward equilibrium. For instance, if income is higher than equilibrium, money demand exceeds money supply, raising interest rates and reducing investment, which brings income back to equilibrium.
This interaction between markets is a key concept frequently tested in JAIIB and CAIIB exams.
Effect of Fiscal Policy in the IS–LM Model
Fiscal policy refers to changes in government spending and taxation. In the IS–LM framework, expansionary fiscal policy, such as increased government spending or tax cuts, shifts the IS curve to the right. This leads to higher income and higher interest rates, assuming the money supply remains constant.
However, a rise in interest rates due to fiscal expansion may reduce private investment, a phenomenon known as crowding out. This concept is important for exam answers, especially in descriptive questions.
Contractionary fiscal policy, such as reduced government spending or higher taxes, shifts the IS curve to the left, leading to lower income and interest rates.
Effect of Monetary Policy in the IS–LM Model
Monetary policy affects the economy by changing the money supply. An expansionary monetary policy, where the central bank increases the money supply, shifts the LM curve to the right. This results in lower interest rates and higher income.
A contractionary monetary policy reduces money supply, shifting the LM curve to the left, leading to higher interest rates and lower income.
Understanding this mechanism helps in analysing the impact of RBI policies on credit growth, investment, and economic activity.
Importance and Limitations of the IS–LM Model
The IS–LM model is important because it provides a clear framework to analyse the interaction between fiscal and monetary policies. It helps policymakers decide the appropriate mix of policies to achieve economic stability and growth. For exams, it also helps in understanding inflation control, output determination, and interest rate behaviour.
However, the model has limitations. It assumes a closed economy with no foreign trade, fixed prices in the short run, and a given money supply. It also does not fully account for expectations and financial market complexities present in modern economies.
Conclusion
The Hicks–Hansen IS–LM model is a powerful analytical tool that explains how income and interest rates are jointly determined through the interaction of goods and money markets.