How does the IS-LM model show the effects of monetary and fiscal policy on interest rates and output?

The IS-LM model is a foundational macroeconomic framework that shows how the goods market (IS) and money market (LM) simultaneously determine the equilibrium interest rate and level of output. It's essential for understanding policy effects.

The Two Curves

• IS curve (Investment-Saving): Shows combinations of interest rates and output where the goods market is in equilibrium (planned spending = output). Downward-sloping because lower interest rates stimulate investment and consumption, increasing output.

• LM curve (Liquidity-Money): Shows combinations of interest rates and output where the money market is in equilibrium (money demand = money supply). Upward-sloping because higher output increases money demand, pushing up interest rates.

Policy Experiment 1: Expansionary Fiscal Policy (Government Spending Increase)

The government of Thornton Republic increases spending by $50B.

• IS curve shifts RIGHT (more spending at every interest rate = higher output demanded)
• LM curve stays put (fiscal policy doesn't directly change money supply)
• New equilibrium: Higher output (Y increases) AND higher interest rate (r increases)

Why does the interest rate rise? Higher government spending boosts income, which increases money demand. With fixed money supply, the only way to restore money market equilibrium is through a higher interest rate.

The Crowding Out Effect:

The higher interest rate discourages some private investment and consumption, partially offsetting the fiscal stimulus. This is 'crowding out' — government spending crowds out private spending through the interest rate channel.

Policy Experiment 2: Expansionary Monetary Policy (Money Supply Increase)

The central bank increases the money supply by buying government bonds.

• LM curve shifts RIGHT/DOWN (more money available at every output level = lower interest rates needed for equilibrium)
• IS curve stays put
• New equilibrium: Higher output (Y increases) AND lower interest rate (r decreases)

Why does output rise? Lower interest rates stimulate investment and interest-sensitive consumption, increasing aggregate demand and output.

Combined Policy (Fiscal + Monetary Together):

Limitations of IS-LM:

1. Assumes fixed price level (no inflation dynamics)
2. Short-run model — doesn't address long-run growth
3. Closed economy version ignores trade and capital flows
4. Simple money demand function may not capture financial market complexity

Exam Tip: CFA Level I questions typically describe a policy action and ask you to predict the direction of change in interest rates and output. Remember: fiscal shifts IS, monetary shifts LM. Know the direction of each shift.

Study macroeconomic frameworks in our CFA Level I Economics course.