The IS-LM model presented in this chapter is the basic model of aggregate demand
that incorporates the money market as well as the goods market. It lays
particular stress on the channels through which monetary and fiscal policy affect
the economy.
The IS curve shows combinations of interest rates and levels of income such that
the goods market is in equilibrium. Increases in the interest rate reduce aggregate
demand by reducing investment spending. Thus, at higher interest rates, the level
of income at which the goods market is in equilibrium is lower: The IS curve slopes
downward.
The demand for money is a demand for real balances. The demand for real balances
increases with income and decreases with the interest rate, the cost of holding
money rather than other assets. With an exogenously fixed supply of real balances,
the LM curve, representing money market equilibrium, is upward-sloping.
The interest rate and level of output are jointly determined by simultaneous equilibrium
of the goods and money markets. This occurs at the point of intersection of the
IS and LM curves.
Monetary policy affects the economy first by affecting the interest rate and then by
affecting aggregate demand. An increase in the money supply reduces the interest
rate, increases investment spending and aggregate demand, and thus increases equilibrium
output.
The IS and LM curves together determine the aggregate demand schedule.
Changes in monetary and fiscal policy affect the economy through the monetary
and fiscal policy multipliers.
