Hence, this tool is sometimes used not only to simple keynesian model pdf economic fluctuations but also to suggest potential levels for appropriate stabilisation policies. Between the 1940s and mid-1970s, it was the leading framework of macroeconomic analysis. While it has been largely absent from macroeconomic research ever since, it is still a backbone conceptual introductory tool in many macroeconomics textbooks. He later presented it in “Mr.
Keynes and the Classics: A Suggested Interpretation”. Hicks later agreed that the model missed important points of Keynesian theory, criticizing it as having very limited use beyond “a classroom gadget”, and criticizing equilibrium methods generally: “When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect. The first problem was that it presents the real and monetary sectors as separate, something Keynes attempted to transcend. For there is no sense in liquidity, unless expectations are uncertain. A shift in one of the IS or LM curves will cause a change in expectations, which shifts the other curve. Although generally accepted as being imperfect, the model is seen as a useful pedagogical tool for imparting an understanding of the questions that macroeconomists today attempt to answer through more nuanced approaches.
The model is presented as a graph of two intersecting lines in the first quadrant. For the investment-saving curve, the independent variable is the interest rate and the dependent variable is the level of income. Note that economics graphs like this one typically place the independent variable—interest rate,in this example—on the vertical axis rather than the horizontal axis. This explains the downward slope of the IS curve. The money market equilibrium diagram. For the liquidity preference and money supply curve, the independent variable is “income” and the dependent variable is “the interest rate. The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium.
It is an upward-sloping curve representing the role of finance and money. Each point on the LM curve reflects a particular equilibrium situation in the money market equilibrium diagram, based on a particular level of income. The liquidity preference function is downward sloping. GDP increases, so does spending and therefore transactions. As GDP is considered exogenous to the liquidity preference function, changes in GDP shift the curve.
For example, an increase in GDP will increase transactions which will increase the demand for money for given interest rates, and cause the Liquidity preference curve to shift to the right. Speculative demand is inversely related to the interest rate. The money supply function for this situation is plotted on the same graph as the liquidity preference function. The money supply is determined by the central bank decisions and willingness of commercial banks to loan money. L being the real demand for money, which is some function of the interest rate i and the level Y of real income. The LM curve shows the combinations of interest rates and levels of real income for which money supply equals money demand—that is, for which the money market is in equilibrium. For a given level of income, the intersection point between the liquidity preference and money supply functions implies a single point on the LM curve: specifically, the point giving the level of the interest rate which equilibrate the money market at the given level of income.