Developed by English economist John Hicks (1904-1989) and American economist Alvin Hansen (1887-1975) to provide a framework for analyzing the factors determining the level of aggregate demand.
IS-LM model (also known as the Hicks-Hansen model) was adopted as a universal framework in studying macroeconomics because it seemed to incorporate different views of the working of the economy. It combines equilibria in the financial market with equilibria in the goods and services market, establishing an equilibrium level for demand.
The framework represents investment-savings (IS) and the liquidity-money supply (LM), and can be used to illustrate how fiscal and monetary policies are employed to alter national income.
J Hicks, ‘Mr. Keynes and the Classics: A Suggested Interpretation’, Econometrica, vol. v (April, 1937), 147-59;
J Dupuit, On the Measurement of the Utility of Public Works (Paris, 1844);
J R Hicks, ‘The Four Consumers’ Surpluses’, Review of Economic Studies, vol. xi (1943), 31-41;
J F Muth, ‘Rational Expectations and the Theory of Price Movements’, Econometrica, vol. XXIX, 3 (1961), 315-35
The IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market (also known as real output in goods and services market plus money market). The intersection of the “investment–saving” (IS) and “liquidity preference–money supply” (LM) curves models “general equilibrium” where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.
The model was developed by John Hicks in 1937, and later extended by Alvin Hansen, as a mathematical representation of Keynesian macroeconomic theory. 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. By itself, the IS–LM model is used to study the short run when prices are fixed or sticky and no inflation is taken into consideration. But in practice the main role of the model is as a path to explain the AD–AS model.