Understanding Equilibrium in the IS/LM Model
Understanding Equilibrium in the IS/LM Model
1995 version
Prof. Humberto Barreto1 Introduction: This brief work is designed to provide additional ammunition for the student in the ongoing war against IS/LM confusion and ignorance. The author has claimed in his Notes on Macroeconomic Theory (1995) that, There should be no mystery or uncertainty surrounding the IS/LM analysis at this point. IS/LM curves are simply a short-cut to finding the equilibrium values for income and interest rate. There are two equations and two unknownsÑwhat simpler strategy than to put them on one graph could be devised? (p. 52) The author still worries, however, that the student is memorizing the equilibrium condition, IS=LM generates Ye, without really understanding why the condition works. Most students are unable to explain why setting IS equal to LM generates the equilibrium level of output. I have, on rare occasion, heard a student give the following explanation: "Along the IS curve the goods market is in equilibrium; along the LM curve the money market is in equilibrium. Therefore, for both markets to be in equilibrium, the system must be on both curves. This only occurs at the intersection of the curves." That's pretty good, and it's the explanation I used in Notes on Macroeconomic Theory; but I still worry that there is too little understanding and too much memorization. I very much want to get across true, complete comprehension of this fundamental macro tool known as the IS/LM graph. To do this, I undertake a detailed analysis of the meaning of equilibrium in the IS/LM Model in the pages that follow.
1 The author wishes to thank Professors Frank Howland and John Naylor for their many
(many!) useful comments and suggestions.
1
The Equilibration Process: In struggling with the problem of teaching the student why the intersection of the IS and LM curves yields the general equilibrium solution to the interest rate and output variables, I wondered why students are
1995 version
Prof. Humberto Barreto1 Introduction: This brief work is designed to provide additional ammunition for the student in the ongoing war against IS/LM confusion and ignorance. The author has claimed in his Notes on Macroeconomic Theory (1995) that, There should be no mystery or uncertainty surrounding the IS/LM analysis at this point. IS/LM curves are simply a short-cut to finding the equilibrium values for income and interest rate. There are two equations and two unknownsÑwhat simpler strategy than to put them on one graph could be devised? (p. 52) The author still worries, however, that the student is memorizing the equilibrium condition, IS=LM generates Ye, without really understanding why the condition works. Most students are unable to explain why setting IS equal to LM generates the equilibrium level of output. I have, on rare occasion, heard a student give the following explanation: "Along the IS curve the goods market is in equilibrium; along the LM curve the money market is in equilibrium. Therefore, for both markets to be in equilibrium, the system must be on both curves. This only occurs at the intersection of the curves." That's pretty good, and it's the explanation I used in Notes on Macroeconomic Theory; but I still worry that there is too little understanding and too much memorization. I very much want to get across true, complete comprehension of this fundamental macro tool known as the IS/LM graph. To do this, I undertake a detailed analysis of the meaning of equilibrium in the IS/LM Model in the pages that follow.
1 The author wishes to thank Professors Frank Howland and John Naylor for their many
(many!) useful comments and suggestions.
1
The Equilibration Process: In struggling with the problem of teaching the student why the intersection of the IS and LM curves yields the general equilibrium solution to the interest rate and output variables, I wondered why students are