The IS-LM Model: Is There a Connection Between Slopes and the Effectiveness of Fiscal and Monetary Policy?

Abstract

The IS-LM model, as noted by Barron and Lowenstein (1996), continues to be an important analytical tool in many money and banking and intermediate macroeconomic textbooks.' The model is used, for example, to explain fluctuations in output and interest rates and to illustrate the analytics of fiscal and monetary policy.2 A number of textbooks also use the IS-LM model to examine how the output effects of given changes in the money supply and government spending (or taxes) depend on the model's parameters and on the slopes of the IS (investment-saving) and LM (liquidity preference-money supply) curves. This has become a particularly important application of the model given recent policies and economic developments.3 In these textbooks, one often finds the following "slope rules": (1) monetary policy is more effective the flatter the IS curve; (2) fiscal policy is more effective the flatter the LM curve; (3) monetary policy is more effective the steeper the LM curve; and, less frequently; (4) fiscal policy is more effective the steeper the IS curve. The use of these slope rules creates at least two problems for an instructor (and the student). First, whereas rules 1 and 2 are always correct, rules 3 and 4 are, at best, misleading and, at worst, incorrect. Second, some students invariably memorize such rules without being able to explain and to show how changes in the underlying parameters of the IS-LM model affect the slopes of the IS and LM curves and the effectiveness of fiscal and monetary policy. Explanations of shifts of the IS curve generally focus on the size of the horizontal distance between the two IS curves, but explanations of shifts of the LM curve generally focus on the size of the vertical distance between the two LM curves. In this article, I offer instructors a slightly different presentation of the IS-LM model. Specifically, a number of benefits emerge if the instructor simply focuses on what determines the size of both the horizontal and vertical distances between the IS curves and between the LM curves. This approach can be easily incorporated into any course that currently presents the IS-LM model. Students will be able to examine graphically how changes in the parameters alter the effectiveness of fiscal and