ISLM Model

The IS-LM model is a classic Keynesian macroeconomic model that means “investment-savings, liquidity preference-money supply.”

Like your classic supply and demand graph, the IS-LM model is a graph with two intersecting, diagonal lines—one being IS and the other LM. The model shows the relationship between interest rates and the real output of goods and services plus money market.

The IS-LM model is really more concept and theory than actually used by macroeconomists. Yet it helped lead the way, as Keynesian economics is the core of modern-day economy policy for the U.S., as well as for many other nations. Yep, Keynes is still king.

The IS line theorizes that interest rates affect investment, which affects real GDP. The lower interest rates are, the higher investment will be, and the higher GDP should be. The LM line theorizes that the more economic activity there is, the higher demand there is for liquidity (for spending money).

Where these two lines cross shows the equilibrium where the economy is stable in terms of real GDP (x-axis) and interest rates (y-axis). The central bank can choose to affect things like interest rates and the money supply, which can change the lines, and thus where the equilibrium point ends up. This is how central banks try to tinker to soften economic recessions and boost the economy.