IS-LM model
/ I-S L-M /
The simple Keynesian cross has a blind spot: it ignores interest rates and the money market. But in reality, how much firms invest depends on the interest rate, and the interest rate depends on the supply of and demand for money. The IS-LM model stitches these two worlds together — the market for goods and the market for money — to find the pair of numbers that makes both balance at once: a level of output and an interest rate.
It has two relationships, each a line on a graph of output against the interest rate. The IS curve ('investment-saving') describes the goods market: it slopes downward because a lower interest rate makes borrowing cheaper, so firms invest more and households spend more, raising output. The LM curve ('liquidity-money') describes the money market: it slopes upward because higher output means people want to hold more money for transactions, which (with a fixed money supply) pushes the interest rate up. Where the two curves cross is the economy's short-run equilibrium — the unique combination of output and interest rate at which both the goods market and the money market are in balance. Shift either curve and you can trace how, say, more government spending (IS shifts right) or more money in the system (LM shifts right) changes both output and interest rates.
The IS-LM model's importance is that it shows monetary and fiscal forces working together rather than in isolation, and it surfaces subtleties the simpler models miss — like crowding out (government borrowing pushing up interest rates and dampening private investment) and the liquidity trap (where rates are so low that adding money does nothing). It was the standard teaching framework for decades. Its honest limits are real, though: it holds the price level fixed (so it's a short-run tool), it was built before modern central banks targeted interest rates directly rather than the money stock, and economists have criticised its lack of explicit expectations. It is best treated as a clear stepping-stone to richer models, not the final word.
Suppose the government boosts spending. In the IS-LM picture the IS curve shifts right, raising output — but the extra activity makes people want more money, nudging the interest rate up, which trims some private investment. The model thus shows both the boost and the partial crowding-out that the Keynesian cross alone could not.
IS-LM finds the output and interest rate where the goods and money markets balance at the same time.
IS-LM fixes the price level and predates modern interest-rate-targeting central banks, so it's a teaching stepping-stone, not a frontier model. Treat its mechanics as intuition-builders rather than precise forecasts.