The IS-LM Framework, IS-LM diagram and money stock

The IS-LM Framework:

As long as we recognize the expected inflation rate, the fact that the nominal interest rate is equivalent to the real interest rate plus the expected inflation rate means that we can plot the IS and LM curves on the same set of axes as given in figure. This is described the IS-LM diagram. The equilibrium level of real GDP as well as of the interest rate is at the point where the IS curve and the LM curve cross. At that level of real GDP as well as total income Y and the real interest rate r, the economy is in equilibrium in mutually the goods market and the money market. Aggregate demand is equivalent to total production, therefore inventories are stable (that's what the IS curve indicates); and money demand is equivalent to money supply (that's what the LM curve indicates). How to compute the economy’s equilibrium position for some specific parameter values of the sticky-price model.

The IS-LM Diagram:

1532_IS-LM diagram.jpg

Legend: Define economy's equilibrium? The economy's equilibrium is that end at which the IS and LM Curves cross. Along the IS Curve total production is equivalent to aggregate demand. Along the LM Curve the amount of money demanded by households and businesses is equal to the money stock. Where the curves cross mutually the goods market and the money market are in balance.

The intersection of the IS and LM curves figure out short-run equilibrium values of real GDP when the money stock is fixed. However in today do world central banks manipulate the money stock to peg interest rates. They do not hold the funds stock fixed.

Therefore the IS-LM analysis is of limited usefulness. It is superior in most cases to think about the IS curve and interest rates and to forget about the LM curve.

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