The IS-LM model is not perfect because it ignores other important variables such as inflation, unemployment, and the paramount role of central banks in determining interest rates. Indeed, it is a very mechanical and arguably static model which assumes that A leads to B without accounting for the dynamism of economies. In Advanced Introduction to Post Keynesian Economics, J.E. King displays and unveils the technical limitations of the model, concluding that “for all these reasons, IS-LM is a source of confusion rather than enlightenment” (2015).
Closing thoughts
Overall, the IS-LM model was Hicks’ brave and arguably successful bid to condense Keynes’ written masterpiece into a rather straightforward, graphical representation. In simple terms, the IS-LM model finds an equilibrium between an economy’s output and interest rates by looking into the numerous variables that play into the goods and money markets. In real life, the model is used to understand the effects that policies (such as monetary or fiscal policy) can have on the interest rate and output of nations. The IS-LM model’s limitations teach us that it is important to take a deeper look at the surrounding context and additional variables before drawing authoritative economic conclusions.
Further reading on Perlego
To find out more about monetary economics and policy, read Macroeconomics and Monetary Theory by Harry G. Johnson
To read more about the applications of economics in real life, read What They Don't Teach You At Harvard Business School by Mark H. McCormack
To find out more about the IS-LM model in textbooks, read Principles of Macroeconomics by Steven A. Greenlaw, Timothy Taylor, and David Shapiro
To find out more about the concept of “liquidity,” read ‘Beyond Liquidity: The Metaphor of Money in Financial Crisis, edited by Brad Pasanek, Simone Polillo, Brad Pasanek, and Simone Polillo
External sources on the IS-LM model
To find out more about Hick’s original interpretation of the IS-LM model, read “Mr Keynes and the Classics: A Suggested Interpretation”
To find out more about Keynesian economics, read Perlego’s study guide: “What is Keynesian Economics?”