Is-LM Model of Macroeconomic Analysis

In Keynesian analysis they assume the investment is inelastic to interest rates because business does not make investment decisions on interest rates but on other factors like future demand and expectations than interest rates. That is investment is inelastic to interest rate or money supply. That is interest rate will not be at a lower level for the economy to be at fuller employment because the sensitive of investment to interest rate is inelastic and the national income will not increase to full-employment level. That is in certain circumstances market economy can come in to equilibrium less than full employment level if market forces are at work. As well, they also assume the demand for money is less sensitive to interest rates and there fore LM curve will be steeper and there fore the economy can be less than full employment level.

In monetarist point of view the investment is elastic to interest rate. There fore IS curve is elastic and there fore if money supply is not excessive it may move the economy towards full employment and market is stable at full employment level. If money supply is not affected excessively by fiscal policy, which will affect interest rate and it will cause prices to rise and interest rates to rise at least in the long term. As well, they assume money demand is sensitive to interest rate. There fore the LM curve is less steeper.

That is in other words the effectiveness of fiscal and monetary policy depends on the shape of IS and LM curves assuming the economy have a tendency to come into equilibrium.

In actual practice the impact on price levels and out put is the effect of these two policies and inflation can be the cause of excessive aggregate demand as well due to other factors or non-monetary factors and not due to aggregate demand alone. As well, they also have a time lag to show their effects in the economy and may have more destabilizing effect than stabilizing the economy.

However, IS-LM analysis is a useful tool to analyze the impact of fiscal and monetary policy or the consquences of policy measures at least in the short term.