Forthcoming in: J. Segura and C. Rodrguez-Braun, eds.

, An Eponymous Dictionary of
Economics, Aldershot: Edward Elgar (2004).

HICKS-HANSEN MODEL
Samuel Bentolila
CEMFI

The Hicks-Hansen or IS-LM, model, developed by Sir John R. Hicks (1904-1989) and
Alvin H. Hansen (1887-1975), was the leading framework of macroeconomic analysis
from the 1940s to the mid-1970s.

Hicks introduced the IS-LM model in his 1937 article Mr. Keynes and the Classics;
A Suggested Interpretation as a device for clarifying the relationship between classical
theory and The General Theory of Employment, Interest and Money (1936) of John
Maynard Keynes (1883-1946). Hicks saw as Keynes main contribution the joint
determination of income and the interest rate in goods and financial markets. His early
mathematical formalization of an important but very difficult book provided the fulcrum
for the development of Keynesian theory, while spurring endless debates on whether it
captured Keynes ideas adequately. Hansen (1949, 1953) extended the model by adding,
among other things, taxes and government spending.

The simplest IS-LM model has three blocks. In the goods market, aggregate demand is
given by the sum of consumption as a function of disposable income, investment as a
function of income and the interest rate, and government spending. In equilibrium,
aggregate demand equals aggregate supply and so Investment equals Saving, yielding
the IS curve. In money market equilibrium, money demand, which depends on income
and the interest rate, equals money supply, giving rise to the LM curve (Liquidity
preference as Keynes called money demand equals Money). In the third block
employment is determined by output through an aggregate production function, with
unemployment appearing if downward rigidity of the nominal wage is assumed. Joint
equilibrium in the output-interest rate space appears in Figure 1. The analysis of
monetary and fiscal policies is straightforward: lower taxes and higher government
spending shift the IS curve out (having a multiplier effect) and higher money supply
shifts the LM curve out.

The IS-LM model represents a static, short-run equilibrium. Not only the capital stock
but also wages and prices are fixed, and expectations crucial in Keynesian theory as
animal spirits play virtually no role. Given that the IS captures a flow equilibrium and
the LM a stock equilibrium, the joint time frame is unclear. There is no economic
foundation for either aggregate demand components or money demand, and output is
demand determined. These limitations stimulated the rise of modern macroeconomics.
In the 1950s, Franco Modigliani and Milton Friedman developed theories of
consumption, and James Tobin developed theories of investment and money demand.
The lack of dynamics was tackled by adding a supply block constituted by the Phillips
curve, an empirical relationship apparently implying a reliable trade-off between the
unemployment rate and price inflation. In the 1960s the IS-LM was enlarged by Robert
Mundell and Marcus Fleming to encompass the open economy.
The extended IS-LM called the neoclassical synthesis or, later, the Aggregate Supply-
Aggregate Demand model gave rise to large macroeconometric models, such as the
MPS model led by Franco Modigliani in the 1960s. It was seen and used as a reliable
tool for forecasting and for conducting policy in fine tuning the economy. This in spite
of ongoing criticism from the monetarists, led by Milton Friedman, who argued that
there was no long-run inflation-unemployment trade-off and that monetary policy rather
than fiscal policy had the strongest impact on output, but also that, since it could be
destabilizing, it should stick to a constant money growth rule.

The IS-LM model is still the backbone of many introductory macroeconomics textbooks
and the predictions of its extended version are consistent with many empirical facts
present in market economies. However, it is now largely absent from macroeconomic
research. Its demise was first brought about both by its inability to account for the
simultaneous high inflation and unemployment rates experienced in the late 1970s, due
to its non-modelling of the supply side, and by its forecasting failures, which lent
support to the Lucas critique, which stated that macroeconometric models which
estimate economic relationships based on past policies without modelling expectations
as rational are not reliable for forecasting under new policies. Current macroeconomic
research is conducted using dynamic general equilibrium models with microeconomic
foundations which integrate the analyses of business cycles and long-term growth.
However, the idea that wage and price rigidities help explain why money affects output
and that they can have important effects on business cycle fluctuations, a foundation of
the IS-LM model, survives in so-called new Keynesian macroeconomics.

REFERENCES

Hansen, A.H. (1949), Monetary Theory and Fiscal Policy, New York: McGraw Hill.
Hansen, A.H. (1953), A Guide to Keynes. New York: McGraw Hill.
Hicks, J.R. (1937), Mr. Keynes and the Classics; A Suggested Interpretation,
Econometrica 5 (2), April, 147-159.
Keynes, J.M. (1936), The General Theory of Employment, Interest and Money. New
York: Macmillan.