How does the IS-LM model help economists in the day to day analysis of the economy? There are just too many assumptions that are not there in the real world.
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2$\begingroup$ IS-LM is not used in day to day analysis. In fact very few models are. $\endgroup$– GiskardCommented Nov 2, 2016 at 20:34
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$\begingroup$ I voted to close because while this is a perfectly legitimate question, it is not suitable for this site as any decent answer would be too long. See e.g. this 2000 book: IS-LM and Modern Macroeconomics. $\endgroup$– user18Commented Nov 5, 2016 at 10:33
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$\begingroup$ A decent answer could still be reasonably succinct here. Many questions on this SE could discussed at length but a short answer + suggestion for further reading is suitable. I think this is one. @KennyLJ $\endgroup$– JamzyCommented Nov 7, 2016 at 0:59
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$\begingroup$ @denesp That is not true- the IS-LM and Mundell-Fleming type model is used by many central banks and organizations, as are DSGE models. $\endgroup$– ChinGCommented Aug 8, 2018 at 17:56
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$\begingroup$ @ChinG X "type model" and X "model" are not the same. I am very happy to learn that central banks use more sophisticated models and not base IS-LM. $\endgroup$– GiskardCommented Aug 8, 2018 at 22:22
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3 Answers
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The best economic models make useful predictions with as little complexity as possible -- in other words, they make assumptions that aren't "true" in the real world, but make predictions that nevertheless turn out to be true.
For instance, advocates of the day-to-day use of the IS-LM model such as Paul Krugman point to the analysis of liquidity traps as an important case where its users have proved to be right where many other analysts have made bad predictions.
From "What I Mean When I Talk About IS-LM (Wonkish)":
Those of us who understood IS-LM and took it seriously declared in advance — in late 2008 and early 2009 — that big deficits and huge increases in the monetary base would lead neither to soaring interest rates nor to soaring inflation. This was very much not what many influential people were saying: there were widespread forecasts of soaring rates and soaring inflation. Later, there were many people denying that austerity would have negative effects on output.
He provides a more detailed explanation of an IS-LM analysis of liquidity traps (and a few other insights that the model provides).
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Two vies on IS-LM, Keynesian and Monetarist, analyses extreme situations of the economy. It provides comparative-static equilibrium condition. It ignores time-lags. It doesn't consider effects of changes in aggregate demand on output and prices.
Keynesian version assumes price level to be constant and inflation ignored. Neoclassical version considers full-employment and so price level is result of nominal money supply and output is exogenous.
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Advantages:
- Large enconomy
- National level problems
- Calculate national income
- Less assumptions
- Working of economic market
Disadvantages:
- Ignorance of individual units
- Incomplete records
- Less exact results
- No individual approach
