Chapter 22: IS-LM in Action
The LM curve shifts because of changes in the demand and supply of money. An increase in demand greater than supply increases the interest rate and vice-versa. In general, the demand for money is stable (people habitually consume the same things), but it can increase when there are significant shifts in consumption. It will also increase when prices increase (it requires more money to buy the same things). And it also tends to increase when people feel uncertain about the future (they tend to put more money in savings accounts).
The IS curve, which plots whether money is held in savings or invested, is also influenced by interest rates - when the return on investments increases, it coaxes more money out of savings. There is also the need for investment vehicles, which are created when businesses need to borrow money to fund new operations. The emergence of anything that can be used productively (a cache of natural resources, a new product invention, etc.) or that requires more to be produced (a sudden increase in the population) causes a need for financing, creating more investment vehicles to be purchased.
Policymakers can use the IS-LM curves to gauge the degree to which policy changes will have an effect. This helps avoid the consequences of simple assumptions: so it can be seen that reducing income taxes gives people more money to spend, but the resulting increase in the money supply will also cause an increase in consumer prices, etc.
Implications for Monetary Policy
The IS-LM model has shown itself to be useful for informing monetary policy decisions, particularly those in which the central bank is face with a choice of changing interest rates or changing the money supply, the latter of which tends to cause less instability.
However, the power of this model is limited by its short-run assumptions, such as the stability of prices in a given market by factors other than inflation due to a change in the money supply. Chances in production and consumption can occur for reasons other than the availability of money to make purchases for consumption or finance the means of production. While production and consumption tend to be stable in the long run, there are many short-term fluctuations.
There is also the notion of long-run monetary neutrality, which maintains that changes in monetary policy produce only short-term results because the markets will invariably return to a state of equilibrium. An increase in wages gives workers more money to spend, but the addition of demand will cause prices to rise, so wages and prices will inevitably drift back to their previous levels, relative to one another.
But policymakers are rather stubborn and arrogant sorts. They are convinced that by tweaking the numbers they can make things better for everyone (or at least the voters that support them) in spite of the evidence that this simply is not possible.