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The Mechanism of IS-LM Model

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In the Post Industrial Revolution era, the economies of many countries have experienced growth, which has resulted in the shape of economic strength and high living standards in the countries such as United States, United Kingdom and Japan. Despite the tremendous progress the economies of these countries also face periodical economic shocks. The time span of these shocks is normally short and the economies revive back to their position. The continuation of this expansion and contraction trend in the economy is known as the business cycle. The subject matter of macroeconomic theory mainly constitutes the business cycle theory.   The effects of the declining trends in the economy expand to all the areas such as production, income, consumption and employment level.

Therefore it has been an important issue for the economists of all eras to study the main concerns such as the causes of the business cycle and the responsive behaviour needs to be adopted by the policymakers. Despite many explanations provided by economists, the questions remain still controversial. The main groups of economists involved in the controversy are the Keynesian economists and classical economists.

According to the classical point of view, the business cycles are the result of disturbances in production and spending. The classical economists do not find the need for government action in order to counter the recessions in the economy. On the other hand, according to the Keynesian economists, the wages and the prices do not respond very quickly to the disturbances in the production level and the employment level. Therefore the Governmental action is needed in order to deal with the situation. In the next section, the essay will further elaborate on the debate between the two schools of thoughts.

The Real Business cycle theory is the extended version of the classical theory, which sees the business cycle as the result of the productivity shocks. According to the Real business cycle theory, the reduction in productivity at a temporary basis creates a declining effect on the real wages, employment level and output and increase the interest rate and the prices.  

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