The

*IS*–*LM*model is a general theory of the aggregate demand for goods and services. The exogenous variables in the model are fiscal policy, monetary policy, and the price level. The model explains two endogenous variables: the interest rate and the level of national income.The

*IS*curve represents the negative relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. The*LM*curve represents the positive relationship between the interest rate and the level of income that arises from equilibrium in the market for real money balances. Equilibrium in the*IS*–*LM*model—the intersection of the *IS*and*LM*curves—represents simultaneous equilibrium in the market for goods and services and in the market for real money balances. 362

The aggregate demand curve summarizes the results from the

*IS*–*LM*model by showing equilibrium income at any given price level. The aggregate demand curve slopes downward because a lower price level increases real money balances, lowers the interest rate, stimulates investment spending, and thereby raises equilibrium income.Expansionary fiscal policy—

an increase in government purchases or a decrease in taxes— shifts the *IS*curve to the right. This shift in the*IS*curve increases the interest rate and income. The increase in income represents a rightward shift in the aggregate demand curve. Similarly, contractionary fiscal policy shifts the*IS*curve to the left, lowers the interest rate and income, and shifts the aggregate demand curve to the left.Expansionary monetary policy shifts the

*LM*curve downward. This shift in the*LM*curve lowers the interest rate and raises income. The increase in income represents a rightward shift of the aggregate demand curve. Similarly, contractionary monetary policy shifts the*LM*curve upward, raises the interest rate, lowers income, and shifts the aggregate demand curve to the left.