The Keynesian cross is a basic model of income determination. It takes fiscal policy and planned investment as exogenous and then shows that there is one level of national income at which actual expenditure equals planned expenditure. It shows that changes in fiscal policy have a multiplied impact on income.
Once we allow planned investment to depend on the interest rate, the Keynesian cross yields a relationship between the interest rate and national income. A higher interest rate lowers planned investment, and this in turn lowers national income. The downward-
The theory of liquidity preference is a basic model of the determination of the interest rate. It takes the money supply and the price level as exogenous and assumes that the interest rate adjusts to equilibrate the supply and demand for real money balances. The theory implies that increases in the money supply lower the interest rate.
Once we allow the demand for real money balances to depend on national income, the theory of liquidity preference yields a relationship between income and the interest rate. A higher level of income raises the demand for real money balances, and this in turn raises the interest rate. The upward-
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The IS–LM model combines the elements of the Keynesian cross and the elements of the theory of liquidity preference. The IS curve shows the points that satisfy equilibrium in the goods market, and the LM curve shows the points that satisfy equilibrium in the money market. The intersection of the IS and LM curves shows the interest rate and income that satisfy equilibrium in both markets for a given price level.