The IS-LM model is built upon two markets, the goods market (IS) and the money market (LM). I will present some views about the IS-LM model from the perspective of effective demand.
Money Market First
The money market is described by a plot of the interest rate (y-axis) and the quantity of money (x-axis). The line drawn is for money demand is given for a given level of nominal income, where nominal income (PY) is the real output multiplied by the price level (inflation). The money market model implies a corresponding and opposite bond market model.
Graph #1: Source of graph, Department of Economics, University of Utah.
As the economy grows, nominal income (PY) shifts right.
Graph #2: Source, Department of Economics, University of Utah.
In graph #2, money demand shifts right as nominal income grows from PY1 to PY2. If we hold the money supply constant, the interest rate will subsequently rise to the red dot. The excess money demand implies excess bond supply. Bond prices fall, thus raising the interest rate back up to the red dot equilibrium, where money supply is the same at a higher interest rate.
Remember that nominal income can grow by increasing real output or by increasing the price level. Normally as the economy grows after a recession, growth is seen by an increase in real output, not the price level. Therefore during this part of the business cycle, the Fed will be accommodative, and through their open market operations of purchasing "bonds", they will keep the interest rate at the blue dot by increasing the money supply.
The equilibrium points in this graph of the money market are plotted in the IS-LM model in order to give the LM curve. The LM curve gives the series of equilibrium points between the interest rate and real output.
Graph#3: Source, Department of Economics, University of Utah.
Graph #3 assumes that the Fed is not going to be accommadative, which is an unreal assumption. Therefore the LM curve should actually be horizontal in graph #3.
Graph #4: Source, Department of Economics, University of Utah. Adjusted by me.
But when does the LM curve slope upwards? When real output reaches the effective demand limit, real output will slow down and further increases in nominal income will show up as increases in the price level (inflation). It is when the real output reaches the effective demand limit that the Fed stops being accommodative. Then the LM curve will start sloping upward at the effective demand limit.
Graph #5: Source, Department of Economics, University of Utah. Adjusted by me.
Graph #5 shows the current situation where the Fed is keeping the interest rate low through being accommodative. Graph #5 assumes that the Fed will start raising the interest as the inflation at the effective demand limit starts to appear. However, there is a complication. The Fed is expecting real output to reach $17 trillion (2009 dollars), while the effective demand limit is currently projected at $16.1 trillion.
The problem with the Fed expecting real output to reach $17 trillion is that they will be inclined to keep the interest rate low beyond the $16.1 trillion effective demand limit.
Graph #6: Source, Department of Economics, University of Utah. Adjusted by me.
Graph #6 shows that the Fed is keeping the interest rate low while inflation begins to appear. They may see the inflation as temporary, and thus not react to it. Also, the Fed may be deep into QE, not expecting real output to slow down and inflation to rise, and would have to unwind QE first before raising the interest rate. Unwinding QE by slowing down purchases of "bonds" may be enough to control inflation. "Bond" prices would fall, thus raising the money market interest rate. People would be more willing to save their excess money income instead of using it to purchase goods and services and put pressure on inflation.
The goods market is described by a graph with aggregate demand (y-axis) and national output (x-axis). Aggregate demand is given by the consumption function which is determined from aggregate autonomous spending (A in graph) plus the marginal propensity to consume multiplied by national income (A + MPC * Y). Equilibrium is found where aggregate demand (Z in graph) is equal to national output (Y). Thus a 45 degree line is drawn to determine equilibrium.
Graph #7: Source, Department of Economics, University of Utah.
As the economy grows, the consumption function will shift upwards for various reasons. Equilibrium output will rise along the 45 degree line. In a standard goods market model, a lower interest rate will shift the aggregate consumption function upwards as equilibrium level of real output increases. The Fed has lowered their overnight Fed rate as low as they can to shift aggregate consumption upward. But they are working against a fallen labor share of income which shifted the aggregate consumption function downward. Be that as it may, the aggregate consumption function continues upward.
What happens when the aggregate demand function reaches the effective demand limit?
Graph #8: Source, Department of Economics, University of Utah. Adjusted by me.
Aggregate demand will grow to the effective demand limit. At that point, output supply (Y) will slow down and stop. As aggregate demand continues to grow and supply stops, the aggregate demand curve slides upward vertically on the effective demand limit curve. That excess demand will not be able to express in increased output as it normally would below the effective demand limit. The result of this excess aggregate demand over supply creates pressures for inflation.
Note: It must be said that an excess aggregate demand over supply does not always lead to inflation, since there must be a mechanism to put that excess demand in the hands of consumers and not those with capital income. If the excess demand ends up in the hands of capital owners, there will be a bubble in assets prices instead of inflation for goods and services.
To transfer the information in graph#8 to the IS-LM curve, the result looks like this...
Graph #9: Source, Department of Economics, University of Utah. Adjusted by me.
The IS curve of the goods market becomes inelastic at the effective demand limit, unless the interest rate has a mechanism to shift the effective demand limit to the right. (Full-employment is reached at the effective demand limit.)
As Keynes said in his General Theory, chapter 21...
"In this case we have constant returns and a rigid wage-unit, so long as there is any unemployment. It follows that an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment, and that employment will increase in exact proportion to any increase in effective demand brought about by the increase in the quantity of money; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand. Thus if there is perfectly elastic supply so long as there is unemployment, and perfectly inelastic supply so soon as full employment is reached, and if effective demand changes in the same proportion as the quantity of money, the Quantity Theory of Money can be enunciated as follows: “So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, prices will change in the same proportion as the quantity of money”."
To wrap it up...
My forecast is that there will be pressures for inflation or a bubble in asset prices when real GDP reaches the "currently projected" effective demand limit of $16.1 trillion (2009 dollars). The Fed will be forced to respond to control these inflationary pressures. They will not be expecting real output to stall since they expect real output to continue up to $17 trillion. The Fed will have to respond by unwinding QE or they will have price level problems.
And the inflationary pressures depend on the momentum that real output growth carries into the effective demand limit. The momentum is economic, instutional, expected and generated. The greater the momentum, the greater the inflationary pressures.