As a starting point, see model below:
It is described as a short-term model of the economy that helps to show how interest rates are determined. Let's go piece by piece.
The IS curve describes the combination of interest rates and income that clear the goods and services market (i.e., think investment/spending = savings/production). The curve is a function of consumer spending, government spending, investment and net exports -- the inputs of the cherished Aggregate Demand that you always hear about. So what explains the curve's slope...well, demand side economics, of course. The logic goes that lower interest rates will lead to greater spending, which will lead to greater production and economic expansion, which leads to more income, some portion of which will go towards savings, ultimately re-establishing the original balance (assuming the desired investment is not greater than this additional savings). And so the virtuous cycle goes.
But the IS curve alone does not pin down interest rates. So enters the LM curve that relates the combinations of interest rates and GDP that match the supply and demand for money, which is ultimately a trade off between liquidity and returns. The Fed controls this market by increasing and decreasing the supply of money -- the lever by which they manage the level of the Fed Funds rate. Generically, higher rates will encourage people to forgo liquidity and consumption, muting demand, while lowering rates will do the opposite. But, as the curve tries to capture, GDP plays an important role, for its increase triggers a matching effect on the demand for money (there is an increase in the volume of transactions in the economy which favors liquidity). Accordingly, the curve slopes upwards because rates must rise in order to temper the demand that comes from increased income.
Put together, the intersection point on the chart between IS and LM is where loanable funds and liquidity preference are in equilibrium with each other.
Which brings us to the here and now. When private demand drops meaningfully, and the Fed lowers rates in response but there is no rebound in the economy, the entire IS curve shifts to the left -- eventually the equilibrium point with LM occurs at the zero bound (0% rates), the level at which the LM line goes horizontal. The Keynesians have argued that in such a scenario fiscal and monetary boosts are needed to move the IS curve back to the right (remember government is part of the IS function) -- and, given the horizontal nature of the LM curve, running huge deficits and tripling the money supply should not have any impact on rates, because in a liquidity trap, people are simply holding cash as a store of value and economic activity has dried up. And therein lies the free lunch. You can spend, spend, spend to goose GDP, but you don't face the consequences of higher rates because of government crowding out the private sector. Joy.
To be clear, the above is simply my first attempt at trying to understand what's going on. The nuances will continue to be fleshed out as I work my way through this stuff. And as I learn some more, so will you.
