The ISLM Model

Copyright © 2014 Pearson Canada Inc.

Web Chapter

THE ISLM MODEL

Mishkin/Serletis

The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition

Copyright © 2014 Pearson Canada Inc. Web-2

Learning Objectives

1. Utilize the Keynesian cross model for the determination of aggregate output

2. Apply the Keynesian ISLM model for the determination of aggregate output

3. Evaluate how fiscal policy variables (spending and taxes) and monetary policy variables (the money supply and the interest rate) enter into these models


The ISLM Model

• Includes money and interest rates in the Keynesian framework

• Examines an equilibrium where aggregate output equals aggregate demand

• Assumes fixed price level where nominal and real quantities are the same

• IS curve is the relationship between equilibrium aggregate output and the interest rate

• LM curve is the combinations of interest rates and aggregate output for which MD = MS


Equilibrium in the Market for Money: The LM Curve

• Demand for money called liquidity preference

• Md/P depends on income (Y) and interest rates (i)

• Positively related to income– raises the level of transactions– increases wealth

• Negatively related to interest rates


Equilibrium in the Market for Money: The LM Curve (cont’d)

• Connects points that satisfy the equilibrium condition that MD = MS

• For each level of aggregate output, the LM curve tells us what the interest rate must be for equilibrium to occur

• The economy tends to move toward points on the LM curve


Deriving the LM Curve


ISLM Diagram: Determination of Output and the Interest Rate


Factors that Cause the LM Curve to Shift

1. Changes in the Money Supply2. Autonomous Changes in Money Demand


Shift in the LM Curve from an increase in the Money Supply


Shift in the LM Curve When Money Demand Increases


Response to a Change in Monetary Policy

• An increase in the money supply creates an excess supply of money

• The interest rate declines• Investment spending and net exports rise• Aggregate demand rises• Aggregate output rises• The excess supply of money is eliminated• Aggregate output is positively related to the money

supply


ISLM Diagram: Simultaneous Determination of Output and the Interest Rate


Response to a Change in Fiscal Policy

• An increase in government spending raises aggregate demand directly; a decrease in taxes makes more income available for spending

• The increase in aggregate demand cause aggregate output to rise

• A higher level of aggregate output increases the demand for money


Response to a Change in Fiscal Policy (cont’d)

• The excess demand for money pushes the interest rate higher

• The rise in the interest rate eliminates the excess demand for money

• Aggregate output and the interest rate are positively related to government spending and negatively related to taxes


Response of Aggregate Output and the Interest Rate to an Expansionary Fiscal Policy


Summary


Effectiveness of Monetary Versus Fiscal Policy

• How can policy makers decide which policies (changing the money supply, changing government spending, or taxes) to use if faced with too much unemployment?

• In practice, fiscal and monetary policies are used together in the combination known as the policy mix


Monetary Policy Versus Fiscal Policy: The Caseof Complete Crowding Out

• Complete crowding out– expansionary fiscal policy does not lead to a rise in output– increased government spending increases the interest rate

and crowds out investment spending and net exports

• The less interest-sensitive money demand is, the more effective monetary policy is relative to fiscal policy


Effectiveness of Monetary and Fiscal Policy When Money Demand Is Unaffected by the Interest Rate


Targeting Money Supply Versus Interest Rates

• If the IS curve is more unstable (uncertain) than the LM curve, a Ms target is preferable

• If the LM curve is more unstable than the IS curve, an interest-rate target is preferred


Money Supply and Interest-Rate Targets When the IS Curve is Unstable and the LM Curve Is Stable


Money Supply and Interest-Rate Targets When the LM Curve Is Unstable and the IS Curve Is Stable


ISLM Model in the Long Run

• Natural rate level of output (Yn)– rate of output at which the price level has no tendency

to change• The IS curve is based on real values, so when the price

level changes, the IS curve does not change• The LM curve is affected by the price level

– as the price level rises, the quantity of money in real terms falls, and the LM curve shifts to the left until it reaches Yn (long-run monetary neutrality)

• Neither monetary nor fiscal policy affects output in the long run


ISLM Model in the Long Run

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The ISLM Model

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