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Week 8

The ISLM model integrates money and interest rates within the Keynesian framework, analyzing equilibrium where aggregate output equals aggregate demand. It features the IS curve, which illustrates the relationship between equilibrium output and interest rates, and the LM curve, which represents the equilibrium condition of money demand and supply. The model also discusses the impacts of monetary and fiscal policy on aggregate output and interest rates, as well as the long-run implications of these policies.

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Promachos IV
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1 views

Week 8

The ISLM model integrates money and interest rates within the Keynesian framework, analyzing equilibrium where aggregate output equals aggregate demand. It features the IS curve, which illustrates the relationship between equilibrium output and interest rates, and the LM curve, which represents the equilibrium condition of money demand and supply. The model also discusses the impacts of monetary and fiscal policy on aggregate output and interest rates, as well as the long-run implications of these policies.

Uploaded by

Promachos IV
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Lecture 8

The ISLM model

Reading: Mishkin, pages 476-504

The ISLM model


Questions and problems:
•Mishkin, Chapter 20, handouts, problems 1-15

1
The ISLM Model
• Includes money and interest rates in the
Keynesian framework
• Examines an equilibrium where aggregate output equals
aggregate demand

The ISLM model


• 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 2
Equilibrium in the Goods Market: The
IS Curve
• Interest rates and planned investment spending
• Negative relationship

• Interest rates and net exports


• Negative relationship

The ISLM model


• IS curve: the points at which the total quantity of goods
produced equals the total quantity of goods demanded
• Output tends to move toward points on the curve that
satisfies the goods market equilibrium

3
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)
• As income increases people want to hold more real money
balances: Positively related to income

The ISLM model


• Raises the level of transactions
• Increases wealth
• Negatively related to interest rates

4
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

The ISLM model


5
FIGURE 9 ISLM Diagram: Simultaneous Determination of
Output and the Interest Rate

The ISLM model


6
Factors that Shift the IS Curve
• A change in autonomous factors that is unrelated to the
interest rate
• Changes in autonomous consumer expenditure
• Changes in planned investment spending unrelated to the

The ISLM model


interest rate
• Changes in government spending
• Changes in taxes
• Changes in net exports unrelated to the
interest rate

7
FIGURE 1 Shift in the IS
Curve

The ISLM model


8
Factors that Shift the LM Curve
• Changes in the money supply
• Autonomous changes in money demand

The ISLM model


9
FIGURE 2 Shift in the LM Curve from an Increase
in the Money Supply

The ISLM model


10
FIGURE 3 Shift in the LM
Curve When Money Demand
Increases

The ISLM model


11
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

The ISLM model


• Aggregate demand rises
• Aggregate output rises
• The excess supply of money is eliminated
• Aggregate output is positively related to the money supply

12
FIGURE 4 Response of Aggregate Output and the
Interest Rate to an Increase in the Money Supply

The ISLM model


13
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

The ISLM model


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

14
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

The ISLM model


to government spending and negatively related to taxes

15
FIGURE 5 Response of Aggregate Output and the
Interest Rate to an Expansionary Fiscal Policy

The ISLM model


16
Summary Table 1 Effects from Factors That Shift
the IS and LM Curves

The ISLM model


17
Monetary versus Fiscal Policy
• 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
• So an increase in AD brought about by higher G causes such a rise

The ISLM model


in ir that completely offsets the increase in Y, because of the fall
in I
• The less interest-sensitive money demand is, the more
effective monetary policy is relative to fiscal policy

18
FIGURE 6 Effectiveness of Monetary and Fiscal Policy
When Money Demand Is Unaffected by the Interest Rate

The ISLM model


19
Targeting Ms 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

The ISLM model


20
FIGURE 7 Money Supply and Interest-Rate Targets
When the IS Curve Is Unstable and the LM Curve Is Stable

The ISLM model


21
FIGURE 8 Money Supply and Interest-Rate Targets
When the LM Curve Is Unstable and the IS Curve Is Stable

The ISLM model


22
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
• Using real values, so when the price level changes, the IS curve

The ISLM model


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 or fiscal policy affects output in the long run
23
FIGURE 9 ISLM Model in the
Long Run

The ISLM model


24
FIGURE 10 Deriving the
Aggregate Demand Curve

The ISLM model


25
Deriving the Aggregate Demand
Curve
• Aggregate demand curve: relationship between the price level
and quantity of aggregate output for which the goods market
and market for money are in equilibrium
• As the price level increases, output falls.

The ISLM model


26
Shifts in the Aggregate Demand Curve
• ISLM analysis shows how the equilibrium level of aggregate
output changes for a given price level
• A change in any factor except the price level, that causes the
IS or LM curve to shift, causes the aggregate demand curve to

The ISLM model


shift

27
FIGURE 11 Shift in the Aggregate Demand Curve
Caused by a Shift in the IS Curve

The ISLM model


28
FIGURE 12 Shift in the Aggregate Demand Curve Caused
by a Shift in the LM Curve

The ISLM model


29

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