T h e I SLM Model

Introduction
We now have a basic idea of how the economy functions in the short run.
Because, in the short run, prices are not completely flexible, changes in aggregate
demand affect output, not just prices. To develop this short-run theory of the
economy, we must now consider aggregate demand and supply in more detail. We
will see a more detailed analysis of aggregate demand based on the ISLM model.
This model was developed by John Hicks in the 1930s as an interpretation of John
Maynard Keyness seminal work, The General Theory of Employment, Interest and
Money, and is based on an analysis of equilibrium in the goods and money
markets, supposing that the price level is fixed. We can interpret the ISLM model
in two distinct ways: first, as a theory of GDP determination, supposing that the
price level is fixed, or, second, as a theory of aggregate demand and so as part of
an aggregate demandaggregate supply model.
The Goods Market and the IS
Curve
The building blocks of the ISLM model are familiar from earlier analysis. The IS side of the model
summarizes equilibrium in the goods market and is based partly on the classical model; the LM side
of the model summarizes equilibrium in the money market and so is related to the analysis of
money.
The basic equation summarizing equilibrium in the goods market, for a closed economy, is familiar:
Y = C + I + G.
As before, we suppose that
C = C(Y T)
I = I(r)
G=
T=.
 The only difference from our earlier analysis is that we are no longer supposing
that real GDP is determined on the supply side, since that is true only in the long
run. But this is far from an innocuous change. Previously, given that Y was fixed
at Y, we were able to use this model to determine the equilibrium interest rate in
the economy. Now, there are different combinations of the interest rate and the
level of GDP that are consistent with equilibrium. Writing equilibrium in terms of
the loans market gives
S(Y) = I(r).
Recall from the analysis of the classical model that
Sp = Y T C
Sg = T G
S = Y C(Y T) G.
 Now, consider how changes in GDP change saving. An increase in GDP
(Y), from this equation, raises saving directly by Y and lowers it by
an amount equal to MPC Y. Thus, the total change in saving is

S = (1 MPC)Y > 0.
So an increase in income increases total saving, other things equal.
We know, therefore, that it decreases the interest rate. Thus, we draw
the conclusion that, for equilibrium to exist in the goods market,
higher levels of GDP must be associated with lower interest rates.
 We can tell the same story another way. Suppose that interest rates increase. This
decreases the level of investment. In response to this fall in investment demand,
firms produce less output. Now recall the circular flow. A decrease in output leads
firms to employ fewer workers and to use their capital less intensively; hence,
income goes down. In response to the decreased income, households consume
less. This effect on consumption reinforces the initial effect, so we get the same
conclusionhigher interest rates are associated with lower output, and vice
versa.
We summarize this reasoning in terms of the IS curve. This is defined as {r, Y}
combinations such that the goods market (equivalently, the loanable-funds
market) is in equilibrium. The previous reasoning tells us that it slopes downward.
The Keynesian Cross
A common means of deriving the IS curve, based on the second
explanation above, is known as the Keynesian cross. The Keynesian
cross also gives us insights into how fiscal policy affects the economy.
The key idea of this model is that planned expenditure may differ from
actual expenditure if firms sell less or more than they anticipated and
so accumulate or decumulate inventory. Planned expenditure is
simply the amount that households, firms, and the government
intend to spend on goods and services. We write it as
PE = C + I + G.
 Suppose, for the moment, that the interest rate is fixed at so that the
level of planned investment is exogenous [I()]. Then, we can write
planned expenditure as
PE = C(Y ) + I() + .
Planned expenditure is thus an increasing function of income.
In equilibrium, planned expenditure equals actual expenditure, which,
of course, equals GDP:
PE = Y.
We can graph both planned and actual expenditure against income to
get the Keynesian cross diagram.
 The adjustment to equilibrium takes the form of changes in inventory. If actual
expenditure exceeds planned expenditure, this means that firms produced too
much. Remember that inventory investment is counted as expenditure; it is as
if firms sell the goods to themselves. Actual expenditure exceeds planned
expenditure when firms accumulate inventory. In this circumstance, firms
would cut back on their production, lessening their inventory accumulation
and so decreasing actual expenditure. An analogous situation occurs if planned
expenditure exceeds actual expenditure. In this case, firms are unintentionally
decumulating inventory, giving them an incentive to increase production. In
practice, we think that this adjustment takes place rapidly, so we focus upon
the situation where the economy is in equilibrium
 What happens if planned spending increases? For example, suppose
that government spending is increased. Such an increase in planned
spending induces firms to produce more output. Recalling the circular
flow, this implies that workers and owners of firms obtain more
income and so increase their consumption. Planned spending and,
ultimately, output go up by more than the original increase in
government spending. To put it another way, government spending
has a multiplier effect on output through the government-purchases
multiplier.
 What is the economics behind this process? The answer can be found in the
circular flow of income. An increase in government purchases (say, G = $1
billion) directly increases GDP by the same amount. Firms hire workers to
produce this extra output, so wages and profits, hence income, rise by an equal
amount. This induces extra consumption equal to MPC G (for example, if MPC
= 0.75, then consumption increases by $750 million). Thus, expenditures, which
originally rose by G, now rise by (1 + MPC)G = $1.75 billion.
The story does not stop here. Since this additional consumption again increases
income, consumption rises even further, by an amount equal to MPC (MPC
G). In this example, consumption increases by a further $563 million. And the
process continues.
 The ultimate increase in GDP is given by

Y = (1 + MPC + MPC2 + MPC3 + . . .)G

= [1/(1 MPC)]G

Y/G = 1/(1 MPC).

 The multiplier has a couple of interpretationsone benign, the other less so.
From one perspective, we can think about the multiplier as telling us that we
have the power to use fiscal policy to affect the economy dramatically in the
short run. This suggests that fiscal policy might be a potent tool for
stimulating the economy in a recession, for example. But another implication
is that fluctuations in spending have magnified effects on GDP. The reasoning
that we have just considered would apply equally well if the initial change
were an exogenous shock to planned investment or consumption. Keynes
suggested that fluctuations in GDP might be caused by initial fluctuations in
investment due to the capricious behavior of investors (which he called their
animal spirits).
 Just as increases in spending increase GDP, so do cuts in taxes. The
mechanism is similar: Tax cuts increase disposable income and hence
stimulate consumption. The only difference comes from the fact that
a tax cut of T increases consumption initially by MPC T. Thus, the
tax multiplier equals the government-purchases multiplier multiplied
by MPC:

Y/T = MPC/(1 MPC).

Case Study: Cutting Taxes to Stimulate the
Economy:
The Kennedy and Bush Tax Cuts
Cuts in personal and corporate income taxes were used by President Kennedy to stimulate the
economy in 1964 on the advice of his Council of Economic Advisers. The economy grew rapidly
in the wake of these cuts. Keynesian economists think that this experience supports the idea,
embodied in the Keynesian cross model, that tax cuts stimulate aggregate demand and boost
the economy. Tax cuts may also increase peoples incentive to supply labor, thus increasing the
aggregate supply of goods and services.
When George W. Bush proposed tax cuts during his campaign in 2000, the economy was near
full employment and some economists were concerned that a tax cut might raise aggregate
demand and spur inflation. But candidate Bushs advisers argued that reductions in marginal tax
rates would increase labor supply, and thus increase aggregate supply. After the election, as the
economy began to weaken, President Bushs advisers began touting the tax-cut proposal as a
way to stimulate spending, and thus increase aggregate demand. The tax cut that finally passed
in May 2001 included a rebate mailed to taxpayers that was intended to speed up the
stimulus to the economy. A subsequent tax cut in 2003 further stimulated the economy, turning
a relatively weak recovery into a more robust one.
The Interest Rate, Investment,
and the IS Curve
The transition from the Keynesian cross model to the IS curve is
achieved by noting that, if the real interest rate changes, this changes
planned investment. The Keynesian cross analysis tells us that
changes in planned investment change GDP. Thus, for example, if
interest rates increase, planned investment falls, and so does output.
Thus, higher levels of the interest rate are associated with lower levels
of output.
How Fiscal Policy Shifts the IS
Curve
The position of the IS curve depends on fiscal-policy variables.
Increases in government spending or decreases in taxes increase the
equilibrium level of output at any given interest rate. Thus they are
associated with outward shifts in the IS curve.
 We can use the Keynesian cross to see how other changes in fiscal policy shift
the IS curve. Because a decrease in taxes also expands expenditure and income,
it, too, shifts the IS curve outward. A decrease in government purchases or an
increase in taxes reduces income; therefore, such a change in fiscal policy shifts
the IS curve inward.
In summary, the IS curve shows the combinations of the interest rate and the
level of income that are consistent with equilibrium in the market for goods and
services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy
that raise the demand for goods and services shift the IS curve to the right.
Changes in fiscal policy that reduce the demand for goods and services shift the
IS curve to the left.
 The Money Market
and the LM Curve
The LM curve plots the relationship between the interest rate and the
level of income that arises in the market for money balances. To
understand this relationship, we begin by looking at a theory of the
interest rate called the theory of liquidity preference.
The Theory of Liquidity
Preference
In his classic work The General Theory, Keynes offered his view of how the
interest rate is determined in the short run. His explanation is called the
theory of liquidity preference because it posits that the interest rate adjusts
to balance the supply and demand for the economys most liquid asset
money. Just as the Keynesian cross is a building block for the IS curve, the
theory of liquidity preference is a building block for the LM curve.
To understand the determination of interest rates, we turn to the money
market. Again, our building blocks are familiar from the classical model. Our
starting point is the condition for equilibrium in the money market:
M/P = L(i, Y).
 According to this equation, the demand for real balances equals the real supply
of money, M/P. The demand for real balances, as explained in Chapter 4,
depends on the level of GDP and the nominal interest rate; this is known as the
theory of liquidity preference. The real supply of money depends on the
nominal money supply, which is an exogenous policy variable, and the price
level, which is also taken to be exogenous in the ISLM model.
Recall from the Fisher equation that the nominal interest rate equals the real
interest rate plus the expected inflation rate. If expected inflation is zero, i = r.
For simplicity, we suppose for the moment that this is the case, so we can write
M/P = L(r, Y).
 Just as the IS curve gives us {r, Y} combinations consistent with
equilibrium in the goods market, the LM curve gives us {r, Y}
combinations consistent with equilibrium in the money market. To see
how this works, consider a diagram of the market for money. Notice
that the demand for money depends on r and Y. Increases in r
decrease the demand for money; increases in Y increase the demand
for money. The supply of and demand for money determine the
equilibrium interest rate. Note also that changes in the money supply
therefore affect the equilibrium interest rate.
Case Study: Did Monetary Tightening
Raise or Lower Interest Rates?
In the early 1980s, Paul Volcker, the chairman of the Federal Reserve,
slowed the rate of money growth in a successful attempt to decrease
inflation. The Fisher equation teaches us that lower inflation tends to
reduce nominal interest rates in the long run. Our analysis of the
money market reveals that when prices are sticky, a decrease in the
supply of money tends to increase interest rates in the short run. Both
effects are visible in the 1980s data.
Income, Money Demand, and
the LM Curve
The basic analysis of the LM curve is now straightforward. Higher GDP
raises the demand for money. If the real supply of money is fixed,
then interest rates must rise in order to bring the demand for money
back in line with the supply. So higher GDP is associated with higher
interest rates when the money market is in equilibrium. The LM curve
slopes upward.
How Monetary Policy Shifts the
LM Curve
The position of the LM curve depends on the real money supply. An increase in
the real money supply for a given level of GDP implies lower interest rates. An
increase in the money supply thus shifts the LM curve downward and conversely.
We can use the theory of liquidity preference to understand how monetary
policy shifts the LM curve. Suppose that the Fed decreases the money supply
from M1 to M2, which causes the supply of real money balances to fall from
M1/P to M2/P. Figure 11-12 shows what happens. Holding constant the amount
of income and thus the demand curve for real money balances, we see that a
reduction in the supply of real money balances raises the interest rate that
equilibrates the money market. Hence, a decrease in the money supply shifts the
LM curve upward.
 In summary, the LM curve shows the combinations of the interest rate
and the level of income that are consistent with equilibrium in the
market for real money balances. The LM curve is drawn for a given
supply of real money balances. Decreases in the supply of real money
balances shift the LM curve upward. Increases in the supply of real
money balances shift the LM curve downward.
Conclusion: The Short-Run
Equilibrium
We now have all the pieces of the ISLM model. The two equations of this
model are
Y = C(Y - T ) + I(r) + G IS,
M/P = L(r, Y ) LM.
The model takes fiscal policy G and T, monetary policy M, and the price level
P as exogenous. Given these exogenous variables, the IS curve provides the
combinations of r and Y that satisfy the equation representing the goods
market, and the LM curve provides the combinations of r and Y that satisfy
the equation representing the money market. These two curves are shown
together in Figure 11-13.
 The equilibrium of the economy is the point at which the IS curve and the LM
curve cross. This point gives the interest rate r and the level of income Y that
satisfy conditions for equilibrium in both the goods market and the money
market. In other words, at this intersection, actual expenditure equals planned
expenditure, and the demand for real money balances equals the supply.
As we conclude, lets recall that our ultimate goal in developing the ISLM model
is to analyze short-run fluctuations in economic activity. Figure 11-14 illustrates
how the different pieces of our theory fit together. We developed the Keynesian
cross and the theory of liquidity preference as building blocks for the ISLM
model. The ISLM model helps explain the position and slope of the aggregate
demand curve. The aggregate demand curve, in turn, is a piece of the model of
aggregate supply and aggregate demand, which economists use to explain the
short-run effects of policy changes and other events on national income.