The ISLM Model of Aggregate Demand

After studying this appendix, you will be able to: Explain the purpose and origin of the ISLM model Define and derive the IS curve Define and derive the LM curve Define and derive ISLM equilibrium Use the ISLM model to analyze the relative effectiveness of fiscal policy and monetary policy Use the ISLM model to derive the aggregate demand curve

Purpose and Origin of the ISLM Model Purpose of the ISLM Model The purpose of the ISLM model is two-fold: To provide a tool for analyzing fiscal policy and monetary policy To derive the aggregate demand curve The ISLM model shows how real GDP and the interest rate are determined simultaneously by equilibrium expenditure and money market equilibrium.

Purpose and Origin of the ISLM Model The ISLM model was invented by John Hicks, of Oxford University, one of the greatest economists of the twentieth century. The model is a logical coherent clarification of Keynes’s General Theory. We begin with the IS curve.

The IS Curve The IS curve shows combinations of real GDP and the interest rate at which aggregate planned expenditure equals real GDP. Figure A28.1 derives the IS curve. The table on the next slide shows the aggregate planned expenditure that occurs at different combinations of the interest rate and real GDP.

The IS Curve Each row is an aggregate expenditure schedule. At a given interest rate, as real GDP increases, aggregate planned expenditure increases. At a given real GDP, as the interest rate falls, aggregate planned expenditure increases.

The IS Curve In each row, the green square shows equilibrium expenditure at the corresponding interest rate. At 6 per cent a year, equilibrium expenditure is £800 billion.

The IS Curve In each row, the green square shows equilibrium expenditure at the corresponding interest rate. At 5 per cent a year, equilibrium expenditure is £1,000 billion.

The IS Curve In each row, the green square shows equilibrium expenditure at the corresponding interest rate. At 4 per cent a year, equilibrium expenditure is £1,200 billion.

The IS Curve In each row, the green square shows equilibrium expenditure at the corresponding interest rate. Equilibrium expenditure increases as the interest rate falls.

The IS Curve In part (a), the AEA curve corresponds to the first row of the table. The interest rate is 6 per cent a year. Equilibrium expenditure is at point A and real GDP is £800 billion. In part (b), point A plots the combination of real GDP of £800 billion and the interest rate of 6 per cent a year.

The IS Curve A fall in the interest rate to 5 per cent a year shifts the AE curve upward to AEB . Equilibrium expenditure is at point B and real GDP is £1,000 billion. In part (b), point B plots the combination of real GDP of £1,000 billion and the interest rate of 5 per cent a year.

The IS Curve A fall in the interest rate to 4 per cent a year shifts the AE curve upward to AEC . Equilibrium expenditure is at point C and real GDP is £1,200 billion. In part (b), point C plots the combination of real GDP of £1,200 billion and the interest rate of 4 per cent a year.

The IS Curve The IS curve shows the equilibrium expenditure at each interest rate. The green line passing through points A, B and C in part (b) is the IS curve.

The LM Curve The LM curve shows combinations of real GDP and the interest rate at which the quantity of real money demanded equals the quantity of real money supplied. Figure A28.2 derives the LM curve. The table on the next slide shows the aggregate planned expenditure that occurs at different combinations of the interest rate and real GDP.

The LM Curve Each column is a demand for money schedule. At a real GDP, as the interest rate falls the quantity of money demanded increases. At a given interest rate, as real GDP increases, the quantity of money demanded increases.

The LM Curve In each row, the green square shows money market equilibrium at the corresponding interest rate. At 4 per cent a year, money market equilibrium occurs at real GDP of £800 billion.

The LM Curve In each row, the green square shows money market equilibrium at the corresponding interest rate. At 5 per cent a year, money market equilibrium occurs at real GDP £1,000 billion.

The LM Curve In each row, the green square shows money market equilibrium at the corresponding interest rate. At 6 per cent a year, money market equilibrium occurs at real GDP £1,200 billion.

The LM Curve In each row, the green square shows money market equilibrium at the corresponding interest rate. In money market equilibrium, real GDP increases as the interest rate rises.

The LM Curve In part (a), the MDD curve corresponds to the first column of the table. Real GDP is £800 billion and money market equilibrium occurs at 4 per cent a year at point D.

The LM Curve In part (b), point D plots the combination of real GDP of £800 billion and the interest rate of 4 per cent a year.

The LM Curve In part (a), the MDE curve corresponds to the first column of the table. Real GDP is £1,000 billion and money market equilibrium occurs at 5 per cent a year at point E.

The LM Curve In part (b), point E plots the combination of real GDP of £1,000 billion and the interest rate of 5 per cent a year.

The LM Curve In part (a), the MDF curve corresponds to the first column of the table. Real GDP is £1,200 billion and money market equilibrium occurs at 6 per cent a year at point F.

The LM Curve In part (b), point F plots the combination of real GDP of £1,200 billion and the interest rate of 6 per cent a year.

The LM Curve The LM curve shows the equilibrium expenditure at each interest rate. The line through D, E and F in part (b) is the LM curve.

ISLM Equilibrium The IS curve and the LM curve determine equilibrium interest rate and real GDP at a given price level. Figure A28.3 on the next slide shows the ISLM equilibrium.

ISLM Equilibrium At point B on the IS curve, aggregate planned expenditure equals real GDP. At point E on the LM curve, the quantity of real money demanded equals the quantity of real money supplied. The equilibrium interest rate is 5 per cent a year and real GDP is £1,000 billion.

ISLM Policy Analysis Fiscal Policy Expansionary fiscal policy shifts the IS curve rightward. The interest rate rises and real GDP increases. The increase in real GDP is less than the shift of the IS curve because the interest rate rises  partial crowding out occurs.

ISLM Policy Analysis Monetary Policy An increase in the quantity of money shifts the LM curve rightward. The interest rate falls and real GDP increases. Real GDP increases because the lower interest rate brings an increase in interest-sensitive expenditure.

ISLM Policy Analysis Two Extreme Cases Extreme Keynesian outcome occurs if the LM curve is horizontal. The LM curve is horizontal only if a liquidity trap exists. In this case, fiscal policy does not change the interest rate, so no crowding out occurs.

ISLM Policy Analysis Two Extreme Cases Extreme monetarist outcome occurs if the LM curve is vertical. The LM curve is vertical only if the demand for money is insensitive to the interest rate. In this case, fiscal policy increases the interest rate and complete crowding out occurs.

The Aggregate Demand Curve We can use the ISLM analysis to derive the AD curve. When the price level is 110, the LM curve is LM0 and ISLM equilibrium occurs at point E. The quantity of real GDP demanded is £1,000 billion. This combination of price level and real GDP demanded is plotted as point E in part (b).

The Aggregate Demand Curve If the price level rises to 120, the LM curve shifts leftward to LM1 and ISLM equilibrium occurs at point J. The quantity of real GDP demanded is £900 billion. This combination of price level and real GDP demanded is plotted as point J in part (b).

The Aggregate Demand Curve If the price level falls to 100, the LM curve shifts rightward to LM2 and ISLM equilibrium occurs at point K. The quantity of real GDP demanded is £1,200 billion. This combination of price level and real GDP demanded is plotted as point K in part (b).

The Aggregate Demand Curve The line joining point J, E and K in part (b) shows the relationship between the quantity of real GDP demanded and the price level. This curve is the AD curve.