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The ISLM model

The ISLM model is one of the most useful basic short-run models in macro. It is a great tool for answering questions related to the effects of fiscal and monetary policy because quickly sketching out the model will give you some answers straight away as to the likely effects on output and the interest rate – which are after all two pretty important consequences of any policy.

Basically you have an IS relation which tells you how the interest rate determines the level of output that will bring the goods market into equilibrium. You have an LM relation which tells you how output determines the interest rate that will bring the money market into equilibrium. Both the goods market and money market will naturally end up in equilibrium, so the equilibrium level of output and interest rate in the economy will be determined by the point at which both these markets are in equilibrium, ie where the IS curve and the LM curves meet.

So you have a simple model like this:

Now we can start answering some questions…

What will be the effect of a fiscal expansion?

The fiscal expansion shifts the IS curve out to the right.

So output rises and so does the interest rate.

If you did it the other way round, a fiscal contraction would mean shifting the IS curve to the left, so output and the interest rate would both fall.

What will be the effect of a monetary expansion?

The monetary expansion shifts the LM curve down.

So output rises and the interest rate falls.

Again if you did the opposite, a monetary contraction would mean the LM curve shifts up, so output falls and the interest rate rises.

Show how a fiscal contraction can be combined with a monetary expansion to prevent a loss of output.

Here we keep output at the same level and have a fall in interest rates.

You can use the ISLM analysis to show why the UK faces a difficult time ahead. George Osborne wants to cut the fiscal deficit, so he is carrying out a fiscal contraction. At the same time, monetary policy is constrained by the fact that interest rates are already pretty much as low as they can go (0.5%) and with inflation exceeding the Bank of England’s target for a while now, it means the next change in monetary policy from the B of E is going to have to be a rise in interest rates (monetary contraction) rather than a monetary expansion.

Here the fiscal contraction has placed downward pressure on interest rates and the Central Bank has contracted monetary policy in order to raise them, both effects have combined to magnify the loss of output.

Categories: ISLM, Macro
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