Transcript Lecture Slides on Web Chapter of Mishkin and Serletis (5th Cdn. ed.)

Mishkin/Serletis
The Economics
of Money, Banking,
and Financial Markets
Fifth Canadian Edition
Web Chapter
THE ISLM MODEL
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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
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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
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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
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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
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Deriving the LM Curve
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ISLM Diagram: Determination of Output and the
Interest Rate
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Factors that Cause the LM Curve to Shift
1. Changes in the Money Supply
2. Autonomous Changes in Money Demand
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Shift in the LM Curve from an increase in the
Money Supply
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Shift in the LM Curve When Money Demand
Increases
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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
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ISLM Diagram: Simultaneous Determination of
Output and the Interest Rate
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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
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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
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Response of Aggregate Output and the Interest
Rate to an Expansionary Fiscal Policy
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Summary
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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
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Monetary Policy Versus Fiscal Policy: The Case
of 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
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Effectiveness of Monetary and Fiscal Policy When
Money Demand Is Unaffected by the Interest Rate
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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
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Money Supply and Interest-Rate Targets When the IS
Curve is Unstable and the LM Curve Is Stable
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Money Supply and Interest-Rate Targets When the LM
Curve Is Unstable and the IS Curve Is Stable
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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
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ISLM Model in the Long Run
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