Chapter 20
The ISLM Model
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Determination of Aggregate
Output
The total quantity demanded of an economy's
output is the sum of four types of spending
Y ad
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Consumption Expenditure and
the Consumption Function
Income is the most important factor determining consumption spending
Disposable income (YD ) is total income less taxes (Y - T)
The marginal propensity to consume (mpc) is the slope of
the consumption function (
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Table 1 Consumption Function: Schedule of
Consumer Expenditure C When mpc = 0.5 and a
= 200 ($ billions)
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FIGURE 1 Consumption Function
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Investment Spending
Fixed investment: always planned
Inventory investment: can be unplanned
Planned investment spending
Interest rates
Expectations
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FIGURE 2 Keynesian Cross
Diagram
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Expenditure Multiplier
A change in planned investment spending leads to an even larger
change in aggregate output
An increase in planned investment spending leads to an
additional increase in consumer expenditure which raises aggregate
demand and output further
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FIGURE 3 Response of Aggregate Output to a
Change in Planned Investment
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FIGURE 4 Response of Aggregate Output to the
Collapse of Investment Spending, 19291933
Source: Economic Report of the President.
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Changes in Autonomous
Spending
Any change in autonomous spending will lead to a multiplied
change in aggregate output
1
Y = a + I
1 mpc
The shift in the aggregate demand function can come from a change
in planned investment, a change in autonomous consumer
spending, or both
Changes in autonomous spending are dominated by animal spirits
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Governments Role
Government spending and taxes
can be used to change the position of the
aggregate demand function
Government spending adds directly
to aggregate demand
Taxes do not affect aggregate demand directly
C
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FIGURE 5 Response of Aggregate Output to
Government Spending and Taxes
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Role of International Trade
A change in net exports (exports - imports) is positively
related to changes in aggregate output
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FIGURE 6 Response of Aggregate
Output to a Change in Net Exports
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Summary Table 2 Response of Aggregate
Output Y to Autonomous Changes in a, I, G,
T, and NX
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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 Goods
Market: The IS Curve
Interest rates and planned investment spending
Negative relationship
Interest rates and net exports
Negative relationship
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
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FIGURE 7
Deriving the IS
Curve
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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 (contd)
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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FIGURE 8 Deriving the LM Curve
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FIGURE 9 ISLM Diagram: Simultaneous
Determination of Output and the Interest Rate
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