THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 625

CHAPTER 22

The ISLM Model 593

interest rate is above its equilibrium level, so the demand for money is less than
the supply. Because people have more money than they want to hold, they will
try to get rid of it by buying bonds. The resulting rise in bond prices causes a fall
in interest rates, which in turn causes both planned investment spending and net
exports to rise, and thus aggregate output rises. The economy then moves down
along the IS curve, and the process continues until the interest rate falls to i* and
aggregate output rises to Y * that is, until the economy is at equilibrium point E.
If the economy is on the LM curve but off the IS curve at point B, it will also head
toward the equilibrium at point E. At point B, even though money demand equals
money supply, output is higher than the equilibrium level and exceeds aggregate
demand. Firms are unable to sell all their output, and unplanned inventory accumulates, prompting them to cut production and lower output. The decline in output
means that the demand for money will fall, lowering interest rates. The economy
then moves down along the LM curve until it reaches equilibrium point E.
We have finally developed a model, the ISLM model, which tells us how both
interest rates and aggregate output are determined when the price level is fixed.
Although we have demonstrated that the economy will head toward an aggregate
output level of Y *, there is no reason to assume that at this level of aggregate output
the economy is at full employment. If the unemployment rate is too high, government policymakers might want to increase aggregate output to reduce it. The ISLM
apparatus indicates that they can do this by manipulating monetary and fiscal policy.
We will conduct an ISLM analysis of how monetary and fiscal policy can affect economic activity in the next chapter.

S U M M A RY
1. In the simple Keynesian framework in which the price
level is fixed, output is determined by the equilibrium
condition in the goods market that aggregate output
equals aggregate demand. Aggregate demand equals
the sum of consumer expenditure, planned investment

spending, government spending, and net exports.
Consumer expenditure is described by the consumption function, which indicates that consumer expenditure will rise as disposable income increases. Keynes s
analysis shows that aggregate output is positively
related to autonomous consumer expenditure,
planned investment spending, government spending,
and net exports and negatively related to the level of
taxes. A change in any of these factors leads, through
the expenditure multiplier, to a multiple change in
aggregate output.
2. The ISLM model determines aggregate output and the
interest rate for a fixed price level using the IS and LM

curves. The IS curve traces the combinations of the
interest rate and aggregate output for which the goods
market is in equilibrium, and the LM curve traces the
combinations for which the market for money is in
equilibrium. The IS curve slopes downward because
higher interest rates lower planned investment spending and so lower equilibrium output. The LM curve
slopes upward because higher aggregate output raises
the demand for money and so raises the equilibrium
interest rate.
3. The simultaneous determination of output and interest rates occurs at the intersection of the IS and LM
curves, where both the goods market and the market for money are in equilibrium. At any other level
of interest rates and output, at least one of the markets will be out of equilibrium, and forces will move
the economy toward the general equilibrium point at
the intersection of the IS and LM curves.