Monetary Policy and Central Banking

14
Monetary Theory I

Module 014 The Keynesian Framework and the

ISLM Model
Objectives
1. To learn about developing the simplest framework for
determining aggregate output, in which all economic actors
(consumers, firms, and others)
2. To have a complete picture of the ISLM model by adding monetary
policy variables: the money supply and the interest rate

Introduction
The ISLM model is valuable not only because it can be used in economic
forecasting, but also because it provides a deeper understanding of how
government policy can affect aggregate economic activity. In Chapter 24 we use it
to evaluate the effects of monetary and fiscal policy on the economy and to learn
some lessons about how monetary policy might best be conducted.
Determination of Aggregate Output
Keynes’s analysis started with the recognition that the total quantity demanded of
an economy’s output was the sum of four types of spending:
(1) Consumer expenditure (C), the total demand for consumer goods and
services (hamburgers, stereos, rock concerts, visits to the doctor, and so on);
(2) Planned investment spending the total planned spending by businesses on
new physical capital (machines, computers, factories, raw materials, and the like)
plus planned spending on new homes;
(3) Government spending (G), the spending by all levels of government on goods
and services (aircraft carriers, government workers, red tape, and so forth); and
(4) Net exports (NX), the net foreign spending on domestic goods and services,
equal to exports minus imports. The total quantity demanded of an economy’s
output, called aggregate demand (Yad), can be written as:

Five autonomous factors (factors independent of income) that shift the aggregate demand
function and hence the level of aggregate output:
1. Changes in autonomous consumer expenditure (a)
2. Changes in planned investment spending (I)
3. Changes in government spending (G)

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 4. Changes in taxes (T)
5. Changes in net exports (NX)

Changes in Autonomous Consumer Spending (a).

A rise in autonomous consumer expenditure a (say, because consumers become
more optimistic about the economy when the stock market booms) directly raises
consumer expenditure and shifts the aggregate demand function upward, resulting
in an increase in aggregate output. A decrease in a causes consumer expenditure to
fall, leading ultimately to a decline in aggregate output. Therefore, aggregate output
is positively related to autonomous consumer expenditure a.
Changes in Planned Investment Spending (l).
A rise in planned investment spending adds directly to aggregate demand, thus
raising the aggregate demand function and aggregate output. A fall in planned
investment spending lowers aggregate demand and causes aggregate output to fall.
Therefore, aggregate output is positively related to planned investment spending I.
Changes in Government Spending (G).
A rise in government spending also adds directly to aggregate demand and raises
the aggregate demand function, increasing aggregate output. A fall directly reduces
aggregate demand, lowers the aggregate demand function, and causes aggregate
output to fall. Therefore, aggregate output is positively related to government
spending G.
Changes in Taxes (T).
A rise in taxes does not affect aggregate demand directly, but does lower the
amount of income available for spending, reducing consumer expenditure. The
decline in consumer expenditure then leads to a fall in the aggregate demand
function, resulting in a decline in aggregate output. A lowering of taxes makes more
income available for spending, raises consumer expenditure, and leads to higher
aggregate output. Therefore, aggregate output is negatively related to the level of
taxes T.
Changes in Net Exports (NX).
A rise in net exports adds directly to aggregate demand and raises the aggregate
demand function, increasing aggregate output. A fall directly reduces aggregate
demand, lowers the aggregate demand function, and causes aggregate output to
fall. Therefore, aggregate output is positively related to net exports NX

The ISLM Model

The full Keynesian ISLM model examines an equilibrium in which
aggregate output produced equals aggregate demand, and since it assumes a fixed
price level, real and nominal quantities are the same.
The first step in constructing the ISLM model is to examine the effect of
interest rates on planned investment spending and hence on aggregate demand.
Next we use a Keynesian cross diagram to see how the interest rate affects the
equilibrium level of aggregate output. The resulting relationship between
equilibrium aggregate output and the interest rate is known as the IS curve.
 Monetary Policy and Central Banking
14
Monetary Theory I

Just as a demand curve alone cannot tell us the quantity of goods sold in a
market, the IS curve by itself cannot tell us what the level of aggregate output will
be because the interest rate is still unknown. We need another relationship, called
the LM curve, which describes the combinations of interest rates and aggregate
output for which the quantity of money demanded equals the quantity of money
supplied.
When the IS and LM curves are combined in the same diagram, the
intersection of the two determines the equilibrium level of aggregate output as
well as the interest rate. Finally, we will have obtained a more complete analysis of
the determination of aggregate output in which monetary policy plays an
important role.
In Keynesian analysis, the primary way that interest rates affect the level of
aggregate output is through their effects on planned investment spending and net
exports. After explaining why interest rates affect planned investment spending
and net exports, we will use Keynesian cross diagrams to learn how interest rates
affect equilibrium aggregate output.
Factors that Cause the IS curve to Shift
1. Changes in Autonomous Consumer Expenditure
2. Changes in Investment Spending Unrelated to the Interest Rate.
3. Changes in Government Spending
4. Changes in Taxes
5. Changes in Net Exports Unrelated to the Interest Rate
Factors that cause the LM Curve to Shift
1. Changes in the Money Supply
2. Autonomous Changes in Money Demand

The ISLM Model and the Aggregate Demand Curve

We obtain a relationship between the price level and quantity of aggregate
output for which the goods market and the market for money are in equilibrium,
called the aggregate demand curve.
Factors that Cause the Aggregate Demand Curve to Shift
1. Shifts in the IS Curve.
Five factors cause the IS curve to shift: changes in autonomous consumer spending,
changes in investment spending related to business confidence, changes in
government spending, changes in taxes, and autonomous changes in net exports.
How changes in these factors lead to a shift in the aggregate demand curve is
examined in Figure 11.

Course Module
 The conclusion from Figure 11 is that any factor that shifts the IS curve shifts the
aggregate demand curve in the same direction.

2. Shifts in the LM Curve.

Shifts in the LM curve are caused by either an autonomous change in money
demand (not caused by a change in P, Y, or i) or a change in the money supply.
Figure 12 shows how either of these changes leads to a shift in the aggregate
demand curve.

Our conclusion from Figure 12 is similar to that of Figure 11: Holding the price
level constant, any factor that shifts the LM curve shifts the aggregate demand
curve in the same direction.
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Monetary Theory I

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