This monograph introduces the macroeconomic ISLM model of an
economy open to international trade and investment. It is aimed at advanced
undergraduates or beginning graduate students wanting a concise introduction. Email
thomph1@auburn.edu.
Introduction
The applied side of macroeconomics is based on models that capture
aggregate economic behavior and the response of the economy to external shocks such
as rising energy prices, financial system bankruptcy, global recession,
exchange rate shocks, and government monetary and fiscal policies. The ISLM
model remains the workhorse model for applied macroeconomics.
The present introduction to the ISLM model focuses on a small
economy open to international trade and investment. The IS in ISLM refers to
the equilibrium between investment and saving in the real economy. The LM represents
the equilibrium between liquidity and money supply in the monetary economy. The
advantage of the ISLM model is that it integrates real and monetary sides of
the economy. The ISLM model includes aggregate measures such as consumption
spending, investment spending, government spending, tax revenue, export revenue,
import spending, the interest rate, exchange rate, and national output or
income.
The appeal of ISLM is its description of how the major
macroeconomic variables in an economy are related. The time horizon of the ISLM
model is up to a year. The ISLM model remains the primary model used by
government policy makers, financial commentators, and macroeconomic
consultants. This introduction presents the open economy ISLM model focused on
the role of government policy to influence output. A range of government
policies are considered including fiscal policy of government spending and taxes,
monetary policy related to the money supply and interest rate, and exchange
rate policy in the choice of a fixed or floating exchange rate. A small open
economy is assumed to be a price taker in the international credit market,
fixing the interest rate at the global level. Adjustments in the balance of
trade and international investment in the capital account are analyzed along
with adjustments in output, the exchange rate regime, floating or fixed, is
critical to the adjustment process.