The Open Economy IS-LM Macroeconomic Model

Henry Thompson

 

This monograph introduces the workhorse macroeconomic ISLM model of an economy open to international trade and investment.

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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 recessions, exchange rate shocks, and erratic government monetary and fiscal policies. The ISLM model remains the workhorse model for such applied macroeconomic issues.

The present introduction 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 refers to equilibrium between liquidity and money supply in the monetary economy. The advantage of the ISLM model is that it integrates real and monetary issues. The ISLM model includes consumption, investment, government spending, taxes, exports, imports, the interest rate, exchange rate, and national income in a consistent theoretical framework.

The ISLM model is not comprehensive. It does not include optimal decision making by households, firms, and government as in microeconomics. It does not include production or distribution of income among labor and capital as in general equilibrium models.  It does not consider optimal economic growth. Even regarding its main applications to policy issues, it falls short by not including models of unemployment and inflation.

Regardless of these shortcomings, its appeal is the description of how the major macroeconomic variables in an economy are related. The time horizon of the model is up to a few quarters or a year. It remains the primary model used by government policy makers, financial commentators, and macroeconomic consultants.

This introduction focuses 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, and exchange rate policy. Inflation is not modeled explicitly but its effects are included. The 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 output. The exchange rate regime, floating or fixed, is critical to the adjustment process.