The Small Open Economy IS-LM Macroeconomic Model


Henry Thompson

Auburn University


This monograph introduces the workhorse macroeconomic ISLM model of an economy open to international trade and investment.  It is appropriate for advanced undergraduates and beginning graduate students wanting a concise introduction.  Email for information on the monograph



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 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 issues.  The ISLM model includes common aggregate measures such as consumption, investment, government spending, taxes, exports, imports, interest rate, exchange rate, and national output or 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 microeconomic optimization models.  ISLM does not include production or distribution of income among labor and capital as in general equilibrium models.  The ISLM model does not include optimal economic growth.  Even regarding its main applications to policy issues, ISLM falls short by not explicitly including models of unemployment and inflation. 

Regardless of these shortcomings, 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 few quarters or 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 focusing 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 of the money supply, and exchange rate policy in the choice of a fixed or floating exchange rate.  Inflation is not modeled explicitly in the ISLM model but its effects are included.  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.