Principles of Economics/ISLM

The Concept

The ISLM model is NOT a supply demand model. Instead, it is a model based on two models that are supply and demand models: The investment-savings model and the money demand(liquidity preference)-money supply model. The ISLM model seeks to present a method for determining multiple equilibria in goods market and money market. This method is frowned upon by certain economists.

The basic concept is that in an economy with N models that seek to obtain equilibria, once N - 1 of those models have attained equilibria, all of them are at equilibrium - which is effectively where the economy goes toward in reality. There are basically three markets in capitalist economies: goods, money, and investment. Finding the equilibrium for the last two put together will yield the equilibrium for all three.

The Model

Fig - 1. The basic investment savings loans money model.

There are two curves, each representing either the IS or the LM set of equilibrium points (NOT set of quantity supplied/demanded). All points along the IS line represent combinations of supply and demand in the investment savings model that reach equilibria; all points along the LM line represent combinations of supply and demand in the money demand model that reach equilibria; the intersection of these two points on the ISLM model represent the point at which both models are at equilibrium. These curves are generally shown more simplistically as straight lines (IS sloping down, LM sloping up). The economy's output Y is the x axis; the interest rate r is the y axis.

If one ever goes below the IS curve, there is a particularly low interest rate considering the amount of money in circulation in the economy (reflected by Y), and firms do more investing (I) than there are savings to do this with (savings S). This forces the point upward, and we return to the IS curve. There is another solution: that low interest rate can be reached if the economy expands, resulting in more savings (which would drive down the interest rate).

If one ever goes below the LM curve, there is a particularly low interest rate considering the amount of money in circulation in the economy (reflected by Y), and the demand for money is greater than there is money available (similar concept to that with the IS curve). This forces the point upward, and we return to the LM curve. The money supply is determined by the Central Bank, and therefore does not depend on Y; however, the demand for money depends on the size of the economy Y. There is another solution: that low interest rate can be reached if the economy shrinks and thereby demands less money.

Changes

Fig - 2. ISLM model showing changes in both equilibrium curves.

An increase in savings in the economy shifts the IS curve downward. A decrease shifts it upward. Shifts in IS curves often result from fiscal policy.

An increase in the money supply shifts the LM curve downward. A decrease shifts it upward. Shifts in LM curves often result from monetary policy.