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ECS1601 I.S.L.M EXPLAINED
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ISLM EXPLAINED
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Simple Notes on the ISLM Model(The Mundell-Fleming Model)
This is a model that describes the dynamics of economies in the short run. It has million
of critiques, and rightfully so. However, even though from the theoretical point of view it has
some loopholes, it continues to be an excellent way of analyzing and understanding the behavior
of economies.
Robert Solow once was asked: “Professor Solow when were at the Counsel of Economic
Advisors, what of all your knowledge did you use the most?” He answered something like this:
“Well you just need the Dornbusch and Fischer, but you have to use it right.” The Dornbusch
and Fischer is essentially the ISLM model. In practical policy making the ISLM dominates at
least 50 percent of discussions. The most important assumption required for this model to work
is that prices (and in particular wages) are fixed or predetermined in the short run.
This model has two schedules that reflect the equilibrium in two markets: goods and
money. In other words, one schedule represents the market in which the supply of goods is equal
to the demand of goods, and the other schedule represents the market in which the supply of
money is equal to the demand of money. Now let us see what happens when we have a model
that has these ingredients…
Model for a closed economy.
First assume that the economy is closed. This will help us better understand the basic model;
later we will proceed with the more complicated version when there are international
transactions on goods and capital.
IS
The total supply of goods in an economy is what we call output: Y. The total demand is what the
agents do with all those goods: either they consume (C), invest (I), or the government consumes
them (G). Imposing the fact that the supply of goods is equal to the demand of goods requires:
Y=C+G+I
We can rearrange this equation such that we equate savings to investment
Y-C-G=I
As can be seen, on the left-hand side we have the total income generated (Y) in the
economy minus the expenses (C+G). This reflects the savings made by consumers and
government. On the other hand, the right hand side is the investment.
Isn’t this interesting? When we impose that the supply of goods has to be equal to the
demand of goods, immediately it has the implication that total savings are equal to investment.
This represents the IS in the model.
, Savings behavior
We are interested in understanding what is the savings behavior when fiscal and monetary policy
are implemented. This is what we are going to do here. We know that part of consumers' income
is taxed. For simplicity assume the tax rate is fixed and given by t. The savings can be written as
follows:
S=(1-t)Y-C + tY-G
What this equation implies is that total savings in the economy are equal to consumers'
savings (the first two terms) plus the government’s savings (the negative of the fiscal deficit).
From the microeconomic literature we know that consumers will consume depending on
their disposable income and the interest rate. The microeconomic literature does not have a
precise answer of what is the effect of interest rates on current consumption. There are two
effects that go in opposite directions: the income and substitution effect. We are not interested in
solving this problem at the macro level, and we will make the assumption that consumption is
unaffected by the interest rate1 . When this is the case, we can write consumption as follows:
C=c(1-t)Y
Where c (less than one) is the marginal propensity to consume for each additional unit of
disposable income ((1-t)Y).
S=(1-c)(1-t)Y+tY-G
Note that if Y or t increases, savings increase. If G or c increases, savings decrease. We will
represent this in the following way:
where the sign on top of the variable indicates the relationship between savings and the variable.
A positive number indicate that they move in the same direction, a negative implies they move in
opposite directions. Therefore, when output increases (a positive) savings increase, while when
the marginal propensity of consumption increases (a negative) savings go down.
A point that I would like to make is that the marginal propensity of consumption is a measure of
the degree of confidence the consumers experience. In other words, if the consumers are very
confident in a bright future, what should they do? Consume. Hence, for the same level of
disposable income (output minus taxes) they consumer a higher proportion (increase in little c).
Consumer sentiment or consumer confidence is one of the most important variables in the
economy because they have a direct effect on consumption patterns. You can think of movements
in little c as movements in that consumer sentiment (a higher degree of confidence reduces
savings, in the same way little c does).
1 In fact this is the case when the elasticity of substitution is equal to one.
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