Question: How does a closed economy adjust to shocks from the outside or to economic policy changes in the short run? Why is using the ISLM a more sophisticated and useful approach than looking at the real and financial sectors separately?ISLM: internal macroeconomic adjustment in the short run
An alarming slowdown in economic growth gnaws away at business confidence, so that increasing numbers of firms lose faith in their ability to hit next year's sales targets, leading them to hold off on investments that would otherwise have gone ahead, depressing economic growth still further. Or instability in the financial markets sees more investors cashing in financial holdings so as to avoid the chance of a fall in their value. It is the macroeconomic implications of scenarios like these that the forbiddingly named ISLM framework helps us to analyse systematically. By selecting the most relevant economic indicators and sketching the expected relationships between them, this framework helps us to trace through the rest of the economy the knock-on effects of destabilising economic developments, such as the ones above, and to work out the kinds of results that we might expect from policy responses to them. The most important variables include the rates of growth of government spending, household consumption, private investment expenditure, and the national output of goods and services. Important, too, are changes in tax rates, money holdings and interest rates. Over a longer period, changes in the price level would be included on this list. When looking at imbalances in the goods and the money markets taken separately or together, the crucial difference is that, in the second case, there are feedback loops between them, going in both directions. The key link by which imbalances in the real economy are transmitted to the financial sector is between the economic activity (or output) and money demand. Imbalances originating in the money market affect the production of goods and services by way of changes in short-term interest rates. And just as we conventionally show the main relationship as between output (Y) and the price level (P) in graphical form when looking at aggregate demand (“PY space”), so it is useful to illustrate the two-way links between the goods and money markets as a relationship between output and short-term interest rates (“IY space”), because these, as I have said, are the main channels through which changes in one market are transmitted to the other. Thus, the IS schedule (the letters stand for “investment” and “savings”) is simply a graphical summary of all possible combinations of interest rates and national output in which goods demand and supply just balance. It incorporates much the same information as in the PY or aggregate demand diagram—since aggregate demand is affected by changes in both the goods and the money markets—but is examined from a different angle so as to bring out the interlinks between the domestic economy’s component markets. As lower interest rates encourage borrowing by firms and households for investment and consumer purchases—and thus also higher levels of economic output—the IS curve is negatively sloped: as interest rates rise, investment, and so economic output, falls. Likewise, the LM schedule (standing for “liquidity preference”, or money demand, and “money”, or money supply) represents all the combinations of interest rates and output in which money supply and demand are in balance. In contrast with the IS line, the LM schedule is positively sloped: as output rises, it takes higher interest rates at every level to equate money demand with a (nominal) money supply that is centrally fixed. Movement along the curve can be read as showing that higher money demand is associated with increased rates of growth in national income—that is, to facilitate the rise in the number of transactions—but that higher rates of interest are required to maintain balance with the fixed money supply. The point of crossover of the two schedules thus represents the unique rates of interest and output growth needed to keep both markets in balance at the same time.
By goods alone: IS
One way to proceed is to contrast the results to be expected following the combined and separate adjustment to developments that upset balance in either market. In the real domestic economy, the kinds of changes that could affect the level of demand for goods and services include alterations in the pace of growth of private investment, household disposable income or government spending. It would also include changes in tax or savings rates, or in the responsiveness of private investment to changes in interest rates. (Reforms of public spending or of the rates of taxation—fiscal policy—are the main policy instruments used by the government to influence activity in the real sector.) Changes in the first set of factors would affect the position of the IS curve, shifting it up or down, boosting or sapping demand for goods and services—and thus the growth rate of national output—at all interest rates. Changes in the second set would tilt the IS curve so that it becomes flatter or steeper. A flatter IS curve implies that only small changes in interest rates are needed to induce a relatively large increase in investment demand. A steeper curve means that even large changes in the interest rate are able to induce only a small change in desired investment. (The slope of the IS curve might be said to reflect the level of development or friendliness of the business environment.) In the short run, changes in domestic spending mean that some combination of firms, households and the government together plan to buy more or fewer goods and services than are currently being supplied. Such a change tells domestic producers whether to make more or fewer products. In this relatively simple model of the domestic economy, firms are assumed to be able to respond unproblematically to imbalances in the goods market by adjusting production for the inputs they need: they supply just as much or as little as is desired.
Money alone: LM
In the financial sector, three factors are typically cited as capable of igniting disturbances. In each case, any imbalance in the money market triggers changes in interest rates, which ensure that a new equilibrium level, higher or lower than the initial one, is achieved. The first factor is a change in the pace of growth of economic activity. For example, a splurge in consumer spending—say, in the run up to Christmas, or ahead of a rise in value-added tax (VAT)—boosts aggregate demand and hence the rate of growth of national income, simultaneously pushing up the demand for money to carry out these additional buys. The LM curve shifts up and left. A second important destabilising factor would be any trend towards holding more private wealth as money. Such a rise in "liquidity preference"—say, in response to high volatility in bond markets, as in my opening paragraph—would likewise shift the LM curve leftwards and up, also by setting off by unbalancing rise in monetary demand. A third important factor that can produce money market imbalance is a change in the growth of the real money supply. In the short run, when prices are fixed, this is identical with the growth or contraction of the nominal money stock, which is controlled by the central authorities as a tool of (monetary) policy to influence other economic indicators, such as the short-term interest rate, or, over the longer term, the pace of growth of the general price level. Typically, it does this by buying or selling government securities (bonds and bills), which increases or decreases amount of cash in the financial sector, pushing interest rates down or up. The excess money supply linked to faster growth in the stock of money in the economy disturbs equilibrium in the money market, triggering a shift in the LM curve, this time rightwards and down, so that money market balance is restored: a reduction in the interest rate induces a switch from less attractive interest-bearing bonds to cash, so that money demand rises to the point where it just offsets the increase in the money supply, restoring money market balance.
Both together: ISLM
Probably the clearest example of the distinct result of the interaction of the goods and money markets can be seen by working through the knock-on effects of a change in demand. From such a change, the main conclusion is that impact of the multiplier, whether positive or negative, is dampened by the interaction with the financial sector, because of the two-way feedback loops between the goods and money markets.
Causes. A rise in demand could be the result either of putting more money into the circular flow of income or of withdrawing less from it. In a closed economy, this might result, for instance, from an increase in government spending, or a tax cut (which would leave households with a larger slice of their income to divide between spending and saving, in this way, assuming that the ratio between them stays the same, boosting consumption demand). Such measures featured heavily in the many "fiscal stimulus packages" that have been implemented by governments around the world since 2008 in an attempt to counter the impact of a sharp drop in foreign demand set off by the global economic crisis. A boost to domestic demand might also stem from an improvement in business or consumer confidence, lifting investment and consumption demand, perhaps because the outlook for economic growth has substantially brightened, or because the latest figures show employment growing more briskly than expected.
Mechanism. An increase in spending and/or confidence boosts aggregate demand, though the rise in output is larger than the original impetus because, along the way, the original sum becomes someone’s income and they, in turn, spend a proportion of it, creating additional goods demand. In the short run, however, with prices relatively rigid, the rise in demand induces only an increase in economic output and the IS curve shifts right: output is higher at all interest rates. But that's not the end of it because the expansion of economic activity shows up in the money market as an increase in demand for money, which is needed to cope with the increased number of transactions. With wealth split, for analytical purposes, between money and bonds, saying that there is an excess of demand for money is the same as saying that there is an excess supply of bonds. With bond offerings exceeding planned new bond purchases, bond prices fall and the yield on bonds moves in the opposite direction—ie the interest rate rises. (Another way or seeing it is that interest rates rise because, in the case of bond-financed government spending, government borrowing bids up the cost of borrowing by creating additional demand for the supply of loanable funds.) This restores balance in the money market by choking off the increase in money demand to equate it to the nominal money supply, which is fixed by the central monetary authorities. At the same time, some business projects are rendered unattractive by the rise in interest rates. This discourages some private investment demand ("crowding out"), reducing aggregate spending and shifting the IS curve somewhat back left. Thus the conclusion is that the full impact of the multiplier on national output is dampened by the feedback loop in the financial sector. This also works the other way, so that the same mechanism will ameliorate the impact on the real economy of a drop in demand. The result contrasts not only with the outcome expected in the goods market taken in isolation, where the impact on the multiplier unfolds fully, but also, looking ahead, with the expected outcome of macroeconomic adjustment over the longer term, once the effect of the inclusion of the domestic labour market is taken into account where fully flexible wages and prices ensure that a boost to government spending produces no increase in output or employment at all (at least, with the classical or monetarist versions of the supply curve). Instead, all of the adjustment takes place in the form of faster price growth and the complete crowding out of private investment. From the point of view of disturbances originating in the financial sector, such as a loosening of monetary policy to try to “jump start” the economy to offset an economic slowdown, or a change in the pattern of distributing assets between money and other forms of wealth, in the first case would see the LM curve shift right, reducing interest rates and pushing up investment demand, which in turn pushes the curve back in the direction it came from.
Practical application
Under what circumstances might such a model be of practical use? A practical use of such a model would be when the international context is either a small or negligible factor for the economy in question, or the international trading environment is stable. This would include countries with economies characterised by a relatively low level of trade of integration with international financial markets. In countries in which the capital or debt markets are underdeveloped, the feedback loop between goods and financial markets is inhibited and the financial sector is an ineffective medium for transmitting official interest rate policy.
