CHAPTER 22 The ISLM Model 587 spending and taxes) to produce a certain level of aggregate output; how the level of interest rates is affected by changes in investment spending as well as by changes in monetary and fiscal policy; how best to conduct monetary policy; and how the ISLM model generates the aggregate demand curve, an essential building block for the aggregate supply and demand analysis used in Chapter 24 and thereafter Like our simplified Keynesian model, the full ISLM model examines an equilibrium in which aggregate output produced equals aggregate demand, and since it assumes a fixed price level, real and nominal quantities are the same The first step in constructing the ISLM model is to examine the effect of interest rates on planned investment spending and hence on aggregate demand Next we use a Keynesian cross diagram to see how the interest rate affects the equilibrium level of aggregate output The resulting relationship between equilibrium aggregate output and the interest rate is known as the IS curve Just as a demand curve alone cannot tell us the quantity of goods sold in a market, the IS curve by itself cannot tell us what the level of aggregate output will be because the interest rate is still unknown We need another relationship, called the LM curve, to describe the combinations of interest rates and aggregate output for which the quantity of money demanded equals the quantity of money supplied When the IS and LM curves are combined in the same diagram, the intersection of the two determines the equilibrium level of aggregate output as well as the interest rate Finally, we will have obtained a more complete analysis of the determination of aggregate output in which monetary policy plays an important role Equilibrium in the Goods Market: The IS Curve In Keynesian analysis, the primary way that interest rates affect the level of aggregate output is through their effects on planned investment spending and net exports After explaining why interest rates affect planned investment spending and net exports, we will use Keynesian cross diagrams to learn how interest rates affect equilibrium aggregate output.6 Businesses make investments in physical capital (machines, factories, and raw materials) as long as they expect to earn more from the physical capital than the interest cost of a loan to finance the investment When the interest rate is high, few investments in physical capital will earn more than the cost of borrowed funds, so planned investment spending is low When the interest rate is low, many investments in physical capital will earn more than the interest cost of borrowed funds Therefore, when interest rates are lower, business firms are more likely to undertake an investment in physical capital, and planned investment spending will be higher Even if a company has surplus funds and does not need to borrow to undertake an investment in physical capital, its planned investment spending will be affected by the interest rate Instead of investing in physical capital, it could purchase a security, such as a bond If the interest rate on this security is high, the opportunity cost (forgone interest earnings) of an investment is high, and planned investment spending will be low because the firm would probably prefer to purchase the security than to invest in physical capital As the interest rate and the opportunity cost of invest- INTEREST RATES AND PLANNED INVESTMENT SPENDING More modern Keynesian approaches suggest that consumer expenditure, particularly for consumer durables (cars, furniture, appliances), is influenced by the interest rate This interest sensitivity of consumer expenditure can be allowed for in the model here by defining planned investment spending more generally to include the interest-sensitive component of consumer expenditure