CHAPTER 22 The ISLM Model 593 interest rate is above its equilibrium level, so the demand for money is less than the supply Because people have more money than they want to hold, they will try to get rid of it by buying bonds The resulting rise in bond prices causes a fall in interest rates, which in turn causes both planned investment spending and net exports to rise, and thus aggregate output rises The economy then moves down along the IS curve, and the process continues until the interest rate falls to i* and aggregate output rises to Y * that is, until the economy is at equilibrium point E If the economy is on the LM curve but off the IS curve at point B, it will also head toward the equilibrium at point E At point B, even though money demand equals money supply, output is higher than the equilibrium level and exceeds aggregate demand Firms are unable to sell all their output, and unplanned inventory accumulates, prompting them to cut production and lower output The decline in output means that the demand for money will fall, lowering interest rates The economy then moves down along the LM curve until it reaches equilibrium point E We have finally developed a model, the ISLM model, which tells us how both interest rates and aggregate output are determined when the price level is fixed Although we have demonstrated that the economy will head toward an aggregate output level of Y *, there is no reason to assume that at this level of aggregate output the economy is at full employment If the unemployment rate is too high, government policymakers might want to increase aggregate output to reduce it The ISLM apparatus indicates that they can this by manipulating monetary and fiscal policy We will conduct an ISLM analysis of how monetary and fiscal policy can affect economic activity in the next chapter S U M M A RY In the simple Keynesian framework in which the price level is fixed, output is determined by the equilibrium condition in the goods market that aggregate output equals aggregate demand Aggregate demand equals the sum of consumer expenditure, planned investment spending, government spending, and net exports Consumer expenditure is described by the consumption function, which indicates that consumer expenditure will rise as disposable income increases Keynes s analysis shows that aggregate output is positively related to autonomous consumer expenditure, planned investment spending, government spending, and net exports and negatively related to the level of taxes A change in any of these factors leads, through the expenditure multiplier, to a multiple change in aggregate output The ISLM model determines aggregate output and the interest rate for a fixed price level using the IS and LM curves The IS curve traces the combinations of the interest rate and aggregate output for which the goods market is in equilibrium, and the LM curve traces the combinations for which the market for money is in equilibrium The IS curve slopes downward because higher interest rates lower planned investment spending and so lower equilibrium output The LM curve slopes upward because higher aggregate output raises the demand for money and so raises the equilibrium interest rate The simultaneous determination of output and interest rates occurs at the intersection of the IS and LM curves, where both the goods market and the market for money are in equilibrium At any other level of interest rates and output, at least one of the markets will be out of equilibrium, and forces will move the economy toward the general equilibrium point at the intersection of the IS and LM curves