Appendix to

Chapter 21
Algebra of the
ISLM Model

Closed-Economy ISLM Model I

C = consumer spending
I = investment spending
G = G = government spending
Y = output
T = T = taxes
M d = money demand
M s = M = money supply
i = interest rate
a = autonomous consumer spending
d = interest sensitivity of investment spending
I = autonomous investment spending related to business confidence
M d = autonomous money demand
e = income sensitivity of money demand
f = interest sensitivity of money demand
mpc = marginal propensity to consume
Copyright 2007 Pearson Addison-Wesley. All rights reserved.

21A-2

Closed-Economy ISLM Model II

In the goods market
Consumption function: C = a + mpc(Y T )
Investment function: I = I di
Taxes: T = T
Government Spending: G = G
Goods market equilibirum condition: Y = Y ad = C + I + G
Substituting for C, I, and G, then solving for Y
The equation for the IS curve is
1
Y=
(a + I mpcT + G di)
1 mpc
Copyright 2007 Pearson Addison-Wesley. All rights reserved.

21A-3

Closed-Economy ISLM Model III

Money market equations
Money demand function: M d = M d + eY fi
Money supply: M s = M
Money Market equilibrium condition: M d = M
Solving for i
The equation for the LM curve is:
M d M + ey
i=
f

Copyright 2007 Pearson Addison-Wesley. All rights reserved.

21A-4

Closed-Economy ISLM Model IV

Equilibrium solution at the intersection of IS and LM
dMd dM
Y=
(a + I mpcT + G
+
)
f
f
1 mpc + de
f
1
[e (a + I mpcT + G) + M d (1 mpc) M (1 mpc)]
i=
f (1 mpc) + d
1

Copyright 2007 Pearson Addison-Wesley. All rights reserved.

21A-5

Closed-Economy ISLM Model V

1. All the coefficients are positive a, I , G, M Y
and T , M d Y
2. a, I , G, M d i
and T , M i
3. f

and

1
1 mpc + de

fiscal policy has more effect on output;

f

d
so monetary policy has less effect on output
f (1 mpc) + de

4. Similarly as d , monetary policy has more effect on output

and fiscal policy has less effect on output
Copyright 2007 Pearson Addison-Wesley. All rights reserved.

21A-6

Open-Economy ISLM Model I

Including net exports in the goods market equilibrium
Y = Y ad = C + I + G + NX
Net exports and exchange relations are written:
NX = NX hE
E = E + ji
NX = net exports
NX = autonomous net exports
h = exchange rate sensitivity of net exports
E=Exchange rate (value of domestic currency)
E = autonomous exchange rate
j = interest-rate sensitivity of exchange rate
Copyright 2007 Pearson Addison-Wesley. All rights reserved.

21A-7

Open-Economy ISLM Model II

Using net exports and the exchange rate equations
Y=

1
[a + I mpcT + G + NX hE (d + hj)i]
1 mpc

The LM curve is the same as in the basic model

Y=

1
1 mpc + (d + hj) e

f
d + hj d d + hj
M +
M + NX hE)
(a + I mpcT + G
f
f
i=

1 mpc + (d + hj)e

[e (a + I mpcT + G + NX hE) + M d (1 mpc) M (1 mpc)]

Copyright 2007 Pearson Addison-Wesley. All rights reserved.

21A-8

Open-Economy ISLM Model III

1. Including net exports in AD is an additional reason for
the negative relationship between Y and i represented by
hj in the term -(d +hj)i
2. The results from the basic model still hold
3. NX Y and E Y
4. NX i and E i

Copyright 2007 Pearson Addison-Wesley. All rights reserved.

21A-9