This workbook implements the ISLM Model.

The fundamental goal is to understand short-run fluctuations (boom and bust behavior) in a market economy.

Organization
There are so many pieces to the model, that it gets confusing. Here's a handy map:

ISLMADAS.xls
ISLMADAS Model
(Y, r, P endo)

AD AS

You are ISLM Model

here. (Y, r endo; P exo)
ISLM.xls

IS LM

Goods Market Money Market

(Y endo; r, P exo) (r endo; Y, P exo)
KCross.xls MoneyMarket.xls

This is the third workbook in the Keynesian Model series of workbooks.

1) KCross.xls
2) MoneyMarket.xls
3) ISLM.xls <-- you are here
4) ISLMADAS.xls

If you are unfamiliar with the material in KCross.xls and MoneyMarket.xls, this workbook will be difficult to follow.
All of the workbooks are available here:
www.depauw.edu/site/learn/macroexcel/excelworkbooks

Previously
The KCross.xls workbook explained the Goods Market and how Planned Expenditures (PE) and income establish an equilibrium Ye.

The MoneyMarket.xls workbook used money demand (L, for liquidity preference) and money supply (M/P, called real balances)
to pin down the equilibrium interest rate (re).

The Key Idea

Page 1 of 16
This workbook connects the goods and money markets into a single model called the ISLM Model.

At its core, the ISLM Model is a clever graph that instantly shows the solution for two variables, Y and r, that are simultaneously in

You can think of it this way:

The goods market determines equilibrium Y, but it depends on r. Y e = f(r)
The money market determines equilibrium r, but it depends on Y. r e = f(Y)

You can show how the two separate goods and money markets bounce back and forth from one to the other until they both settle
at equilibrium, but the ISLM graph saves all that trouble.

The intersection of the IS curve (points of equilibrium in the goods market) and the LM curve (expressing equilibria in the money ma
is the one place where both the goods and money markets are simultaneously in equilibrium.
It is called the ISLM Model because Investment = Saving (IS) and Liquidity preference = Money Supply (LM) in equilib

Steps in Learning the ISLM Model

The best way to truly understand the ISLM Model is to first work with a simplified version that has only a one way link between r an
This allows you to see the goods and money markets together for the first time.
The NoFeedback sheet has this version of the model.

Having mastered this simple version, we move to the usual, two way relationship between r and Y.
We will quickly see that the feedback loop requires a new graphical display and it will help you understand how the ISLM Model work
See the ISLM sheet for the fully connected, two way interaction model.

Having seen how the ISLM graph works to pin down the general equilibrium solution, the next step is to derive the IS followed by the
As we reveal the source of the IS and LM curves, we emphasize critical elasticities that impact the shape of each
A useful way to think of IS and LM curves is that they act like magnets. They attract points off of the curves.

Before proceeding to a comparative statics analysis of the model, we will explore alternative stories about the equilibration process
This is advanced stuff and many books never even discuss this, but it helps to reinforce what the IS and LM curve

Our final step is comparative statics. We compare multipliers from past models and under different conditions.
This is where things get confusing.

One especially important skill that must be developed is how to read a graph. The ISLM Model strategically places variables on the x
for convenient stacking and organizing of graphs. This means that sometimes exogenous variables appear on the y axis and endoge
variables are placed on the x axis, contrary to conventional practice.

No matter how crazy and overwhleming it gets, try to remember this critical idea:
By putting the IS and LM curves on the same graph, the general equilibrium solution is easily found on one graph.

It all starts with the NoFeedback sheet. Good luck!

Page 2 of 16
 (This sheet prints on 3 landscaped pages)

cult to follow.

e establish an equilibrium Ye.

(M/P, called real balances)

Page 3 of 16
nd r, that are simultaneously in equilibrium.

the other until they both settle down

ssing equilibria in the money market)

e = Money Supply (LM) in equilibrium.

only a one way link between r and Y.

stand how the ISLM Model works.

to derive the IS followed by the LM curve.

that impact the shape of each curve.
ct points off of the curves.

about the equilibration process.

force what the IS and LM curves mean.

gically places variables on the x and y axes

appear on the y axis and endogenous

Page 4 of 16
This workbook has eleven screencasts, organized into three groups.
Each screencast has an associated question. Watch the screencast, then do the task.

Group 1: The first four screencasts are focused on the initial equilibrium and how it is obtained.

1.A) ISLM with No Feedback

vimeo.com/econexcel/islmintro

Task 1.A: Click the Random Parameters button in the NoFeedback sheet to generate your own economy.
Compute and compare the G, T, and Ms multipliers. Describe your procedure and your results.
Put your answer in a Word doc and take pictures as needed that illustrate and support your answer.

1.B) Understanding Equilibrium in the ISLM Model

vimeo.com/econexcel/islmequilibration

Task 1.B: Click the Random Parameters button in the ISLM sheet to generate your own economy and click Yes to the po
Now you have the same set of random parameters in the NoFeedback and ISLM sheets, with the money demand interce
With your random economy and in your own words, explain why LY > 0 is so critical to the ISLM Model. Focus on differen
Put your answer in a Word doc and take pictures as needed that illustrate and support your answer.

1.C) Asset Market Equilibration

vimeo.com/econexcel/islmassetmarket

Task 1.C: Create a copy of the ISLM sheet and click the Random Parameters button to generate your own economy. Re
Referring to specific numbers from your random economy, explain how asset market equilibration differs from cobweb e
Put your answer in a Word doc and take pictures as needed that illustrate and support your answer.

1.D) The Stability of Cobweb Equilibration

vimeo.com/econexcel/islmstability

Task 1.D: Create a copy of the ISLM sheet and click the Random Parameters button to generate your own economy. Re
Click the Show Stability in your new economy to see if your economy is stable or not.
Choose an r, Y pair above the LM curve and to the left of the IS curve and enter these values in cells B18 and B19.
Use the Clear Goods Market and Clear Money Market buttons to demonstrate that the equilibrium is or is not stable.
Keep track of the positions of the two markets as you equilibrate one, then the other and report these results in a Wor
Does your analysis agree with cell G38? Is this a surprise?

Group 2: The next three screencasts are concerned with the mechanics of the model itself and how it functions.

2.A) Deriving the IS and LM Curves

vimeo.com/econexcel/islmderive

Task 2.A: Create a copy of the ISLMCS sheet and click the Random Parameters button to generate your own economy.
Use the scroll bar to make investment demand as elastic as possible.
Take a picture of the Investment graph and paste it in a Word doc.
Below this graph in your Word doc, answer this question: Would the Fed prefer this investment demand to an extremely

2.B): Exactly Correctly Shifting Curves

vimeo.com/econexcel/islmshifting

Task 2.B: Click the link below to search the web for "is lm" in image files (or do this manually if the link doesn't work):
https://www.google.com/search?q="is lm"&tbm=isch
Scan the images and find one that is wrong because the shift shown is incorrect.
Copy and paste the graph in a Word doc and explain why it is wrong.
2.C) Attenuation and Crowding Out
vimeo.com/econexcel/islmcrowdingout

Task 2.C: Show that the tax multplier is also attenuated as we move from the No Feedback to the standard ISLM Mode
Take screenshots as needed and explain what is going on in a Word doc.

Group 3: The final four screencasts are devoted to the comparative statics properties of the model, including applications and analy

3.A) Shocks to Explain Economic Fluctuations

vimeo.com/econexcel/islmfluctuations

Task 3.A: Try to add random noise (with the RAND() function) to a different exogenous variable to see if it matches t
Take screenshots as needed and write up your procedure and results in a Word.doc.

3.B) Macro Policy Tools

vimeo.com/econexcel/islmpolicy

Task 3.B: Click the Random Parameters button in the ISLMCS sheet to generate your own economy.
Suppose full-employment, potential GDP is 10% greater than Ye. Show how G, T, and Ms can be used to stimulate the e
Take screenshots as needed and write up your procedure and results in a Word.doc.

3.C) Breaking the Monetary Transmission Mechanism

vimeo.com/econexcel/islmfedpowerless

Task 3.C: Using the same random parameters as Task 3.B, make money demand extremely elastic and show how this
Take screenshots as needed and write up your procedure and results in a Word.doc.

3.D) Deriving AD
vimeo.com/econexcel/islmderivingad

Task 3.D: Use the ISLMAD sheet to explore the effect on AD of changing the MPC.
Figure out if the shift in AD is constant for different levels of P (like G and T) or varying (like Ms).
Take screenshots as needed and write up your procedure and results in a Word.doc.

Since you made it this far, you might be interested in putting your knowledge of ISLM to a fun test.

Also, don't forget to check out the Final sheet.

 our own economy.

your answer.

economy and click Yes to the pop up question.

, with the money demand intercept adjusted to produce the same initial equilibrium solution.
he ISLM Model. Focus on differences in the way the model behaves.
your answer.

generate your own economy. Rename the sheet Task1C .

quilibration differs from cobweb equilibration.
your answer.

generate your own economy. Rename the sheet Task1D .

values in cells B18 and B19.

equilibrium is or is not stable.
and report these results in a Word doc (taking pictures is an easy way to do this or you can use Excel's Scenario Manager).

w it functions.

to generate your own economy. Rename the sheet Task2A .

estment demand to an extremely inelastic investment demand? Why or why not?

manually if the link doesn't work):

dback to the standard ISLM Model.

, including applications and analysis of fiscal and monetary policy.

us variable to see if it matches the fluctuations in observed Y, C, and I.

wn economy.
s can be used to stimulate the economy and steer it to its full-employment level of output.

emely elastic and show how this affects the Fed's ability to stimulate the economy.
 Data for graphs can be seen by scrolling down.

Goods Market
40 Must click the Initial button to have the reduced-for
INITIAL
35
Zoom Amount re 12,403%
30 PE
2 Ye 17,86853317
25
trillion $

20 NEW
re #¿NOMBRE?
15 Ye #¿NOMBRE?
10

5 Shock DL_Y_slope +0
45o Dre #¿NOMBRE?
0
0 5 10 15 20 25 30 35 40 DYe #¿NOMBRE?
Y (income in trillion $)

Money Market Investment

26,0% MS /P 26,0%
25,0% 25,0%
24,0% 24,0%
23,0% 23,0%
r --> I --> PE --> Y 22,0% 22,0%
21,0% 21,0%
20,0% 20,0%
19,0% 19,0%
18,0% 18,0%
17,0% 17,0%
interest rate

interest rate
16,0% 16,0%
15,0% 15,0%
14,0% 14,0%
13,0% 13,0%
12,0% 12,0%
11,0% 11,0%
10,0% 10,0%
9,0% 9,0%
8,0% 8,0%
7,0% 7,0%
6,0% 6,0%
5,0% 5,0%
4,0% 4,0%
3,0% 3,0%
2,0% 2,0%
1,0% L 1,0%
0,0% 0,0%
0 2 4 6 8 10 12 14 16 18 0
M (trillion S)
al button to have the reduced-form solution in cells B18, B19 for the cells below to work.

trillion $

trillion $

Investment

5 10
I (trillion $)
 Data for graphs can be seen by scrolling down.

Goods Market Speed

30

50
25
Zoom Amount
PE
2
20
trillion $

15

10

45o
0
0 5 10 15 20 25 30
Y (income in trillion $)

ISLM Money Market

11,0% 11,0% 11,0%
Ms/P
10,0% 10,0% 10,0%
9,0% 9,0% 9,0%
8,0% 8,0% 8,0%
7,0% 7,0% 7,0%
interest rate

interest rate
interest rate

6,0% 6,0% 6,0%

5,0% 5,0% 5,0%
LM 4,0% 4,0%
4,0%
3,0% 3,0% 3,0%
2,0% 2,0% 2,0%
1,0% 1,0% 1,0%
L
0,0% IS 0,0% 0,0%
0 5 10 15 20 25 30 0 2 4 6 0

Y (income in trillion $) trillion $

24 IS intercept
-250 IS slope
-0,006 LM intercept
0,002 LM slope
Investment

1 2 3 4
trillion $
This sheet summarizes important lessons from this workbook and points to the next step in the study of our Keynesian Model.

The goods market, depicted in Keynesian cross diagram, is the basic building block.
It shows that equilibrium output and income, Y, the most important variable in macroeconomics, is determined by the sum of
planned expenditures by consumers, firms, and governments:
Y = C(Y, T) + I(r) + G

The ISLM Model essentially endogenizes r, making equilibrium r a function of Y.

This gives us a two-variable model, Y and r, that are functions of a bunch of exogenous variables.

The interaction of the variables is captured by this loop:

Y r

Md

In equilibrium, the level of Y yields a money demand that produces an r that gives an I so that C + I + G determines the same level o
that we started with.

The IS and LM curves make finding the equilibrium solution easy.

The IS curve gives the equilibrium Y for any given r.

The LM curve gives the equilibrium r for any given Y.
The curves are magnets that attract points in a left/right fashion for IS and up/down for LM.
The intersection of the IS and LM curves gives the equilibrium pair of Y and r.

The shapes of the IS and LM curves, flat or steep, depend upon underlying functions like investment and money demand.
The amount of shifting is also dependent upon parameter values.
Many macroeconomists accept, in broad terms, a model like the one implemented here, but disagree over parameter values
and shapes of curves.

The ISLM Model is used for understanding how shocks affect the economy.
In essence, a constant stream of shocks push the economy around and this explains why we see fluctuations.
We can get shocks from anywhere, but volatility in investment is a prime source of cyclical movement in economic performance.

The model is also used for policy analysis. It shows how the fiscal policy tools (G and T) and monetary policy (Ms) affects Y.
So, if Y is too low (and, thus, unemployment too high), the economy can be steered to its full-employment position.
In the United States, the Fed controls monetary policy and it infuences the economy via the interest rate's effect on investment.

The IS shifts left/right as G and T are manipulated while the LM curve shifts up/down as the money supply is changed.

The three policy tools all have multpliers and these can be used to compute the size of an appopriate policy move.
Of course, this is all in theory and actual practice is way more complicated. Not only don't we know parameter values,
we don't know how long a particular policy move will take.
Policy is as much art as science.

The multipliers in the ISLM model are less powerful than in the original, basic Keynesian cross model.
Any increase in Y will produce an increase in interest rates that feedback and lower Y.
This is a general property of modeling: as we expand the model, adding feedback mechanisms, the multpliers get smaller.
When G, T, or Ms are used to stimulate the economy, part of the change in Y will be crowded out by a higher interest rate.
There are many other flavors of the ISLM Model. For example, instead of T as a single number, taxes can be a function of income, li
Or, additional channels can be inserted into C via r and P (since it makes sense that consumer spending depends on interest rates a
In fact, the implementation in this Excel workbook is about as simple an ISLM Model as you can find.

The ISLM Model is a traditional, canonical model in macroeconomics, but it has a severe limitation in that it says nothing about price
In fact, the price level is assumed constant.
By changing P, we can track equilibrium Y and derive an AD curve in Y-P space.
This leaves us poised to make the leap to the next level: a model that endogenizes P and has three equilibrium variables: Y, r, and P

This is the topic of the next and final workbook, ISLMADAS.xls.

 udy of our Keynesian Model.

determined by the sum of

+ G determines the same level of Y

t and money demand.

e over parameter values

ent in economic performance.

tary policy (Ms) affects Y.

oyment position.
t rate's effect on investment.

y supply is changed.

te policy move.
w parameter values,

multpliers get smaller.

y a higher interest rate.
 s can be a function of income, like this: T = tY.
nding depends on interest rates and prices).

that it says nothing about prices.

equilibrium variables: Y, r, and P.