Limitations of ISLM
Both the simple incomeexpenditure model and the quantity
theory of money engage in drastic aggregation. The quantity
theory of money aggregates the economy into only two
markets, the market for money balances and the market for
all other things. The simple incomeexpenditure model
involves an equally drastic but different aggregation, to a
market for goods and services and a market for all other
things. Then each, by Walras' Law, ignores the second market
and focuses on only one market. These drastic aggregations
make sense if the main source of problems in a market
economy arise in only one sector and the problems that are
evident in other sectors are simply reflections of problems
that originate in that one sector. A year after the
publication of the General Theory, John Hicks
proposed ISLM as a less dramatic aggregation that he saw as
a more general case of both the quantity theory and the
simple incomeexpenditure model. Part of its popularity this
model, which has reigned as the standard macroeconomic model
for half a century, undoubtedly lies in its ability to
present macroeconomics in terms of a model with exactly the
same structure and mechanics as the model of supply and
demand.
Though the ISLM model is a fundamental model of
macroeconomics, seldom do macroeconomists try to estimate
the parameters of the model and use it to predict the future
course of GDP. There has been at least one attempt to
estimate the importance of fiscal and monetary policy with
equations similar to the equation one attains when one
solves the model for equilibrium income. However, many
economists have argued that such an approach could not
capture the subtleties of how the economy works and thus do
not give reliable estimates.^{1}
The fact that economists have not used the ISLM model in
their attempts to numerically predict the effects of
policy suggests that ISLM has weaknesses. The first of these
is the question of whether or not ISLM is meant as a
longrun or shortrun model. If it is meant as a longrun
model, then its prediction that equilibrium can exist at any
level of output is controversial. ISLM aggregates the
economy into three markets: goods, money, and all other.
This aggregation makes sense if nothing interesting happens
in the "allother" market, if it simply adjusts passively to
changes in the goods and money market. Included in the
passively adjusting sector is the resource market, even
though many economists point to the labor market as a sector
that does not readjust rapidly.
ISLM predicts the equilibrium can be at any level because
it assumes, as does the simple incomeexpenditure model, a
passive supply. Sellers produce whatever is demanded, and
all adjustment to changes in demand are in the form of
changes in output and none of the adjustment is in the form
of changes in prices. Adjustment cannot be in the form of
price changes because the price level does not enter the
model. Since changes in prices are the primary way markets
adjust in microeconomic theory, the failure of ISLM to say
anything about prices is a serious weakness.
If meant as a shortrun model, the model is severely
limited because it does not incorporate the rate of
inflation. Inflation creates a difference between real and
nominal interest rates. The nominal rate is the visible rate
that people pay and receive, and the real interest rate is
what is happening in terms of purchasing power. Thus if the
rate of interest is 5% and the rate of inflation is 10%, a
person who borrows $100 and pays back $105 in a year will
pay back less in terms of purchasing power than he borrowed.
He pays back 105 dollars, but each dollar can buy 10% less
than it did a year earlier. Hence his rate of interest in
real terms is actually negative. The real interest rate is
computed as the nominal interest rate less the rate of
inflation.^{2}
The distinction between real and nominal interest rates
is important in ISLM because investment spending should
respond to the real interest rate and money demand to the
nominal interest rate. To see why investment depends on the
real rate, consider a situation of zero inflation in which a
person buys a machine that will cost $100 and earn $105 one
year later. This purchase will be worthwhile if the interest
rate is below 5%. Now suppose that inflation jumps from zero
to 10%. The same machine will produce the same output, but
because of the increase in prices, the output will be 10%
more valuable in terms of the money it brings. Thus the $100
machine will earn $115.05 (which is 10% more than 105) in
one year. The investment is now worthwhile at any nominal
rate under 15% (which is a real rate under 5%.) Investment
will remain constant if the real interest rate does not
change; change in nominal rates will not change investment
if it does not change the real rate.
To keep the demand for money constant (which means that
the velocity of circulation remains constant), the nominal
interest rate must remain constant. When people hold cash
balances for transactions; they are concerned with
purchasing power. If all prices double, the amount of
money people want to hold will double, but the amount of
purchasing power they want will remain constant.^{3}
The interest rate is a cost of holding purchasing power. If
the rate of inflation increases, and the rate of interest
with it, holding money becomes more expensive and people
will want to hold smaller amounts of purchasing power.
Thinking of the demand for money in terms of purchasing
power lets us ignore price level and is the key to seeing
the effects of the rate of interest. It is the nominal rate,
not the real rate, that matters.
Further, the rate of inflation independently affects the
demand for money by changing its desirability as a store of
wealth. In cases of very serious inflation, such as the
German hyperinflation of 1923, people try to spend money as
quickly as possible because it is losing its value. As a
result, the velocity of money increases. To some extent
estimates of how sensitive money demand is to interest rates
may be catching this sensitivity of money demand to
inflation because rates of inflation and interest rates move
together.
One could graph the ISLM model assuming that the vertical
axis measured the real rate. Then any time the rate of
inflation changed (and thus the nominal rate), one could
shift the LM curve. A more rapid inflation would shift the
LM curve to the right, for example, reducing real interest
rates and increasing income. The problem with this solution,
however, is that it leaves the rate of inflation as
autonomous, unrelated to what is happening to fiscal and
monetary policy. Though there have been times when many
economists considered inflation autonomous ("costpush"
theories that were very popular in the 1950s are an
exampleprices rise because costs rise), most economists
believe that macroeconomic policy is by far the most
important determinant of rates of inflation.
Given these serious weaknesses, why has ISLM remained as
a framework for so much macroeconomic thinking? A major
reason is that no other simple model gives as much insight.
ISLM suggests that economic disturbances can arise in either
the money market or the goods market, a conclusion that
predates ISLM. Economists want a simple model that concludes
this. Also, ISLM can be expanded and made more complex in an
effort to overcome its limitations.
An recent alternative to ISLM is Aggregate
Supply and Demand.
^{1 }The study was done by
economists at the Federal Reserve Bank of St. Louis and
found that monetary policy was much more powerful than
fiscal policy. It is interesting to speculate how positions
on this study would have changed if the study had shown that
fiscal policy was more powerful than monetary
policy.
^{2 }Actually this equation is
only approximate. The exact formula is:
real rate = (nominal rate  inflation)/(1 + inflation).
When the rate of inflation is low, the denominator can be
ignored.
^{3} It is important to realize
that this last statement is discussing two situations of
equilibrium, one with prices higher than the other. The rate
of inflation is assumed to be the same in both situations.
That people will hold constant amounts of purchasing power
is the central tenant of the quantity theory of
money.
Copyright
Robert Schenk
