Overview: Search for Synthesis

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Macroeconomics has long focused on two types of actions that the government can use to influence inflation or unemployment. Monetary policy, which the central bank controls, was explained using the quantity theory of money. Fiscal policy, the use of government spending or taxes to change total spending, was explained by the income-expenditure model. These two models presented very different views of the world--the income-expenditure model, for example, had no role for monetary policy, nor did the quantity theory have a role for fiscal policy.

The interest rate can bridge the chasm between the simple income-expenditure model and the quantity theory. The introduction of interest rates opens the possibility of fiscal policy working in a quantity-theory view, and monetary policy working in an income-expenditure view. These possibilities can be shown in a compromise model called the ISLM model.

This group of readings explains the logic and workings of the ISLM model, a model that dominated macroeconomics for many decades, but that has slowly been losing influence. It will point out some of the conclusions and insights that can be deduced from the model, and also some of the weaknesses of the model. We conclude by looking at how ISLM meshes with the alternative synthesis of aggregate demand and supply.

After you complete this unit, you should be able to:

  • Explain what changes one must make to the income-expenditure model for it to include effective monetary policy.
  • Explain what changes one must make to the quantity theory for it to include effective fiscal policy.
  • Explain what effects fiscal and monetary policy will have in the ISLM model.
  • Explain why monetarists argue that fiscal policy can be crowded out.
  • Explain why ISLM is troubled by the distinction between real and nominal interest rates.
  • Define money illusion.
  • Explain how one can get an aggregate demand curve from ISLM, and how the aggregate supply curve depends on how prices are set.
Copyright Robert Schenk