Interpretations II

The dispute over how to measure monetary policy involves assumptions about people's demand for money and about the role of interest rates on investment. From the discussion above, however, you will not see the full role that the demand for money plays. The above discussion focuses on the financial markets which ISLM dismisses by an appeal to Walras' Law.4

Consider what would happen in the ISLM model if the demand for money was independent of interest rates. Then if the amount of money changed, people would be thrown out of equilibrium and would not regain equilibrium until spending changed. Even if they all buy financial assets, and as a result interest rates change, they will still be out of equilibrium. Interest rates play no role in this case, and there is no rationale here to measure monetary policy with interest rates.

However, suppose that the demand for money is highly sensitive to interest rates. If money changes, people will still be thrown out of equilibrium. Now if they try to get rid of excess cash balances by buying financial assets, any decrease in interest rates will bring them closer to equilibrium. There is no need for spending to change at all for equilibrium to be reestablished for those holding cash balances.

The chain that ISLM encourages us to see is a change in money causing people to be thrown out of equilibrium in terms of money holdings, but getting back into equilibrium by trading money for financial assets (or assets for money) and changing the interest rate. The change in the interest rate throws business out of equilibrium because at the new interest rate it will want to alter the amounts it invests. As business changes investment to get back into equilibrium, total spending changes. If either the demand for money is highly sensitive to interest rates or investment is insensitive to interest rates, monetary policy will have little effect in this model. If demand for money is highly sensitive, a small change in interest rate will make people happy to hold extra money, but a small change in interest will only have a small change on investment. If investment is not sensitive to changes in interest rates, then even big changes in money may have little effect on total spending.



4 ISLM assumes that the economy can be aggregated into three markets: money, goods, and everything else. If the first two markets are in equilibrium, the third also must be in equilibrium.

Copyright Robert Schenk