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.
back
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
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