ISLM model Essay Example | Topics and Well Written Essays - 1000 words

ISLM model - Essay Example money demand equals to money supply. In the IS-LM model, money demand is assumed to be given exogenously at any point of time. It is the Central Bank, which determines money supply in any economy at any given point of time. The intersection of the two curves is known to be as the point of general equilibrium at which both the money market and the goods market are in equilibrium. In the above figure, the positively sloped curve is the LM curve, while the negatively sloped curve is the IS curve. E* is the intersection point of the two curves and represents general equilibrium. r* and y* is the general equilibrium values of r and y at which goods and money markets are simultaneously in equilibrium. Whether an economic model is reliable in terms of the values of different variables that it predicts and/or whether an economic model is capable enough of capturing what is actually happening in the real world depends on the reasonability of the assumptions it is based on. To examine how well IS-LM model captures what actually happens in the economy, one needs to check whether the two basic assumptions of the IS-LM model are reasonable. The major problem with the IS-LM model is that its two basic assumptions mentioned above have certain limitations and for this reason in spite of being a fundamental macroeconomic model, economists not very frequently use it for estimating the parameters involved in this model as well as the future values of output. (Clarida and Gertler, 1999 First, consider the problem with the assumption of price rigidity. IS-LM model always makes a prediction that equilibrium can be obtained at any level a it considers a passive kind of supply. According to this model, producers produce whatever is demanded by the buyers. In IS-Lm framework, if in an economy demand changes, then the economy will make all the adjustments to that change in demand in