Abstract

Economic Policy and the Business Cycle in a Modified ISLM Model

The model presented here extends traditional ISLM analysis by adding a nonlinear, income-dependent investment effect. The result is a sigmoid IS function that rises positively in the medium income range. Where monetary policy is stringent, steep LM curve, the ISLM equilibrium is clear-cut despite the induced investment. In contrast, multiple equilibria occur under slight monetary restrictions. In such a case, if at the start there is ISLM equilibrium for low incomes, one-time financial and monetary policy measures of limited duration cause a permanently higher income. If, in addition, price level effects are taken into account, in this model it is of decisive importance what level or levels the price-level-neutral income has. Overall equilibrium, ISLM equilibrium at constant price levels, may in certain circumstances be unstable or only possible in the case of low incomes. The consequence is that active financial and/or monetary policy can give rise to a higher income only for a limited period, since the inflation effects triggered by non-linear income-dependence offset the employment effect. Under these circumstances, the higher income can be maintained only where continual financing of a rising price level is practiced by way of monetary policy. Otherwise a business cycle induced by economic policy will ensue.