Problems with Static Interest Rates in the ISLM

September 1st, 2016
in history, macroeconomics

by Philip Pilkington

Article of the Week from Fixing the Economists

The ISLM takes quite a beating from Post-Keynesians — and, I would argue, rightly so. There are any number of reasons for this but let me just here highlight one that is not very regularly talked about.

Follow up:

As is well-known and can be seen in the below diagram the ISLM considers output to be a function of the interest rate. At a higher level of interest rates output is thought to be lower and at a lower level of interest rates output is thought to be higher.

ISLM interest rate increase

The problem with this presentation? It is not true. You see, even if we allow that interest rates have a substantial effect on output, it is not so much the absolute levels of interest rates that matters so much as it is the relative rate. Relative to what? To itself of course. What I mean is that if interest rates have effects on output it is the change in the interest rate rather than the absolute level that leads to expansions or contractions in output.

This can clearly be seen by simply looking at data for a wide variety of countries. If the ISLM were correct we would assume that countries with high interest rates would have low output, but this is simply not the case. Take Brazil as an example. Their interest rate has been between 18% and 8% since 2006,


From the perspective of the ISLM these extremely high interest rates should translate into low output growth, but this is simply not the case. Throughout the period — barring an interruption by the worldwide recession in 2008 — output growth in Brazil has been fairly high, running between about 2% and 9% annually,


This is not simply a case of the nominal interest rate being high while the real interest rate is low either. If we look at the inflation rate over this period it is not particularly high at all — at least, for a developing country — and has proved relatively stable,


I would say that over this period we are seeing an average interest rate of about 12% or so and an average rate of inflation of about 5% or so. Real interest rates, on average, then are about 7% — not to be sniffed at — and yet GDP growth averaged maybe 4-5% if we control for the recession.

The lesson here is obvious: it is not the absolute level of the interest rate that has an effect on output but rather the change in the interest rate. Large changes can cause expansions and contractions in output, but the effects of the absolute level is far less clear.

In this regard, the ISLM — even if we take it on its own terms — is somewhat misleading. The relationship between interest rates and output is not a mechanical one that can be represented in two-dimensions, rather it is one that rests on changes taking place in the variables.

Some will now say:

“Oh, but we’re not stupid… everyone already knows that…”.

Actually, I think that this is far from clear. When economists — like Krugman, for example — talk about a natural rate of interest that would result in full employment they tend to talk in absolute terms;

“The natural rate is –x%…”.

Now, I obviously do not believe in this natural rate but even if I did I would point out that it is the rate at which the interest rate is changed from the present rate to the natural rate that is important, not the absolute level of the natural rate per se. Even if the so-called natural rate were assumed to function it would likely not do so if the interest rate was lowered very gradually to this rate, over the course of, say, 5 years. Rather it would have to be done rather quickly; maybe over the course of a few weeks. Central banks are fully aware of this, of course, which is why they always try to time their interest rate changes precisely so as to ensure the intended effects.

So, the ISLM framework, with its static ideas about interest rates and output, does indeed lead to confusion among those who use it. One more reason, among many, to throw it out.

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