Fiscal and Monetary Policy Analysis in an ISLM Model

By adding the government sector to the ISLM model we can use it to start analysing the role and effectiveness of fiscal and monetary policies. The advocacy of deliberate government action to regulate the level of aggregate demand is the hallmark of Keynesian economics. In orthodox Keynesian analysis the economy can get stuck at an equilibrium level of output which is below the full-employment level. Here the government is able to restore full employment by raising the level of aggregate demand. It can do this by either increasing government expenditure, reducing taxation which raises consumers’ demand or by increasing the money supply. Inflation caused by excess aggregate demand can be controlled by the converse set of policies which reduce the level of aggregate demand.