The Small Open ISLM Economy

Henry Thompson

This monograph introduces the macroeconomic ISLM model of an economy open to international trade and investment. It is aimed at advanced undergraduates or beginning graduate students wanting a concise introduction. Email


The applied side of macroeconomics is based on models that capture aggregate economic behavior and the response of the economy to external shocks such as rising energy prices, financial system bankruptcy, global recession, exchange rate shocks, and government monetary and fiscal policies. The ISLM model remains the workhorse model for applied macroeconomics.

The present introduction to the ISLM model focuses on a small economy open to international trade and investment. The IS in ISLM refers to the equilibrium between investment and saving in the real economy. The LM represents the equilibrium between liquidity and money supply in the monetary economy. The advantage of the ISLM model is that it integrates real and monetary sides of the economy. The ISLM model includes aggregate measures such as consumption spending, investment spending, government spending, tax revenue, export revenue, import spending, the interest rate, exchange rate, and national output or income.

The appeal of ISLM is its description of how the major macroeconomic variables in an economy are related. The time horizon of the ISLM model is up to a year. The ISLM model remains the primary model used by government policy makers, financial commentators, and macroeconomic consultants. This introduction presents the open economy ISLM model focused on the role of government policy to influence output. A range of government policies are considered including fiscal policy of government spending and taxes, monetary policy related to the money supply and interest rate, and exchange rate policy in the choice of a fixed or floating exchange rate. A small open economy is assumed to be a price taker in the international credit market, fixing the interest rate at the global level. Adjustments in the balance of trade and international investment in the capital account are analyzed along with adjustments in output, the exchange rate regime, floating or fixed, is critical to the adjustment process.