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Monetary and Fiscal Policy in the IS-LM Model

Chapter 4

Instructor: MELTEM INCE

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The Definition of Money

Money is defined as any good or asset that serves thefollowing three functions:

Medium of ExchangeStore of ValueUnit of Account

The Money Supply (MS) is equal to currency incirculation plus checking accounts at banks and thriftinstitutions.

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Money Demand

The demand for money is determined by people’s need for money to facilitatetransactions.

If Income (Y) Md If the Price Level (P) Md

Notice: Real money demand = is unaffected by PThe demand for money also depends negatively on the cost of holding money,the interest rate (r).

If r Md as people switch out of money into interest-bearing savings accounts or other financial assets

Algebraically, the general linear form of Md is:

(M/P) = kY – hi

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What Shifts Money Demand?

The main shift factor for real Md is income (Y). Additional shift factors include:

Interest paid on money: If money pays more interest Md rises Wealth: If people become wealthier, some of the additional

wealth may be held as money, so Md rises. Expected future inflation: If people expect P to rise quickly

in the future, they will try to hold as little money as possible. Payment technologies: Any technological development that

alters how people pay for goods and services, or the ease of switching between money and non-money assets can change Md

Examples: Credit Cards and ATMs

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The IS Curve: Equilibrium in the Goods Market

The goods market clears when desired investment

equals desired national saving. For any level of output

Y, the IS curve shows the real interest rate r for which

the goods market is in equilibrium

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The IS CurveAE = C+Ip+G

C=C0+cDPI = C0+c(Y+TR-T)

I=I0-bi

G=G0 T=T0 +tY

AE=C0+c(Y+TR-T)+I0-bi+G0

AE= A0-bi+c(1-t)Y where A0= C0+cTR0-cT0+I0+G0

Y=AE

Y= A0-bi+c(1-t)Y

Y-c(1-t)Y=A0-bi

Y=ke(A0 –bi)

i = A0/ b – Y/keb

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The IS Curve: Equilibrium in the Goods Market

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The IS Curve

The saving curve slopes upward because a higher real interest rate increases saving

An increase in output shifts the saving curve to the right, because people save more when their income is higher

The investment curve slopes downward because a higher real interest rate reduces the desired capital stock, thus reducing investment

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Effect on the IS curve of a temporary increase in government purchases

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The IS Curve The IS curve shifts up and to the right because of

an increase in expected future output an increase in wealth a temporary increase in government purchases a decline in taxes (if Ricardian equivalence doesn’t hold) an increase in the expected future marginal product of

capital a decrease in the effective tax rate on capital

The IS curve shifts down and to the left when the opposite happens to the six factors above

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LM Curve

The LM Curve shows all the possible combinations of Y and r such that the money market is in equilibrium.

Algebraic Derivation:At equilibrium, real MS equals real Md:

Yh

k

P

M

hr

S

1Solving for r yields:

(Ms/P) = kY – hi

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What shifts and rotates the LM Curve?

Anything that only affects the intercept term will shift the LM curve: If MS LM shifts → If P LM shifts → Not captured by slope term: Md LM shifts ←

Anything that affects the slope term will cause a rotation of the LM curve: If h LM becomes steeper If f LM becomes flatter

i = (k/h)Y – (1/h)M/P

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LM Curve

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LM Curve

Factors that shift the LM curve Any change that reduces real money supply relative to real

money demand shifts the LM curve up For a given level of output, the reduction in real money

supply relative to real money demand causes the equilibrium real interest rate to rise

The rise in the real interest rate is shown as an upward shift of the LM curve

Similarly, a change that increases real money supply relative to real money demand shifts the LM curve down and to the right

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LM Curve

The LM curve shifts down and to the right because of an increase in the nominal money supply a decrease in the price level an increase in expected inflation a decrease in the nominal interest rate on money a decrease in wealth a decrease in the risk of alternative assets relative to the risk

of holding money an increase in the liquidity of alternative assets an increase in the efficiency of payment technologies

The LM curve shifts up and to the left when the opposite happens to the eight factors listed above

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An Increase In The Real Money Supply Shifts The LM Curve Down And To The Right

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LM Curve

Changes in the real money supply• A drop in real money supply shifts the LM curve up

and to the left• An increase in real money demand shifts the LM

curve up and to the left

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An increase in the real money demand shifts the LM curve up and to the left

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The General Equilibrium

A General Equilibrium is a situation of simultaneous equilibrium in all of the markets of the economy.

How does the economy adjust to the general equilibrium? If the goods market is out of equilibrium involuntary

inventory decumulation or accumulation occurs firms respond by increasing or decreasing production Y moves to equilibrium

If the money market is out of equilibrium pressure on interest rates will bring back monetary equilibrium

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General equilibrium in the IS-LM model

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The FE Line: Equilibrium in the Labor Market

If we plot output against the real interest rate, we get avertical line, since labor market equilibrium isunaffected by changes in the real interest rate.

Labor market in showed how equilibrium inthe labor market leads to employment at its fullemployment level and output at its full-employmentlevel

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Factors that shift the FE line

The full employment level of output is determined by the fullemployment level of employment and the current levels of capital and productivity; any change in these variables shifts the FE line

The full-employment line shifts right because of a beneficial supply shock an increase in labor supply an increase in the capital stock

The full-employment line shifts left when the opposite happens to the three factors above

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Monetary Policy

An expansionary monetary policy is one that has the effect of lowering interest rates and raising GDP.

A contractionary monetary policy is one that has the effect of raising interest rates and lowering GDP.

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The Effect of Increase in the Money Supply

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Fiscal Policy and “Crowding Out”

An expansionary fiscal policy is one that has the effect of raising GDP, but also raising interest ratesNote: r Private Autonomous Spending

The reduction in the amount of consumption and/or investment spending due to an increase in G (or fall in T) is known as “Crowding Out”

Can crowding out be avoided?Yes! If the Fed simultaneously MS r

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The Effect on Real Income and the Interest Rate Increase in Government Spending

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Monetary and Fiscal Policy Effectiveness

Monetary policy is strong when: The IS curve is relatively flat and/or The LM curve is steep

Monetary policy is weak when: The IS curve is very steep and/or The LM curve is relatively flat

Fiscal policy is strong when: The IS curve is very steep and/or The LM curve is relatively flat

Fiscal policy is weak when: The IS curve is relatively flat and/or The LM curve is steep

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The Effect on Real Income of a Fiscal Stimulus

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The Liquidity Trap

A Liquidity Trap occurs when investors are indifferent between holding money and short-term assets. Why might investors be indifferent?

Because the nominal interest rate on short-term assets is close to zero!

Why is a liquidity trap a problem? Because the interest rate is close to zero, the Fed can no longer

use monetary policy to lower the interest rate to boost output. How is a liquidity trap represented?

The LM curve starts off horizontal at very low interest rates before having its normal upward slope.

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Aggregate Demand and Aggregate Supply

Use the IS-LM model to develop the AD-AS model The two models are equivalent Depending on the issue, one model or the other may

prove more useful IS-LM relates the real interest rate to output AD-AS relates the price level to output

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Aggregate Demand and Aggregate Supply

The aggregate demand curveThe AD curve shows the relationship between the

quantity of goods demanded and the price level when the goods market and asset market are in equilibrium

So the AD curve represents the price level and output level at which the IS and LM curves intersect

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Aggregate Demand and Aggregate Supply

The aggregate demand curve The AD curve is unlike other demand curves, which relate

the quantity demanded of a good to its relative price; the AD curve relates the total quantity of goods demanded to the general price level, not a relative price

The AD curve slopes downward because a higher price level is associated with lower real money supply, shifting the LM curve up, raising the real interest rate, and decreasing output demanded

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The effect of an increase in government purchases on the aggregate demand curve

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Aggregate Demand and Aggregate Supply

Factors that shift the IS curve up and to the right and thus theAD curve up and to the right as well

Increases in future output, wealth, government purchases, or the expected future marginal productivity of capital

Decreases in taxes if Ricardian equivalence doesn’t hold, or the effective tax rate on capital

Factors that shift the LM curve down and to the right and thusthe AD curve up and to the right as well

Increases in the nominal money supply or in expected inflation Decreases in the nominal interest rate on money or the real

demand for money

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Aggregate Demand and Aggregate Supply

The aggregate supply curve The aggregate supply curve shows the relationship

between the price level and the aggregate amount of output that firms supply

In the short run, prices remain fixed, so firms supply whatever output is demanded

The short-run aggregate supply curve is horizontal

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Full-employment output isn’t affected by the price level, so the long-run aggregate supply curve (LRAS) is a vertical line

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Aggregate Demand and Aggregate Supply

Factors that shift the aggregate supply curves The SRAS curve shifts whenever firms change their prices in

the short run Factors like increased costs of producing goods lead firms

to increase prices, shifting SRAS up Factors leading to reduced prices shift SRAS down

Anything that increases full-employment output shifts the LRAS curve right; anything that decreases full-employment output shifts LRAS left

Examples include changes in the labor force or productivity changes that affect labor demand

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Short-run equilibrium: AD intersects SRASLong-run equilibrium: AD intersects LRAS

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Adverse Supply Shock

Y Income, Y

SRAS1

SRAS2

LRAS

AD

Price,P

A

B

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Adverse Supply Shock

If aggregate demand is held constant, the economy movesfrom A to B. The price level rises and the amount of outputfalls below the natural level. This is called Stagflation,because it combines falling output with rising price level. As a summary, the real wage, employment, and outputdecline, while the real interest rate and price level arehigher. Since the real interest rate is higher and output islower, consumption and investment must be lower

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Accommodating an Adverse Supply Shock

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Accommodating an Adverse Supply Shock

If the increase in aggregate demand coincides with

the shock to aggregate supply, the economy goes

immediately from E to H. The price level is

permanently higher. There is no way to maintain

full employment and keep the price level stable.