Chapter 24

Monetary and Fiscal Policy in the ISLM Model

© 2004 Pearson Addison-Wesley. All rights reserved 1-2

Shift in the IS Curve

1. C : at given iA, Yad , Y IS shifts right

2. Same reasoning when I , G , NX , T

© 2004 Pearson Addison-Wesley. All rights reserved 1-3

Shift in the LM Curve from a Rise in Ms

1. Ms : at given YA, i in panel (b) and (a) LM shifts to the right

© 2004 Pearson Addison-Wesley. All rights reserved 1-4

Shift in the LM Curve from a Rise in M d

1. M d : at given YA, i in panel (b) and (a) LM shifts to the left

© 2004 Pearson Addison-Wesley. All rights reserved 1-5

Response to an Increase in Ms

1. M s : i , LM shifts right Y i

© 2004 Pearson Addison-Wesley. All rights reserved 1-6

Response to Expansionary Fiscal Policy

1. G or T : Yad , IS shifts right Y i

© 2004 Pearson Addison-Wesley. All rights reserved 1-7

Summary: Factors that Shift IS and LM Curves

1-8

Effectiveness of Monetary and Fiscal Policy

1. M d is unrelated to i i , M d = M s at same Y LM vertical

2. Panel (a): G , IS shifts right i , Y stays same (complete crowding out)

3. Panel (b): M s , Y so M d , LM shifts right i Y Conclusion: Less interest sensitive is M d, more effective is monetary policy relative to fiscal policy

© 2004 Pearson Addison-Wesley. All rights reserved 1-9

Optimal Choice of Monetary Policy Instruments (Poole, QJE 1970)

Assume that random variables and have normal distribution and their means are 0 and variances and .

( ) ( )Y C Y T I i G

( , )M

L i YP

2 2

© 2004 Pearson Addison-Wesley. All rights reserved 1-10

Ms vs. i Targets When IS Unstable

1. IS unstable: fluctuates from IS' to IS''

2. i target at i*: Y fluctuates from YI' to YI''

3. M target, LM = LM*: Y fluctuates from YM' to YM''

4. Y fluctuation is less with M target

Conclusion: If IS curve is more unstable than LM curve, M target is preferred

© 2004 Pearson Addison-Wesley. All rights reserved 1-11

Ms vs. i Targets When LM Unstable

1. LM unstable: fluctuates from LM' to LM''

2. i target at i*: Y = Y*

3. M target: Y fluctuates from YM' to YM''

4. Y fluctuation is less with i target

Conclusion: If LM curve is more unstable than IS curve, i target is preferred

© 2004 Pearson Addison-Wesley. All rights reserved 1-12

The ISLM Model in the Long Run

Panel (a)1. Ms , LM right to LM2, go to point 2, i to i2, Y to Y2

2. Because Y2 > Yn, P , M/P , LM back to LM1, go back to point 1Panel (b)1. G , IS right to IS2, go to point 2 where i = i2 and Y = Y2

2. Because Y2 > Yn, P , M/P , LM left to LM2, go to point 2', i = i2` and Y = Yn.

© 2004 Pearson Addison-Wesley. All rights reserved 1-13

Deriving AD Curve

P , M/P , LM shifts in, Y Points 1, 2, 3

© 2004 Pearson Addison-Wesley. All rights reserved 1-14

Shift in AD from Shift in IS

At given PA, IS shifts right: Y in panel (b) AD shifts right in panel (a)

© 2004 Pearson Addison-Wesley. All rights reserved 1-15

Shift in AD from Shift in LM

At given PA, LM shifts right: Y in panel (b) AD shifts right in panel (a)

© 2004 Pearson Addison-Wesley. All rights reserved 1-16

Deriving the AD curve from IS-LM

• Combine these two equation by substituting di,

• Or ,

2( ) ( )

(1 )

d

d

i Y i

Y i Y i

dM ML dG C dT I dP

P PdYC L L I

( )dY idY C dY dT I di dG

2Y i

PdM MdPL dY L di

P

2( ) ( )

d

YY i

i i

L dYPdM MdPdY C dY dT I dG

P L L

© 2004 Pearson Addison-Wesley. All rights reserved 1-17

Deriving the AD curve from IS-LM

• The slope of AD (let dG = dT = dM = 0)

• Shift of AD caused by dG (let dP = dT = dM = 0)

• Shift of AD caused by dM (let dP = dT = dG = 0)

2

(1 )| 0dY i Y iAD

i

C L L IPMY IP

| 0(1 )

D

iAD

Y i Y i

LY

G C L L I

/| 0

(1 )D

iAD

Y i Y i

I PY

M C L L I

© 2004 Pearson Addison-Wesley. All rights reserved 1-18

Deriving the AD curve from IS-LM

• If there is liquidity trap:

• AD curve is vertical.

2

(1 )lim lim D

i i

Y i Y i

L L

i

C L L IPMY IP