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Chapter 26 Money and Economic Stability in the ISLM World CHAPTER OUTLINE I. Monetary Policy, Fiscal Policy, and Crowding Out. II. Is the Private Sector Inherently Unstable? III. Flexible Prices, the Natural Rate of Interest, and Real Crowding Out. Appendix: Interest Rates Versus the Money Supply Under Uncertainty. CHAPTER SUMMARY In this chapter, the IS-LM model is used to discuss the fundamental difference between noninterventionists (Monetarist-New Classicals) and interventionists (Keynesians). Noninterventionists believe the economy is inherently stable, or at least that policy makers do not have the information or the skill to make it more stable. In contrast, Keynesians believe that the economy is sufficiently unstable that, although policy cannot make it work perfectly, it can surely improve how it works. This chapter provides some historical perspective on the intervention- nonintervention debate. It focuses on the factors that shift the IS and LM curves and determine their slopes. The economy becomes less stable in response to autonomous spending shocks as the IS curve steepens and the LM curve flattens. These shifts reflect an increasing marginal propensity to consume, a decreased sensitivity on investment to interest rate changes, and an increased sensitivity of money demand to interest rate changes. Under these conditions, a positive spending shock would induce a large increase in consumption; the resulting increase in output and money demand would not cause the interest rate to rise much; and the rise in the interest rate would not cause investment to fall much. Thus, the shock would have the maximum effect on aggregate demand. By similar reasoning, a shock would have the minimum effect on aggregate demand if the LM curve were steep and the IS curve flat. The stability discussion in this chapter focuses on the stability of the aggregate demand curve. Much of the current debate on this subject has shifted to discussions of price and wage flexibility and the importance of expectations. Discussion of these subjects begins in the real crowding out section of this chapter and continues in the next two chapters.
