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IS-LM Model
Fiscal Policy
&Monetary Policy
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Outline Introduction
Revision
Slope & Shift of IS curve
Slope & Shift of LM curve
Fiscal Policy
Expansionary & Contrationary Fiscal Policy
Crowding-Out Effect
Effectiveness of Fiscal Policy
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Outline Monetary Policy
Expansionary & Contractionary Monetary Policy
Effectiveness of Monetary Policy
Deflationary & Inflationary Income Gap
IS-LM model versus Simple KeynesianModel
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Introduction Unemployment (when Y < Yf) is one of
the major economic problems
The government always tries to attain fullemployment Yf
In the simple Keynesian model, the
government can adopt expansionary fiscalpolicy (G’ T’) when there is a
deflationary / recessionary gap (Yf - Y)
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Introduction Y will then increase by the amount of k EG’
OR k TT’
Since in a three-sector Keynesian model
Y=
Y = OR Y =
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Introduction Will income increase by the same
amount as in the elementary Keynesianmodel when the government adopt adiscretionary (fiscal / monetary) policy,when both interest rate and income are
endogenous variables in the IS-LMmodel?
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Revision - IS Curve
r =
slope = r/ Y =
Y =
x-intercept =
when r = 0
C = C’ + cYd = C’ - cT’ + cY
T = T’
I = I’ - br
G = G’
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Revision - IS Curve
IS1
r
Y
When b is smaller, the IS curve will be
When s is larger, the IS curve will be
But k E will be
Construct IS2
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Revision - IS Curveb =
s =
k E =
r
Y
r
Y
b =
s =
k E =
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Revision - IS Curve Y =
Y/ G’ =
Y/ T’ =
x-intercept =
when r = 0
r
Y
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Revision - LM CurveMs = Ms’
Mt = dY
Ma = Ma’ - er
r =
slope = r/ Y =
Y =
x-intercept =
when r = 0
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Revision - LM CurveWhen e is larger, the LM curve will be
When d is smaller, the LM curve will be
But 1/d will be
LM1
Construct LM2
r
Y
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Revision - LM Curve
r
Y
r
Y
e =
d =
1/d =
e =
d =
1/d =
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Revision - LM Curve Y =
Y/ Ms’ =
x-intercept =
when r = 0
Y
r
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Expansionary Fiscal Policy
+veG’ OR -ve
T’
r
Y
ISLM
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Contractionary Fiscal Policy
-veG’ OR +ve
T’
r
Y
ISLM
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Crowding-Out Effect
Expansionary Fiscal PolicyG’
r
Y
IS1 LMIS2
r1 *
When r = r1, there isexcess money _____ as Y rises and _____ rises
_____ has to decrease inorder to restoreequilibrium in the moneymarket Ms = Mt + Ma
Y1 Y2
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Crowding-Out Effect
Expansionary Fiscal PolicyG’
When government expenditure increases, G’, IScurve will shift outward by k EG’.
If interest rate remains constant, when Y ,there will be excess money demand, as
transactions demand for money has increased
Mt = dY
In order to restore equilibrium in the moneymarket Ms’ = Mt + Ma
Interest rate has to increase r in order toreduce the asset demand for money
Ma = Ma’ - er
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Zero Crowding Out
Expansionary Fiscal PolicyG’
r
Y
Horizontal LM
slope = r/ Y = d/e =
e = Ma/
r =
IS1
LM
IS2
When Y by k E G
Mt Ma to restore equilibrium
Since e = , r = 0 and I= 0.
Thus, NO Crowding-out Effect
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Zero Crowding Out
Expansionary Fiscal PolicyG’
r
Y
Horizontal LM
slope = r/ Y = d/e =
d = Mt/
Y =
IS1
LM
IS2
When Y by k E G
Since d=0, Mt=0 and Ma=0,
in order to maintain equilibrium
Thus, r = 0 and I = 0.
Thus, NO Crowding-out Effect
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Zero Crowding Out ???
Expansionary Fiscal PolicyG’
r
Y
Vertical IS
slope = r/ Y = -s/b =
s =
= 1/k E
k E =
Y = k E G’ =
IS LM
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Full Crowding Out
Expansionary Fiscal PolicyG’
r
Y
Vertical LM
slope = r/ Y = d/e =
e = Ma/
r =0 Mt but as Ma= 0
r I Y in order
to reduce Mt to the
original level
IS1 IS2 LM
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Full Crowding Out
Expansionary Fiscal PolicyG’
r
Y
Vertical LM
slope = r/ Y = d/e =
d = Mt/
Y =
Mt Ma
r I Y in order
to reduce Mt to the
original level
IS1 IS2 LM
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Full Crowding Out
Expansionary Fiscal PolicyG’
r
Y
Horizontal IS
slope = r/ Y = -s/b =
s = 0 = 1/k E k E =
b =
IS
LM
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Crowding-Out Effect Zero crowding-out effect occurs when
IS curve is vertical with b = 0
LM curve is horizontal with e = or d = 0 How about the case when IS curve is vertical with s=?
Full crowding-out effect occurs when
IS curve is horizontal with b = LM curve is vertical with e = 0 or d =
How about the case when IS curve is vertical with s=0?
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1999 A#7 If consumption expenditure does not only depend
positively on income but also negatively on interest
rate, the IS curve will become ___ and thecrowding out effect of fiscal policy will be ___(assuming that the LM curve is upward sloping)
A. flatter… smaller
B. flatter… bigger
C. steeper… smaller
D. steeper… bigger
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1997 C#6 Use the IS-LM model to explain the meaning
of the crowding-out effect and how it affects
the impact of government expenditure onnational income. Illustrate your answer with adiagram. (5 marks)
Explain whether the crowding-out effect will
definitely occur when an increase ingovernment expenditure leads to an increasein the interest rate. Illustrate your answer witha diagram. (5 marks)
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1997 C#6 (a)r
Y
Crowding-out effect means that as
government increases its expenditure,
interest rate will be bid up, which in turn
will reduce investment. The reduction
in investment will reduce the impact
of government expenditure on income
IS1 IS2 LM
Y=k E G’
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1997 C#6 (b)Suppose investment is independent
of interest rate b = 0. IS curve will be
vertical. Increase in government
expenditure will shift the IS curve to
the right. The increase in interest rate
will not lead to any reduction in I.
There will be no crowding out effect.
IS1 LM r
Y
Many candidates argued that when the LM curve was horizontal, there would be
no crowding out effect. But the question specified that the interest rate will rise.
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Effectiveness of Fiscal PolicyG’ k E Y d Mt
Excess Money Demand e r b
I k E Y
The effectiveness of fiscal policy depends on
k E
d
e
b
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Effectiveness of Fiscal Policy The smaller income elasticity of money demand d (=Mt/ Y), the more effective will be the fiscal policy.
Given any increase in Y, the increase in Mt will besmaller.
Smaller excess money demand means smallerincrease in interest rate, which cuts back Ma, isenough
Smaller increase in interest rate means smallerdecrease in investment, i.e., smaller crowding-out
effect.
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Effectiveness of Fiscal Policy The greater interest elasticity of money
demand e (= Ma/r), the more effective will
be the fiscal policy. Given any excess money demand, smaller
increase in interest rate is enough to cut back
Ma to restore equilibrium in the money market. Smaller increase in interest rate means smaller
decrease in investment and smaller crowding
out effect.
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Effectiveness of Fiscal Policy The smaller the interest elasticity of
investment b (= I/r), the more
effective will be the fiscal policy. Given any increase in interest rate, the
reduction in investment is smaller, and
hence a smaller crowding out effect.
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Effectiveness of Fiscal Policymore effective fiscal policy means less crowding-out
effect, so compare with the cases of zero crowding-out
Fiscal policy will be more effective when
simple Keynesian income multiplier rises k E
income elasticity of money demand falls d
interest elasticity of money demand rises e
interest elasticity of investment falls b
Fiscal policy will be more effective when IS curve is steeper when b not because of s
s will affect the shift of the IS curve
LM curve is flatter when e or d
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Effectiveness of Fiscal Policy
LM
r
Y
The increase in Y is greater when
the IS curve is steeper, i.e.,
smaller interest elasticity of
investment b
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Effectiveness of Fiscal PolicyThe increase in Y is greater when the LM curve is flatter, i.e
interest elasticity of money demand e greater
income elasticity of money demand d smaller
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Expansionary Monetary Policy
+veMs’
r
Y
IS LM
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Contractionary Monetary Policy
-veMs’
r
Y
ISLM
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Expansionary Monetary Policy
+veMs’
Ms’ ESM r e Ma
b I k E Y
d
Mt
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Expansionary Monetary Policy
+veMs’
A rise in money supply (Ms’) will lead to
excess supply of money (ESM) initially.
Interest rate will fall (r ), the assetdemand for money will increase (Ma) toabsorb part of the excess money supply
Ma = Ma’ - er
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Expansionary Monetary Policy
+veMs’
When interest rate falls (r ), investment
will increase (I )
I = I’ - br
Here, the adjustment in the money markethas already been transmitted to the goods
market.
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Expansionary Monetary Policy
+veMs’
The rise in investment (I )will cause income
to increase (Y ) in a multiplying way.
Y = k E I
When income increases, transaction demandfor money will also increase (Mt ).
Mt = dY
This will then help to absorb the excessmoney supply
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Effectiveness of Monetary Policy The effectiveness of monetary policy
depends on
e b
k E
d
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Effectiveness of Monetary Policy The smaller the interest elasticity of money
demand e (= Ma/r), the more effective is the
monetary policy Given an increase in money supply, interest rate
has to fall by a greater extent to stimulatesufficient Ma to absorb the excess money
supply. The greater the fall in interest rate, the greater
the rise in investment and the greater theincrease in income.
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Effectiveness of Monetary Policy The greater the interest elasticity of
investment b (= I/r), the more effective
is the monetary policy. Given the excess money supply, interest
rate will fall.
If investment is more elastic to interestrate, investment will then increase by agreater extent and so will the income
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Effectiveness of Monetary Policy The greater the income multiplier k E
(= Y/E’), the more effective is the
monetary policy. Given any increase in money supply, interest
rate will fall and investment will increase.
If the income multiplier is larger, income willincrease by a greater extent.
k E is larger if the marginal leakage rate w
(i.e. s, t, m) is smaller
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Effectiveness of Monetary Policy The smaller the income elasticity of money
demand d (=Mt/ Y), the more effective
is the monetary policy. Given any increase in money supply,
interest rate will fall, investment and
income will increase. If the money demand is less income
elastic, the rise in transaction demand will
be smaller.
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Effectiveness of Monetary Policycont’d
Thus, interest rate has to fall by a greaterextent in order to generate sufficient Ma
to absorb the excess money supply. With a greater fall in interest rate, the rise
in investment and income will be larger.
The shift of the LM curve will be affectedby d .
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Effectiveness of Monetary Policy
Monetary policy will be more effective when
interest elasticity of money demand rises e
interest elasticity of investment falls b simple Keynesian income multiplier rises k E
income elasticity of money demand falls d
Monetary policy will be more effective when IS curve is flatter when b or w
LM curve is steeper when e not because of d
d will affect the shift of the LM curve
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Effectiveness of Monetary Policy
r
Y
The increase in Y is greater when the IS curve is flatter, i.e.,
larger interest elasticity of investment b
smaller marginal leakage rate w
Flatter IS
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Effectiveness of Monetary Policy
r
Y
The increase in Y is greater when LM is steeper, i.e.,
smaller interest elasticity of money demand e
BUT d has also to be small, otherwise the shift will be smaller
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Monetary Policy will be most
effective with horizontal ISr
Y
Horizontal IS: w/b = 0
when b =
OR
when w= 0
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Monetary Policy will be mosteffective with vertical LM
r
Y
Vertical LM: d/e =
when e = 0
!!!
BUT when d =
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Monetary Policy will be totallyineffective with vertical IS
r
Y
Vertical IS: w/b =
when b = 0
OR
when w =
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Monetary Policy will be totallyineffective with horizontal LM
r
Y
Horizontal LM: d/e = 0
when e =
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Monetary Policy will be totallyineffective with horizontal LM
If money demand is perfectly interest elastic,people are willing to hold whatever amount of
money as asset demand Ma at the prevailinginterest rate
Accordingly, any excess money supply caused byan expansionary monetary policy will then
immediately be absorbed as asset demandwithout leading to a fall in interest rate.
With interest rate constant, no change ininvestment and income can then be conceived.
f f
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If money demand is perfectlyelastic to interest rate e =
r
Ma
Mt
Y
l l
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Expansionary Fiscal PolicyFull Employment
When government expenditure rises,aggregate expenditure increases.
Given flexible prices and full employment,the excess demand in the goods marketwill raise the price level, rather than output.
i i l li
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Expansionary Fiscal PolicyFull Employment
The increase in the price level will lead to afall in real money supply [refer IS-LM.model 2
slide 12]
Ms / P = m s Real interest rate will rise which leads to a
reduction in investment. The excess demand in the goods market
will be eliminated.
E i Fi l P li
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Expansionary Fiscal PolicyFull Employment
Full crowding-out will occur.
Since the subsequent fall in investment
must equal the initial rise in governmentspending for aggregate demand to fallback to the full employment level.
Hence, an expansionary fiscal policy willonly cause the price level and real interestrate to rise but have no effect on income.
E i M t P li
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Expansionary Monetary PolicyFull Employment
If an expansionary monetary policy isapplied, interest rate will fall to stimulate
investment, causing aggregate demand torise.
Given flexible prices and full employment,
the rise in aggregate demand will raiseprices.
This will cause the real money supply to fall
E i M t P li
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Expansionary Monetary PolicyFull Employment
Interest rate will then increase and cutback the aggregate demand for goods.
As a whole, real money supply, realinterest rate and aggregate demand willreturn to the original level and income
will remain unchanged. Only price levelhas risen.
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Deflationary Income Gap
Yf Yf
r r
Y Y
Expansionary Monetary Policy Expansionary Fiscal Policy
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Inflationary Income Gap
Yf Yf
r r
Y Y
Contractionary Monetary Policy Contractionary Fiscal Policy
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Numerical Example
C = 150 + 0.5Yd
I = 100 - 400r
G = 150
T = 100
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Numerical Example
Mt = 0.25 Y
Ma = 50 - 100r
Ms = 180
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Numerical Example
Yf = 1000
Ye =
Inflationary / Deflationary Gap
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More on fiscal policy
Refer Three-sector.model slide 61-68
Location of Effects
Reversibility of Policy
Time Lags
Recognition, Decision, Action/Executive, Outside
Efficiency of Taxation
Total tax burden = Tax payment + Excess burden