Monetary and Fiscal Policy in the IS-LM Model Chapter 4 Monetary and Fiscal Policy in the IS-LM Model

The Definition of Money Money is defined as any good or asset that serves the following three functions: Medium of Exchange Store of Value Unit of Account The Money Supply (MS) is equal to currency in circulation plus checking accounts at banks and thrift institutions. The Fed is assumed to determine the money supply (see Chapter 13 for more details). Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Money Demand The demand for money is determined by people’s need for money to facilitate transactions. If Income (Y)  Md If the Price Level (P)  Md Notice: Real money demand = is unaffected by P The 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: (where h, f > 0) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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 (which was not possible before 1978), 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-1 The Demand for Money, the Interest Rate, and Real Income Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-2 Effect on the Money Demand Schedule of a Decline in Real Income from $8,000 to $6,000 Billion Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

The 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: Solving for r yields: Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

What shifts and rotates the LM Curve? Recall: 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-3 Derivation of the LM Curve Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-4 The IS and LM Schedules Cross at Last Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-5 The Effect of a $1,000 Billion Increase in the Money Supply with a Normal LM Curve When real money supply rises from $2000 to $3000 this will create “excess money supply” at the prevailing interest rate. Excess money supply, individuals transfer some money into saving accounts or to buy bonds. The price of bonds increase and the interest rate decrease. The lower interest rate raises the desired level autonomous consumption and investment spending thus equilibrium income (output ) will increase. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fiscal Policy and “Crowding Out” An expansionary fiscal policy is one that has the effect of raising GDP, but also raising interest rates Note: 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 CB simultaneously MS  r Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-6 The Effect on Real Income and the Interest Rate of a $500 Billion Increase in Government Spending The G increase by $500 bil. Assume k=4, thus the equilibrium should increase by $2000 and reach $9000 at E2. There is “excess demand” for money. However at E2 commodity market is at equilibrium but the money market is not. $500bil. k=4 excess demand for money put pressure on interest rate to increase where decrease autonomous consumption and investment spending. So real income (output) does not increase by $2000 but only by half as much, $1000. When the requirements of the money market taken into account, fiscal policy multiplier is 2 rather than 4. Thus fully half of the original multiplier of 4 is “crowded out” Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Monetary and Fiscal Policy Effectiveness Monetary policy is strong when: The IS curve is relatively flat (caused by a low interest-responsiveness of autonomous planned spending) and/or The LM curve is steep (The LM curve becomes steeper as the interest responsiveness of the demand for money declines.) Monetary policy is weak when: The IS curve is very steep (caused by a highly interest responsiveness of autonomous planned spending) and/or The LM curve is relatively flat (caused by a highly interest-responsive demand for money) 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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-7 The Effect of an Increase in the Money Supply with a Normal LM Curve and a Vertical LM Curve Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-8 Effect of the Same Increase in the Real Money Supply with a Zero Interest Responsiveness of Spending and with a High Interest Responsiveness of the Demand for Money Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-9 Effect of a Fiscal Stimulus when Money Demand Has an Infinite and a Zero Interest Responsiveness Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (1 of 2) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (2 of 2) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

International Perspective: Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade” Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

International Perspective: Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade” Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Appendix Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Appendix Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Appendix Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Appendix Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Appendix Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Appendix Equations Copyright © 2009 Pearson Addison-Wesley. All rights reserved.