Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 4 Strong and Weak Policy Effects in the IS-LM Model

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 4-2 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 (M S ) 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 © 2012 Pearson Addison-Wesley. All rights reserved. 4-3 Money Demand The demand for money is determined by people’s need for money to facilitate transactions. –If Income (Y)   M d  –If the Price Level (P)   M d  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   M d  as people switch out of money into interest- bearing savings accounts or other financial assets Algebraically, the general linear form of M d is: (where h, f > 0)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 4-4 Figure 4-1 The Demand for Money, the Interest Rate, and Real Income

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 4-5 Figure 4-2 Effect on the Money Demand Schedule of a Decline in Real Income

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 4-6 What Shifts Money Demand? The main shift factor for real M d is income (Y). Additional shift factors include: – Interest paid on money: If money pays more interest (which was not possible before 1978), M d rises – Wealth: If people become wealthier, some of the additional wealth may be held as money, so M d 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 M d Examples: Credit Cards and ATM’s

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 4-7 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 M S equals real M d : Solving for r yields:

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 4-8 Figure 4-3 Derivation of the LM Curve

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 4-9 What shifts and rotates the LM Curve? Recall: Anything that only affects the intercept term will shift the LM curve: –If M S   LM shifts → –If P   LM shifts → –Not captured by slope term: M d   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 © 2012 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 © 2012 Pearson Addison-Wesley. All rights reserved Figure 4-4 The IS and LM Schedules Cross at Last

Copyright © 2012 Pearson Addison-Wesley. All rights reserved The IS/LM Model and the Global Economic Crisis How can the Global Economic Crisis be modeled using the IS/LM model? During the crisis, the IS curve shifted left. Why? –Household wealth and consumer optimism  C α  –Business pessimism  I –Greater difficulty in obtaining loans  C α  and I Summary: Private spending  IS shifts   Y, r

Copyright © 2012 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 © 2012 Pearson Addison-Wesley. All rights reserved Figure 4-5 The Effect of an Increase in the Money Supply With a Normal LM Curve

Copyright © 2012 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 Fed simultaneously M S   r 

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 4-6 The Effect on Real Income and the Interest Rate of an Increase in Government Spending

Copyright © 2012 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2012 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 © 2012 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 © 2012 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 © 2012 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 3)

Copyright © 2012 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 3)

Copyright © 2012 Pearson Addison-Wesley. All rights reserved Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (3 of 3)

Copyright © 2012 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 © 2012 Pearson Addison-Wesley. All rights reserved International Perspective Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”

Copyright © 2012 Pearson Addison-Wesley. All rights reserved International Perspective Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”