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 i A, Y ad , 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 M s 1.M s  : at given Y A, 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 Y A, 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 M s 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  : Y ad , 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.

© 2004 Pearson Addison-Wesley. All rights reserved 1-10 M s vs. i Targets When IS Unstable 1.IS unstable: fluctuates from IS' to IS'' 2.i target at i*: Y fluctuates from Y I ' to Y I '' 3.M target, LM = LM*: Y fluctuates from Y M ' to Y M '' 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 M s 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 Y M ' to Y M '' 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.M s , LM right to LM 2, go to point 2, i to i 2, Y to Y 2 2.Because Y 2 > Y n, P , M/P , LM back to LM 1, go back to point 1 Panel (b) 1.G , IS right to IS 2, go to point 2 where i = i 2 and Y = Y 2 2.Because Y 2 > Y n, P , M/P , LM left to LM 2, go to point 2', i = i 2` and Y = Y n.

© 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 P A, 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 P A, 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,

© 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)

© 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.