1 ISLM, FISCAL AND MONETARY POLICY Week 8 SF Intermediate Economics Professor Dermot McAleese

2 OUTLINE  Derivation and Analysis of IS curve  Derivation and Analysis of LM curve  ISLM Equilibrium  What happens if actual Y does not coincide potential (full employment) Y?  Policy Implications

3 Definition of IS curve The IS curve is an equilibrium locus showing combinations of interest rate (r) and output/expenditure (Y) that are consistent with equilibrium in the goods market. I=S at all points along this curve. It is downward-sloping because … [complete in your own words].

4 Derivation of LM  Money Supply assumed exogenous, determined by Central Bank  Money Demand determined by a) price level, b) level of Y and c) interest rate (r)  Equilibrium condition: Ms = Md  This maps into upward sloping LM curve, with r on vertical axis and Y on horizontal axis  LM is upward sloping because as Y (+)s, Md increases. But Ms is fixed, therefore equilibrium in money market can only be maintained if something happens elsewhere to reduce demand. The elsewhere is the interest rate. If r (+)s, Md tends to fall. Hence for each (+) Y there is some (+) r that will restore equilibrium. The locus of such r,Y points is the LM curve. T

5 LM curve shifts outwards if …  Money supply increases  Price level falls  Interest rate sensitivity of demand increases  Income elasticity of money falls  Technology changes (ATMs, more use of credit cards etc) 

6 STABILITY OF MONEY DEMAND  Money demand is stable if it changes in a predictable fashion, i.e. parameters of money demand are relatively constant over time  Does NOT mean that money demand is fixed, does not change  ECB view is that Md is reasonably stable so money supply targets are meaningful policy instrument  Bank of England and Federal Reserve Bank more sceptical – believe money demand inherently unstable  If money demand unstable so is LM curve, thus limiting the possibility of activist monetary policy

7 NOW PLACE IS CURVE AND LM CURVE ON SAME GRAPH TO DERIVE EQUILIBRIUM POINT E LM IS E Ya r

8 IF Y a < Y F, WHAT HAPPENS? 1) Wages flexible, workers price themselves back into jobs, unemployment falls and IS shifts outwards 2) Price level will also decline, Ms/p will increase, consumer spending will increase. This is the REAL BALANCE EFFECT 3) As real money supply (+)s, interest rate will fall, leading to (+) in total spending (see McA )

9 KEYNES’ RESPONSE TO CLASSICAL (CONVENTIONAL) POSITION  Automatic Adjustment mechanisms operate too slowly – in the long run we are all dead  Need for hands-on intervention to shift AD curve outwards  Policies to shift IS outwards likely to be more effective than moving LM, because IS curve slopes downwards steeply. That is, fiscal policy more effective than monetary policy BIRTH OF THEORY AND PRACTICE OF COUNTER-CYCLICAL POLICY and EXTENDED ROLE OF STATE

10 COUNTER-CYCLICAL FISCAL POLICY Price level AD AD 2 E2E2 Output E1E1 E*E* AD 1 KAS Y*Y* Y2Y2 The Keynesian Aggregate Supply (KAS) curve Keynesian economics applies up to Y* (full employment); after that point we are back to vertical AS curve and the long run AS model

11 Table. 3 Government spending (%GDP) Source: European Economy, Annual Report No 59, 1995; European Economy, special Supplement, Spring 1995; OECD; pre-Second World War figures taken from Vito Tanzi and Ludger Schuknecht, ‘The Growth of Government and the Reform of the State in Industrial Countries’, IMF Working Paper, December 1995; European Economy No. 68, 1999.

12 Table. 4 General Government Net Debt (%GDP) Source: European Monetary Institute, First Annual Report, April 1995; OECD Economic Outlook,, various issues.

13 For Interest: A Recent Paper Comments on Total Factor Productivity (TFP) A growing body of evidence suggests that, even after physical and human capital accumulation are accounted for, something else accounts for the bulk of cross country differences in the level and growth rate of GDP per head. Economists typically refer to the something else as total factor productivity Easterly and Levine “What have we learned from a decade of empirical research on growth?” The World Bank Economic Review No

14 3 pages of ISLM Equations For those who prefer equations to graphs, here is how equilibrium Y and r can be derived

15 Y = C + I C = a + bY I = d – f i  Y = a + bY + d – f i Deriving the IS curve

16 Deriving the LM curve The LM curve summarises the relationship between real output and real interest rates such that the aggregate demand for money (L) is just equated with the money stock (M) L = M => LM equation

17 IS-LM Equilibrium IS equation: LM equation: Equilibrium: