1 IS-LM Model Fiscal Policy & Monetary Policy

2 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

3 Outline Monetary Policy Expansionary & Contractionary Monetary Policy Effectiveness of Monetary Policy Deflationary & Inflationary Income Gap IS-LM model versus Simple Keynesian Model

4 Introduction Unemployment (when Y < Yf) is one of the major economic problems The government always tries to attain full employment Yf In the simple Keynesian model, the government can adopt expansionary fiscal policy (  G ’  T ’ ) when there is a deflationary / recessionary gap (Yf - Y)

5 Introduction Y will then increase by the amount of k E  G ’ OR k T  T ’ Since in a three-sector Keynesian model Y=  Y =OR  Y =

6 Introduction Will income increase by the same amount as in the elementary Keynesian model when the government adopt a discretionary (fiscal / monetary) policy, when both interest rate and income are endogenous variables in the IS-LM model?

7 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’

8 Revision - IS Curve IS 1 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 IS 2

9 Revision - IS Curve b = s = k E = r Y r Y b = s = k E =

10 Revision - IS Curve Y =  Y/  G’ =  Y/  T’ = x-intercept = when r = 0 r Y

11 Revision - LM Curve Ms = Ms’ Mt = dY Ma = Ma’ - er r = slope =  r/  Y = Y = x-intercept = when r = 0

12 Revision - LM Curve When e is larger, the LM curve will be When d is smaller, the LM curve will be But 1/d will be LM 1 Construct LM 2 r Y

13 Revision - LM Curve r Y r Y e = d = 1/d = e = d = 1/d =

14 Revision - LM Curve Y =  Y/  Ms’ = x-intercept = when r = 0 Y r

15 Expansionary Fiscal Policy +ve  G ’ OR -ve  T ’ r Y IS LM

16 Contractionary Fiscal Policy -ve  G ’ OR +ve  T ’ r Y IS LM

17 Crowding-Out Effect Expansionary Fiscal Policy  G ’ r Y IS 1 LMIS 2 r1r1 * When r = r 1, there is excess money _____ as Y rises and _____ rises _____ has to decrease in order to restore equilibrium in the money market Ms = Mt + Ma Y1 Y2

18 Crowding-Out Effect Expansionary Fiscal Policy  G ’ When government expenditure increases, G ’ , IS curve will shift outward by k E  G ’. 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 money market Ms ’ = Mt  + Ma  Interest rate has to increase r  in order to reduce the asset demand for money Ma  = Ma ’ - er 

19 Crowding-Out Effect Expansionary Fiscal Policy  G ’ But when r  investment will decrease I  I  = I ’ - br  Income will decrease Y  through the multiplier effect  Y = k E  I As a result,  Y is less than that as in the simple Keynesian model

20 Crowding-Out Effect Expansionary Fiscal Policy  G ’ If interest rate will increase (How about e=  ?) and investment will decrease (How about b=0?), the effectiveness of an expansionary fiscal policy on income is reduced. Crowding-out effect refers to the situation in which a rise in government expenditure raises interest rate, causing interest sensitive investment to fall.

21 Zero Crowding Out Expansionary Fiscal Policy  G ’ r Y Horizontal LM slope =  r/  Y = d/e = e =  Ma/  r = IS 1 LM IS 2 When Y  by k E  G Mt  Ma  to restore equilibrium Since e = ,  r = 0 and  I= 0. Thus, NO Crowding-out Effect

22 Zero Crowding Out Expansionary Fiscal Policy  G ’ r Y Horizontal LM slope =  r/  Y = d/e = d =  Mt/  Y = IS 1 LM IS 2 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

23 Zero Crowding Out ??? Expansionary Fiscal Policy  G ’ r Y Vertical IS slope =  r/  Y = -s/b = s =  = 1/k E  k E =  Y = k E  G’ = IS LM

24 Zero Crowding Out Expansionary Fiscal Policy  G ’ r Y Vertical IS slope =  r/  Y = -s/b = b =  I/  r = IS 1 LM IS 2 When Y  by k E  G Mt  Ma , in order to maintain money mkt equilibrium r  but  I = 0 since b = 0 Thus, NO Crowding-out Effect

25 Full Crowding Out Expansionary Fiscal Policy  G ’ 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 IS 1 IS 2 LM

26 Full Crowding Out Expansionary Fiscal Policy  G ’ 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 IS 1 IS 2 LM

27 Full Crowding Out Expansionary Fiscal Policy  G ’ r Y Horizontal IS slope =  r/  Y = -s/b = s = 0 = 1/k E  k E = b =  IS LM

28 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?

A#7 If consumption expenditure does not only depend positively on income but also negatively on interest rate, the IS curve will become ___ and the crowding 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

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 on national income. Illustrate your answer with a diagram. (5 marks) Explain whether the crowding-out effect will definitely occur when an increase in government expenditure leads to an increase in the interest rate. Illustrate your answer with a diagram. (5 marks)

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 IS 1 IS 2 LM  Y=k E  G’

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. IS 1 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.

33 Effectiveness of Fiscal Policy G ’   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

34 Effectiveness of Fiscal Policy The greater the simple Keynesian multiplier k E (=  Y/  G ’ ), the larger the multiplying effect & the more effective/ potent will be the fiscal policy k E is larger when MPS is smaller / MPC is larger, proportional tax rate t is smaller, MPM is smaller

35 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 be smaller. Smaller excess money demand means smaller increase in interest rate, which cuts back Ma, is enough Smaller increase in interest rate means smaller decrease in investment, i.e., smaller crowding-out effect.

36 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.

37 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.

38 Effectiveness of Fiscal Policy more 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 

39 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

40 Effectiveness of Fiscal Policy The 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

41 Expansionary Monetary Policy +ve  Ms ’ r Y ISLM

42 Contractionary Monetary Policy -ve  Ms ’ r Y IS LM

43 Expansionary Monetary Policy +ve  Ms ’ Ms ’   ESM  r   e  Ma    b  I   k E  Y    d  Mt 

44 Expansionary Monetary Policy +ve  Ms ’ A rise in money supply (Ms ’  ) will lead to excess supply of money (ESM) initially. Interest rate will fall (r  ), the asset demand for money will increase (Ma  ) to absorb part of the excess money supply Ma  = Ma ’ - er 

45 Expansionary Monetary Policy +ve  Ms ’ When interest rate falls (r  ), investment will increase (I  ) I  = I ’ - br  Here, the adjustment in the money market has already been transmitted to the goods market.

46 Expansionary Monetary Policy +ve  Ms ’ The rise in investment (I  )will cause income to increase (Y  ) in a multiplying way.  Y = k E  I When income increases, transaction demand for money will also increase (Mt  ). Mt  = dY  This will then help to absorb the excess money supply

47 Effectiveness of Monetary Policy The effectiveness of monetary policy depends on e b k E d

48 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 stimulate sufficient Ma  to absorb the excess money supply. The greater the fall in interest rate, the greater the rise in investment and the greater the increase in income.

49 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 interest rate, investment will then increase by a greater extent and so will the income

50 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 will increase by a greater extent. k E is larger if the marginal leakage rate w (i.e. s, t, m) is smaller

51 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.

52 Effectiveness of Monetary Policy cont ’ d Thus, interest rate has to fall by a greater extent 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 affected by d.

53 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

54 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

55 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

56 Monetary Policy will be most effective with horizontal IS r Y Horizontal IS: w/b = 0 when b =  OR when w= 0

57 Monetary Policy will be most effective with vertical LM r Y Vertical LM: d/e =  when e = 0 !!! BUT when d = 

58 Monetary Policy will be totally ineffective with vertical IS r Y Vertical IS: w/b =  when b = 0 OR when w = 

59 Monetary Policy will be totally ineffective with horizontal LM r Y Horizontal LM: d/e = 0 when e = 

60 Monetary Policy will be totally ineffective 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 prevailing interest rate Accordingly, any excess money supply caused by an expansionary monetary policy will then immediately be absorbed as asset demand without leading to a fall in interest rate. With interest rate constant, no change in investment and income can then be conceived.

61 If money demand is perfectly elastic to interest rate e =  r Ma Mt Y

62 Expansionary Fiscal Policy Full Employment When government expenditure rises, aggregate expenditure increases. Given flexible prices and full employment, the excess demand in the goods market will raise the price level, rather than output.

63 Expansionary Fiscal Policy Full Employment The increase in the price level will lead to a fall 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.

64 Expansionary Fiscal Policy Full Employment Full crowding-out will occur. Since the subsequent fall in investment must equal the initial rise in government spending for aggregate demand to fall back to the full employment level. Hence, an expansionary fiscal policy will only cause the price level and real interest rate to rise but have no effect on income.

65 Expansionary Monetary Policy Full Employment If an expansionary monetary policy is applied, interest rate will fall to stimulate investment, causing aggregate demand to rise. Given flexible prices and full employment, the rise in aggregate demand will raise prices. This will cause the real money supply to fall

66 Expansionary Monetary Policy Full Employment Interest rate will then increase and cut back the aggregate demand for goods. As a whole, real money supply, real interest rate and aggregate demand will return to the original level and income will remain unchanged. Only price level has risen.

67 Deflationary Income Gap Yf r r YY Expansionary Monetary PolicyExpansionary Fiscal Policy

68 Inflationary Income Gap Yf r r YY Contractionary Monetary PolicyContractionary Fiscal Policy

69 Numerical Example C = Yd I = r G = 150 T = 100

70 Numerical Example Mt = 0.25 Y Ma = r Ms = 180

71 Numerical Example Yf = 1000 Ye = Inflationary / Deflationary Gap

72 More on fiscal policy Refer Three-sector.model slide Location of Effects Reversibility of Policy Time Lags Recognition, Decision, Action/Executive, Outside Efficiency of Taxation Total tax burden = Tax payment + Excess burden