1 Monetary and Fiscal Policy in the IS-LM Model Chapter 4 Instructor: MELTEM INCE

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.

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: (M/P) = kY – hi

4 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 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 ATMs

5 The IS Curve: Equilibrium in the Goods Market The goods market clears when desired investment equals desired national saving. For any level of output Y, the IS curve shows the real interest rate r for which the goods market is in equilibrium

6 The IS Curve AE = C+I p +G C=C 0 +cDPI = C 0 +c(Y+TR-T) I=I 0 -bi G=G 0 T=T 0 +tY AE=C 0 +c(Y+TR-T)+I 0 -bi+G 0 AE= A 0 -bi+c(1-t)Y where A 0 = C 0 +cTR 0 -cT 0 +I 0 +G 0 Y=AE Y= A 0 -bi+c(1-t)Y Y-c(1-t)Y=A 0 -bi Y=k e (A 0 –bi) i = A 0 / b – Y/k e b

7 The IS Curve: Equilibrium in the Goods Market

8 The IS Curve  The saving curve slopes upward because a higher real interest rate increases saving  An increase in output shifts the saving curve to the right, because people save more when their income is higher  The investment curve slopes downward because a higher real interest rate reduces the desired capital stock, thus reducing investment

9 Effect on the IS curve of a temporary increase in government purchases

10 The IS Curve  The IS curve shifts up and to the right because of an increase in expected future output an increase in wealth a temporary increase in government purchases a decline in taxes (if Ricardian equivalence doesn’t hold) an increase in the expected future marginal product of capital a decrease in the effective tax rate on capital  The IS curve shifts down and to the left when the opposite happens to the six factors above

11 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: (M s /P) = kY – hi

12 What shifts and rotates the LM Curve? 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 i = (k/h)Y – (1/h)M/P

13 LM Curve

14 LM Curve Factors that shift the LM curve  Any change that reduces real money supply relative to real money demand shifts the LM curve up For a given level of output, the reduction in real money supply relative to real money demand causes the equilibrium real interest rate to rise The rise in the real interest rate is shown as an upward shift of the LM curve  Similarly, a change that increases real money supply relative to real money demand shifts the LM curve down and to the right

15 LM Curve  The LM curve shifts down and to the right because of an increase in the nominal money supply a decrease in the price level an increase in expected inflation a decrease in the nominal interest rate on money a decrease in wealth a decrease in the risk of alternative assets relative to the risk of holding money an increase in the liquidity of alternative assets an increase in the efficiency of payment technologies  The LM curve shifts up and to the left when the opposite happens to the eight factors listed above

16 An Increase In The Real Money Supply Shifts The LM Curve Down And To The Right

17 LM Curve Changes in the real money supply A drop in real money supply shifts the LM curve up and to the left An increase in real money demand shifts the LM curve up and to the left

18 An increase in the real money demand shifts the LM curve up and to the left

19 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

20 General equilibrium in the IS-LM model

21 The FE Line: Equilibrium in the Labor Market If we plot output against the real interest rate, we get a vertical line, since labor market equilibrium is unaffected by changes in the real interest rate. Labor market in showed how equilibrium in the labor market leads to employment at its full employment level and output at its full-employment level

22 Factors that shift the FE line The full employment level of output is determined by the full employment level of employment and the current levels of capital and productivity; any change in these variables shifts the FE line  The full-employment line shifts right because of a beneficial supply shock an increase in labor supply an increase in the capital stock  The full-employment line shifts left when the opposite happens to the three factors above

23 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.

24 The Effect of Increase in the Money Supply

25 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 

26 The Effect on Real Income and the Interest Rate Increase in Government Spending

27 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

28 The Effect on Real Income of a Fiscal Stimulus

29 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.

30 Aggregate Demand and Aggregate Supply Use the IS-LM model to develop the AD-AS model  The two models are equivalent  Depending on the issue, one model or the other may prove more useful IS-LM relates the real interest rate to output AD-AS relates the price level to output

31 Aggregate Demand and Aggregate Supply The aggregate demand curve  The AD curve shows the relationship between the quantity of goods demanded and the price level when the goods market and asset market are in equilibrium  So the AD curve represents the price level and output level at which the IS and LM curves intersect

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33 Aggregate Demand and Aggregate Supply The aggregate demand curve  The AD curve is unlike other demand curves, which relate the quantity demanded of a good to its relative price; the AD curve relates the total quantity of goods demanded to the general price level, not a relative price  The AD curve slopes downward because a higher price level is associated with lower real money supply, shifting the LM curve up, raising the real interest rate, and decreasing output demanded

34 The effect of an increase in government purchases on the aggregate demand curve

35 Aggregate Demand and Aggregate Supply Factors that shift the IS curve up and to the right and thus the AD curve up and to the right as well  Increases in future output, wealth, government purchases, or the expected future marginal productivity of capital  Decreases in taxes if Ricardian equivalence doesn’t hold, or the effective tax rate on capital Factors that shift the LM curve down and to the right and thus the AD curve up and to the right as well  Increases in the nominal money supply or in expected inflation  Decreases in the nominal interest rate on money or the real demand for money

36 Aggregate Demand and Aggregate Supply The aggregate supply curve  The aggregate supply curve shows the relationship between the price level and the aggregate amount of output that firms supply  In the short run, prices remain fixed, so firms supply whatever output is demanded The short-run aggregate supply curve is horizontal

37 Full-employment output isn’t affected by the price level, so the long-run aggregate supply curve (LRAS) is a vertical line

38 Aggregate Demand and Aggregate Supply Factors that shift the aggregate supply curves The SRAS curve shifts whenever firms change their prices in the short run  Factors like increased costs of producing goods lead firms to increase prices, shifting SRAS up  Factors leading to reduced prices shift SRAS down Anything that increases full-employment output shifts the LRAS curve right; anything that decreases full- employment output shifts LRAS left Examples include changes in the labor force or productivity changes that affect labor demand

39 Short-run equilibrium: AD intersects SRAS Long-run equilibrium: AD intersects LRAS

40 Adverse Supply Shock Y Income, Y SRAS 1 SRAS 2 LRAS AD Price,P A B

41 Adverse Supply Shock If aggregate demand is held constant, the economy moves from A to B. The price level rises and the amount of output falls below the natural level. This is called Stagflation, because it combines falling output with rising price level. As a summary, the real wage, employment, and output decline, while the real interest rate and price level are higher. Since the real interest rate is higher and output is lower, consumption and investment must be lower

42 Accommodating an Adverse Supply Shock

43 Accommodating an Adverse Supply Shock If the increase in aggregate demand coincides with the shock to aggregate supply, the economy goes immediately from E to H. The price level is permanently higher. There is no way to maintain full employment and keep the price level stable.