© 2008 Pearson Education Canada23.1 Chapter 23 Monetary and Fiscal Policy in the ISLM Model

1. Factors that Shift the IS Curve A change in autonomous factors that is unrelated to the interest rate – Changes in (autonomous) consumer expenditure unrelated to income: C – Changes in (planned) investment spending unrelated to the interest rate: I – Changes in government spending: G – Changes in taxes: T – Changes in net exports: NX © 2008 Pearson Education Canada23.2

Summary: What shifts IS? IS(C+I+G+X-M; T) © 2008 Pearson Education Canada23.3

2. What Shifts LM Curve? Changes in the money supply: M - Expansionary Monetary Policy shifts LM to the right - Contractionary Monetary Policy shifts LM to the left Autonomous changes in money demand= Shocks/Disturbances in Monetary Markets: u -More Money Demand sends LM to the left -Less Money Demand sends LM to the right Changes in the Price Level: P © 2008 Pearson Education Canada23.4

*Sum: What shift LM curve? (MS/P, u) © 2008 Pearson Education Canada23.5

Example 1) Shift in the LM Curve from an Increase in the Money Supply © 2008 Pearson Education Canada23.6

Example 2) Shift in the LM Curve from an Increase in Money Demand © 2008 Pearson Education Canada23.7

The above case of an increased money demand is highly relevant to the current financial crisis: Recall that Money Market and Bond Market are closely related(substitutes) An increase in demand for cash = decrease in demand for financial assets such as bonds The LM curve shifts to the ‘left’ The net impact on the Money Market is equivalent to a decrease in Money Supply © 2008 Pearson Education Canada23.8

3. Combining IS and LM shift What will happen to the equilibrium Y and the equilibrium i if LM shifts? © 2008 Pearson Education Canada23.9

(1) Response to a Change in Monetary Policy An increase in the money supply creates an excess supply of money -The interest rate declines -Investment spending and net exports rise - Y rises in the IS-LM. -Aggregate demand side of National Income rises © 2008 Pearson Education Canada23.10

Response of National Income and Interest Rate to an Increase in the Money Supply © 2008 Pearson Education Canada23.11

* Effects from Various Factors That Shift (the IS and) LM Curves © 2008 Pearson Education Canada23.12

(3) Effectiveness of (Expansionary) Monetary Policy on Interest Rate and Y With a normally shaped upward-sloping LM curve and a variety shapes of IS curves: With a normally shaped IS and a speicial form of LM curve: © 2008 Pearson Education Canada23.13

© 2008 Pearson Education Canada23.14

Monetary Policy The less interest-sensitive money demand is, the more effective monetary policy is relative to fiscal policy © 2008 Pearson Education Canada23.15

4. Long-Run IS-LM 1) Flexible Price Level in LR So far, we have assumed that the Price Level is fixed- it is justifiable in the Short-run In the Long-run, the Price Level is flexible. Thus, the LM curve adjusts itself so that the equilibrium Y is equal to the full employment national income(Yf)1) © 2008 Pearson Education Canada23.16

(2) Yn in the Long Run Full employment nantional income is called ‘Natural rate level of output (Y n )’ – It is called ‘Full Employment National Income’ Yf as well – Rate of output at which the price level has no tendency to change – Neither monetary nor fiscal policy affects output in the long run – It is affected by Capital, Labor, and Technology. © 2008 Pearson Education Canada23.17

(3) Which adjusts? The IS curve is based on real values, so when the price level changes, the IS curve does not change The LM curve is affected by the price level – As the price level rises, the quantity of money in real terms falls, and the LM curve shifts to the left until it reaches Y n (long-run monetary neutrality) © 2008 Pearson Education Canada23.18

(4) Illustration: ISLM in the Long Run © 2008 Pearson Education Canada23.19

This is the end of IS-LM model. The rest of chapter 23 serves as an introduction of Chapter 24 © 2008 Pearson Education Canada23.20

5. Ultimately, AS-AD Model (1) AS and AD Aggregate Supply Short-run AS Long-run AS Aggregate Demand © 2008 Pearson Education Canada23.21

(1) AS Curve There are two AS curves: One is the Short-run AS curve, and the other corresponds to Yf or Yn © 2008 Pearson Education Canada23.22

(2) AD First, focus on Deriving AD curve, And then shifting AD © 2008 Pearson Education Canada23.23

(i) deriving the AD Curve by changing Price Level © 2008 Pearson Education Canada23.24

(ii) Shifts of Aggregate Demand Curve For a given price level - change in C, I, G, NX,and/or T shifts IS curve and then AD curve(illustrated in b) - changes in M, u shifts LM curve and then AD curve(illustrate in a) © 2008 Pearson Education Canada23.25

(a) Shift in the Aggregate Demand Curve from a Shift in the LM Curve © 2008 Pearson Education Canada23.26

(b) Shift in the Aggregate Demand Curve from a Shift in the IS Curve © 2008 Pearson Education Canada23.27

In sum, AD shifts due to Δ in C, I, G, NX, T and M, u. © 2008 Pearson Education Canada23.28

(3) Equilibrium of AS-AD (i) Basic © 2008 Pearson Education Canada23.29

(ii) Changes to an increased MS In the short-run, Y rises. In the long-run, it depends on where the initial Y is compared to Yf. © 2008 Pearson Education Canada23.30