1. Chapter 20 Monetary and fiscal policy
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Monetary policies
A given monetary policy has two aspects.
To what variable does it refer?
the interest rate or the money supply?
For the reasons given in the previous two chapters, we prefer to focus on the interest rate.
A particular relationship defining how the interest rate is chosen.
This may reflect discretionary choices of the central bank
or a commitment to a particular rule.
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Monetary policies (2)
In the heyday of monetarism, central banks used to adjust interest rates to stop the money supply deviating from a given target path of monetary growth.
Most central banks have abandoned this policy, preferring to target the inflation rate itself.
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4. The IS Schedule: Goods market equilibrium
The goods market is in equilibrium when aggregate demand and actual income are equal.
The IS schedule shows the different combinations of income and interest rates at which the goods market is in equilibrium.
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The IS schedule
AD0 r0
At a relatively high interest
rate r0, consumption and
investment are relatively
low – so AD is also low. AD
45o line
AD1
At a lower interest rate r1
consumption, investment
and AD are higher. r1 Y1
Equilibrium is at Y1.
Equilibrium is at Y0. Y0
Income r IS
The IS schedule shows all
the combinations of real
incomes and interest rates
at which the goods market
is in equilibrium.
Income
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6. Shifts in the IS schedule
Changes in aggregate demand shift the IS schedule. For a given interest rate, more optimism about future profits raises investment demand.
Higher expected future incomes raise consumption demand.
Higher government spending adds directly to aggregate demand.
Any of these, by raising aggregate demand at a given interest rate, raise equilibrium output at any interest rate,
And lead to an upward shift in the IS schedule.
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7. The slope of the IS schedule
The IS schedule slopes down. Lower interest rates boost aggregate demand and output.
The slope of the IS schedule reflects the sensitivity of aggregate demand to interest rates.
If demand is sensitive to interest rates, the IS schedule is flat.
Conversely, if output demand is insensitive to interest rates, the IS schedule is steep.
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8. The LM schedule: Money market equilibrium
The money market is in equilibrium when money demand equals money supply.
The LM schedule shows the different combinations of income and interest rates at which the money market is in equilibrium.
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The LM schedule r r LM
The LM schedule traces out the combinations of real income
and interest rate in which the money market is in equilibrium.
At Y1, money demand is at LL1,and equilibrium is at r1. r1 Y1
LL1
LL0 r0 Y0
At income Y0, money demand is at LL0 and equilibrium
in the money market requires an interest rate of r0. r0 L0
Real money
balances
Income
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10. The slope of the schedule
The LM schedule slopes up.
Higher output induces a higher interest rate to keep money demand in line with money supply.
The more sensitive is money demand to income and output, the more the interest rate must change to maintain money market equilibrium, and the steeper is the LM schedule.
Similarly, if money demand is not responsive to interest rates, it takes a big change in interest rates to offset output effects on money demand, and the LM schedule is steep.
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11. Shifts in the LM schedule
Shifts in the schedule reflect a change in monetary policy. 
A rise in the target money supply means that money demand must also be increased to maintain money market equilibrium.
This implies a rightward shift in the LM schedule.
Output is higher, or interest rates lower, raising money demand in line with the rise in real money supply.
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12. Equilibrium in goods & money marketsIS
Bringing together the
IS schedule (showing
goods market equilibrium) LM
and the LM schedule
(showing money market
equilibrium) Y* r*
We can identify the
unique combination of
real income and interest
rate (r*, Y*) which ensures
overall equilibrium.
Income
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13. Fiscal policy in the IS-LM model
Y0, r0 represents the
initial equilibrium. r
IS1
A bond-financed
increase in government
spending shifts the IS
schedule to IS1. LM
Equilibrium is now at r1, Y1. r1 Y1  r0 
Some private spending
(Y1Y’) has been crowded out by the increase in the rate of interest. Y’ 
IS0 Y0
Income
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14. Monetary policy in the IS-LM model
Y0, r0 represents the
initial equilibrium. r
LM0
LM1
An increase in money
supply shifts the LM
schedule to the right. r0  Y1 r1
Equilibrium is now
at r1, Y1. 
IS0 Y0
Income
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15. Combining policies in the IS-LM model
Y0, r0 represents the
initial equilibrium. r LM
IS1
A bond-financed
increase in government
spending shifts the IS
schedule to IS1.
Loosening monetary
policy in order to keep the rate of interest at r0 allows output to expand to Y2. Y2 
LM’
Equilibrium is now at r1, Y1. r1 Y1  r0 
IS0 Y0
Income
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The policy mix
Demand management is the use of monetary and fiscal policy
to stabilise the level of income around a high average level. Y*
Income level Y* can
be attained by: r
IS1
LM1 r1
OR with ‘easy’ fiscal
policy (IS1) with ‘tight’
monetary policy (LM1).  r0
LM0
IS0
‘Tight’ fiscal policy (IS0)
with ‘easy’ monetary
policy (LM0) 
This affects the private:
public balance of spending in the economy.
Income
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17. The effect of future taxes: Ricardian equivalence
Individuals will react to a shock such as a tax change in different ways, depending on whether changes are seen to be temporary or permanent.
If the government cut taxes today, but individuals realise this will have to be balanced by higher taxes in the future, then present consumption may not adjust.
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But...
The IS-LM model seems to offer governments a range of options for influencing equilibrium income.
However…
there are other issues to be considered
the price level and inflation
the supply-side of the economy
the exchange rate
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