1. Monetary and Fiscal Policy in the IS-LM Model
Chapter 4
Monetary and Fiscal Policy in the IS-LM Model

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 (MS) is equal to currency in circulation plus checking accounts at banks and thrift institutions.
The Fed is assumed to determine the money supply (see Chapter 13 for more details).
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3. Money Demand
The demand for money is determined by people’s need for money to facilitate transactions.
If Income (Y)  Md
If the Price Level (P)  Md
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  Md as people switch out of money into interest-bearing savings accounts or other financial assets
Algebraically, the general linear form of Md is:
(where h, f > 0)
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4. What Shifts Money Demand?
The main shift factor for real Md is income (Y).
Additional shift factors include:
Interest paid on money: If money pays more interest (which was not possible before 1978), Md rises
Wealth: If people become wealthier, some of the additional wealth may be held as money, so Md 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 Md
Examples: Credit Cards and ATMs
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5. Figure 4-1 The Demand for Money, the Interest Rate, and Real Income
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6. Figure 4-2 Effect on the Money Demand Schedule of a Decline in Real Income from $8,000 to $6,000 Billion
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7. The 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 MS equals real Md:
Solving for r yields:
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8. What shifts and rotates the LM Curve?
Recall:
Anything that only affects the intercept term will shift the LM curve:
If MS  LM shifts →
If P  LM shifts →
Not captured by slope term: Md   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
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9. Figure 4-3 Derivation of the LM Curve
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10. 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
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11. Figure 4-4 The IS and LM Schedules Cross at Last
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12. 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.
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13. Figure 4-5 The Effect of a $1,000 Billion Increase in the Money Supply with a Normal LM Curve
When real money supply rises from
$2000 to $3000 this will create
“excess money supply” at the
prevailing interest rate.
Excess money supply,
individuals transfer some
money into saving accounts or
to buy bonds. The price of bonds
increase and the interest rate
decrease. The lower interest rate
raises the desired level
autonomous consumption and
investment spending thus
equilibrium income (output ) will
increase.
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14. 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 CB simultaneously MS  r
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15. Figure 4-6 The Effect on Real Income and the Interest Rate of a $500 Billion Increase in Government Spending
The G increase by $500 bil. Assume
k=4, thus the equilibrium should
increase by $2000 and reach $9000 at E2.
There is “excess demand” for money.
However at E2 commodity market is at
equilibrium but the money market is not.
$500bil.
k=4
excess demand for money
put pressure on interest rate to increase where decrease
autonomous consumption and investment spending.
So real income (output) does not increase by $2000
but only by half as much, $1000. When the
requirements of the money market taken into account,
fiscal policy multiplier is 2 rather than 4. Thus fully
half of the original multiplier of 4 is “crowded out”
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16. Monetary and Fiscal Policy Effectiveness
Monetary policy is strong when:
The IS curve is relatively flat (caused by a low interest-responsiveness of autonomous planned spending) and/or
The LM curve is steep (The LM curve becomes steeper as the interest responsiveness of the demand for money declines.)
Monetary policy is weak when:
The IS curve is very steep (caused by a highly interest responsiveness of autonomous planned spending) and/or
The LM curve is relatively flat (caused by a highly interest-responsive demand for money)
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
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17. Figure 4-7 The Effect of an Increase in the Money Supply with a Normal LM Curve and a Vertical LM Curve
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18. Figure 4-8 Effect of the Same Increase in the Real Money Supply with a Zero Interest Responsiveness of Spending and with a High Interest Responsiveness of the Demand for Money
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19. Figure 4-9 Effect of a Fiscal Stimulus when Money Demand Has an Infinite and a Zero Interest Responsiveness
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20. Figure The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (1 of 2)
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21. Figure The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (2 of 2)
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22. Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies
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23. 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.
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24. International Perspective: Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”
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25. International Perspective: Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”
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26. Chapter Equations
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27. Chapter Equations
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28. Appendix Equations
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29. Appendix Equations
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30. Appendix Equations
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31. Appendix Equations
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32. Appendix Equations
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33. Appendix Equations
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