1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 4 Monetary and Fiscal Policy in the IS-LM Model

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-2 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. – The Fed is assumed to determine the money supply (see Chapter 13 for more details).

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-3 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: (where h, f > 0)

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-4 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 (which was not possible before 1978), 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-5 Figure 4-1 The Demand for Money, the Interest Rate, and Real Income

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-6 Figure 4-2 Effect on the Money Demand Schedule of a Decline in Real Income from $8,000 to $6,000 Billion

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-7 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 M S equals real M d : Solving for r yields:

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-8 What shifts and rotates the LM Curve? Recall: 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

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-9 Figure 4-3 Derivation of the LM Curve

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-10 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

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-11 Figure 4-4 The IS and LM Schedules Cross at Last

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-12 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.

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-13 How Monetary Policy Actually Worked in 2001–04

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-14 Figure 4-5 The Effect of a $1,000 Billion Increase in the Money Supply with a Normal LM Curve

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-15 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 

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-16 Figure 4-6 The Effect on Real Income and the Interest Rate of a $500 Billion Increase in Government Spending

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-17 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

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-18 Figure 4-7 The Effect of an Increase in the Money Supply with a Normal LM Curve and a Vertical LM Curve

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-19 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

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-20 Figure 4-9 Effect of a Fiscal Stimulus when Money Demand Has an Infinite and a Zero Interest Responsiveness

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-21 Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (1 of 2)

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-22 Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (2 of 2)

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-23 Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-24 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.

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-25 International Perspective: Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”

26. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-26 International Perspective: Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”

27. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-27 Chapter Equations

28. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-28 Chapter Equations

29. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-29 Appendix Equations

30. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-30 Appendix Equations

31. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-31 Appendix Equations

32. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-32 Appendix Equations

33. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-33 Appendix Equations

34. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4-34 Appendix Equations