1. Macroeconomics Lecture 7 The IS-LM model Monetary Policy

2. Outline Active monetary policy in the IS-LM model. Monetary rules: money versus interest rate control.

3. Monetary Policy Open market operation (OMO) Central Bank Buy bonds Inject money Sell bonds Retire money

4. A C ESM A’

5. Non-neutrality of Money The IS-LM model.The classical model Money are neutral Money are non-neutral

6. The Keynesian Transmission mechanism L2L2 i1i1 L1L1 MP Money market Goods market feedback small L 2 + large i 1 = effective transmission If L 2 =  or i 1 =0, then the transmission mechanism fails.

7. The Monetary Policy Multiplier The effect on Y when M S changes and the interest rate is allowed to adjust to its equilibrium level “The transmission mechanism” simple multiplier feedback

8. Active Monetary Policy An expansion of M s can effectively stimulate the level of activity and employment if the Keynesian Transmission Mechanism is effective: –Real money demand is insensitive to R. –Investment demand is sensitive to R.

9. Caveats The IS-LM models shows that monetary policy is non-neutral in a closed economy if the price level can be taken as fixed and the Keynesian transmission mechanism works. The transmission mechanism may not work, e.g., if the interest rate is very close to zero (liquidity trap). The price level is unlikely to stay constant in response to a large and sustained expansion of M S and so inflation will eventually reduce the potency of monetary. Monetary rules versus active monetary policy.

10. Monetary policy instruments OMO = The central bank increases/decreases cash in circulation by buying/selling government bonds in the financial markets. The base rate = The base rate is the official rate at which banks can obtain cash from the central bank. 1.Money supply control: For given M S, the interest rate is allowed to clear the money market. 2.Interest rate control The central bank supplies money to the money market such that the market clears at the chosen interest rate.

11. Money versus interest control The central bank is like a monopolistic firm facing a downwards sloping demand curve, so… it can either set the volume and let the market determine the price or it can set the price and let the market determine the volume MDMD R Option 1: Set M s and let market determine R Money supply with fixed M s Money supply with fixed R Option 2: Set R and let market determine M s

12. The choice of monetary policy instrument. If there is no uncertainty about the location of the LM and the IS curves, the two instruments can achieve equivalent outcomes. Uncertainty because of business cycle shocks: Real demand shocks: Nominal demand shocks: uncertainty about the location of the IS curve. uncertainty about the location of the LM curve. 1.Reaction time => fix a target based on expectations about shocks. 2.The central bank can either use a money target or an interest rate target. 3.Which of these instruments would cause the least fluctuations in output?

13. Monetary control Interest control No income fluctuation Income fluctuation No transmission. Transmission. Nominal demand shocks

14. Monetary control Small income fluctuations Interest control Large income fluctuations but counter cyclically! No counter cyclical crowding out of I. Real demand shocks but

15. Summary The “optimal” choice of monetary policy instrument (rule) depends on the source of business cycle fluctuations. If the business cycle is mainly driven by real demand shock (IS), then money supply control is better at reducing fluctuations. If the business cycle is mainly driven by nominal demand shocks (LM), then interest rate control is better at reducing fluctuations.

16. What is next? The great depression and the IS-LM model.

17. Effectiveness of monetary policy Transmission mechanism Keynesian multiplier Slope of IS Slope of LM small large small shallow steep shallow Effect Effective Ineffective Parameters large Feedback effect small large