Fiscal and monetary policy in the is-lm model

1. Fiscal and monetary policy in the is-lm model

2. Lecture outline: • The IS-LM model equilibrium. • How to use the IS-LM model to analyze the effects of fiscal and monetary policy. • Why the slope of the LM curve has an important bearing on the effectiveness of fiscal and monetary policy.

3. IS-LM Model: the Short-Run Equilibrium

4. Policy in the IS-LM Model • Fiscal Policy • Expansionary fiscal policy shifts the IS curve to the right • Contractionary fiscal policy shifts the IS curve to the left • Monetary Policy • Expansionary monetary policy shifts the LM curve to the right • Contractionary monetary policy shifts the LM curve to the left

5. Monetary Policy: an increase in M

6. Money demand function M = (kY – hr)P M – demand for money r – interest rate P – price level k, h – coefficients k – how much money demand increases when income increases h – how much money demand declines when interest rate raises Real money = money supply M divided by price level P M/P = kY – hr The demand for real money depends positively on real GDP and negatively on the interest rate.

7. The Case of the Liquidity Trap • The first two basic elements of • a liquidity trap are: • Interest rate extremely low, possibly zero; • The LM curve is completely flat at that low interest rate.

8. How do we escape from the Liquidity Trap There are two ways to increase equilibrium income according the IS-LM model: Expansionary Fiscal Policy: this policy is really effective in a liquiditytrap. Suppose an increase in government expenditure. We have seen that when the LM curve is flat, the multiplier of the government expenditure is equal to the case in the Keynesian Cross case, meaning that this policy will be very effective in increasing equilibrium income. Expansionary Monetary Policy: in the liquidity trap this policy does notwork. An increase in money supply would reduce the interest rate, however, in the liquidity trap the interest rate is already at theminimum level and cannot be decreased further.

9. Fiscal Policy: An increase in G The shift in IS affects both endogenous variables (output and interest rate). The fact that an increase in public expenditure (or decrease in Taxes) increases the interest rate is called CROWDING OUT.

10. Crowding Out • What factors determine how much crowding out takes place? • Income increases more and interest rates increase less, the flatter the LM schedule. • Income increases less and interest rates increase less, the flatter the IS schedule. • Income and interest rates increase more the larger the multiplier, and thusthe larger the horizontal shift of the IS schedule.

11. Fiscal and Monetary Policy Together • Suppose government increases G. • Possible responses by the Central Bank: 1. hold M constant 2. hold r constant 3. hold Y constant

12. Case 1: Holding M constant If government raises G, the IS curve shifts right. If Central bank holds M constant, then LM curve doesn’t shift. Results: income increases and interest rate increases.

13. Case 2: Holding r constant If government raises G, the IS curve shifts right. To keep r constant, Central bank increases M to shift LM curve right. Results: income increases more than in the case where the LM is fixed and the interest rate does not change.

14. Case 3: Holding Y constant If government raises G, the IS curve shifts right. In this case the Central bank must decrease M to compensate the increase in G. Results: income does not change and the interest rate increases more than in the case where the LM remains fixed.

15. Shocks in the IS -LM model IS shocks: exogenous changes in the demand for goods & services. Examples: • stock market boom or crash change in households’ wealth  C • change in business or consumer confidence or expectations  I and/or C

16. Shocks in the IS -LM model LM shocks: exogenous changes in the demand for money. Examples: • a wave of credit card fraud increases demand for money. • more ATMs or the Internet reduce money demand.