Chapter 7 Effectiveness of Monetary Policy and Fiscal Policy

1. Chapter 7 Effectiveness of Monetary Policy and Fiscal Policy

2. Contents: • More about the IS-LM model • Effectiveness of monetary policy & fiscal policy • Advanced Material 7.1: Interest rate vs. money supply as an instrument of monetary policy • Advanced Material 7.2: Comparison between the IS-LM model and the Y-E model

3. More about the IS-LM Model

4. >0 <0 Determinants of the slope of the IS curve • The slope of the IS curve: • The slope is negative.

5. r IS (I is less interest elastic) Y 0 Interest elasticity of investment(rEI or b ) • The larger the interest elasticity when r changes, the larger the change in I  the larger the required change in Y (& W) to restore equilibrium, i.e., the gentler the IS curve. IS* (I is more interest elastic)

6. r Y 0 Income elasticity of saving(YES or s or MPS) • The larger the income elasticity when Y changes, the larger the change in S  the larger the required change in r (& J) to restore equilibrium, i.e., the steeper the IS curve. IS* (S is less income elastic) IS (S is more income elastic)

7. 1. If r remains unchanged,Y has to  to raise W until J=W, • IS curve shifts rightward. 2.If Y remains unchanged, r has to  to lower J until J=W, • IS curve shifts upward. Determinants of the extent of shift of the IS curve Reason of the shift: (an autonomous ∆ in J or W) • e.g., an autonomous  in J J > W

8. r Y 0 Interest elasticity of investment Consider two IS curves with different rEI but equal YES  • An auton.  in J • The IS curve with a larger interest elasticity requires a smaller  in r to restore equilibrium • As they have the same income elasticity, they require the same  in Y to restore equilibrium.    IS* (I is more interest elastic) IS (I is less interest elastic)

9. r  Y 0 Income elasticity of saving Consider two IS curves with different YES but equal rEI • An auton.  in J • The IS curve with a larger income elasticity requires a smaller  in Y to restore equilibrium • As they have the same interest elasticity, they require the same  in r to restore the equilibrium.    IS (S is less income elastic) IS* (S is more income elastic)

11. Extreme cases of the IS curve

12. > 0 < 0 Determinants of the slope of the LM curve • The slope of the LM curve: • The slope is positive.

13. Q7.2: Given a two-sector economy, with S = 0.2Y – 100 and I = 10 – 20r. (a) Derive the IS equation. (b) Suppose there is an autonomous rise in I by 40. (i) What is the extent of rightward shift of the IS curve? (ii) What is the extent of upward shift of the IS curve?

14. r Y 0 Interest elasticity of asset demand for money • The larger the interest elasticity, when r changes, the larger the change in Ma the larger the required change in Y (& Mt) to restore equilibrium, i.e., the gentler the LM curve. LM (Ma is less interest elastic) LM* (Ma is more interest elastic)

15. r Y 0 Income elasticity of transactions demand for money • The larger the income elasticity, when Y changes, the larger the change in Mt the larger the required change in r (& Ma) to restore equilibrium, i.e., the steeper the LM curve. LM* (Mt is more income elastic) LM (Mt is less income elastic)

16. 1. If r remains unchanged,Y has to  to raise Mtuntil Md = Ms, • LM curve shifts rightward. 2. If Y remains unchanged, r has to to raise Mauntil Md = Ms, • LM curve shifts downward. Determinants of the extent of shift in the LM curve Reason of the shift: (an autonomous Δ in Md or Ms) • e.g., an autonomous  in money supply  Md < Ms

17. r LM1* LM1 Y 0 Interest elasticity of asset demand for money Consider two LM curves with different rEMa but equal YEMt LM0* (Ma is more interest elastic) LM0 (Ma is less interest elastic) • As they have the same income elasticity, they require the same  in Y to restore the equilibrium • An auton.  in Ms • The LM curve with a larger interest elasticity requires a smaller Δin r to restore equilibrium    

18. r LM1* LM1 Y 0 Income elasticity of transactions demand for money Consider two LM curves with different YEMt but equal rEMa LM0 (Mt is less income elastic) LM0*(Mt is more income elastic) • As they have the same interest elasticity, they require the same  in r to restore the equilibrium • An auton.  in Ms • The LM curve with a larger income elasticity requires a smaller  in Y to restore equilibrium    

19. Extreme cases of the LM curve

21. Monetary policy (MP) is the government measure which achieves economic objectives through manipulating the money supply or interest rate. • Fiscal policy (FP) is the government measure which achieves economic objectives through manipulating the government revenue or expenditure.

22. Effectiveness of Monetary Policy and Fiscal Policy

23. Mechanism: Effectiveness of monetary policy Effect of monetary policy • e.g., an expansionary monetary policy (Ms) Md<Ms r Ma I Y J>W W Mt • until J=W & Md=Ma+Mt=Ms

24. Determinants of the effectiveness of MP 1. Multiplier 2. Interest elasticity of investment 3. Income elasticity of saving 4. Interest elasticity of asset demand for money 5. Income elasticity of transactions demand for money

25. Multiplier ΔY = ΔI X Multiplier The larger the multiplier  The larger the change in Y  The more effective the monetary policy

26. r LM1 Y0 Y1 Y*1 Y 0 Interest elasticity of investment (rEI) • The larger the rEI, the larger the  in I & the larger the  in Y. IS LM0  The more effectivethe MP IS* (I is more interest elastic)

27. r LM1 IS* (S is less income elastic) Y1 Y*1 Y 0 Income elasticity of saving (YES) • The smaller theYES , the larger the required  in Y to raise enough W to restore equil. IS LM0  The more effective the MP Y0

28. r LM*1 LM1 Y1 Y*1 Y 0 Interest elasticity of asset demand for money (rEMa) • The smaller the rEMa , the larger the required  in r to raise enough Ma to restore the equil. • Then the larger the  in I & Y LM*0 (Ma is less interest elastic) IS LM0   The more effective the MP Y0

29. r LM1 LM1* Y1 Y*1 Y 0 Income elasticity of transaction demand for money (YEMt) LM0*(Mt is less income elastic) • The smaller the YEMt , the larger the required  in Y to raise enough Mt to restore the equil. LM0 IS  The more effective the MP  Y0

30. Effectiveness of Fiscal Policy Effect of fiscal policy • e.g., an expansionary fiscal policy (G) Mechanism: J>W Y W I r Mt Md>Ms Ma • until J=W and Md=Ma+Mt=Ms

31. Determinants of the effectiveness of FP 1. Multiplier 2. Interest elasticity of asset demand for money 3. Income elasticity of transactions demand for money 4. Interest elasticity of investment 5. Income elasticity of saving

32. Multiplier ΔY = ΔG X G-Multiplier ΔY = ΔT X T-Multiplier The larger the multipliers  The larger the change in Y  Fiscal Policy is more effective

33. IS1 r Y1 Y*1 Y 0 Interest elasticity of asset demand for money (rEMa) • The larger the rEMa , the smaller the required  in r to restore the equil. and the smaller the crowding out effect. IS0 LM LM* (Ma is more interest elastic)  The more effectivethe FP Y0

34. r IS1 Y1 Y*1 Y 0 Income elasticity of transactions demand for money (YEMt) • The smaller the YEMt , the smaller the in Mt and the smaller the required  in r to restore the equil. and the smaller the crowding out effect. IS0 LM LM* (Mt is less income elastic)  The more effectivethe FP Y0

35. r IS*1 IS1 Y1 Y*1 Y 0 Interest elasticity of investment (rEI) IS*0 (I is less income elastic) • The smaller the rEI, the smaller the drop in I and the smaller the crowding out effect. LM IS0  The more effectivethe FP  Y0

36. r IS*1 IS1 Y1 Y*1 Y 0 Income elasticity of saving (YES) • The smaller the YES , the larger the required  in Y to raise enough W to restore the equil. LM   The more effectivethe FP IS*0 (S is less income elastic) IS0 Y0

37. Effectiveness of the policies in extreme cases

38. Horizontal IS • Effectiveness of MP Cause of horizontal IS:rEI =  or YEs = 0 r LM0 LM1 IS0 E.g., an expansionary MP  MP is most effective Y Y0 Y1

39. Effectiveness of FP Horizontal IS Cause of horizontal IS:rEI =  r LM0 IS0 E.g., an expansionary FP = IS1  FP is completely ineffective Y = Y1 Y0

40. IS1 • Effectiveness of FP Horizontal IS Cause of horizontal IS:YEs = 0 r LM0 IS0 E.g., an expansionary FP  FP is most effective Y Y0 Y1

41. Vertical IS • Effectiveness of MP Cause of vertical IS:rEI =0 or YEs = r IS0 LM0 LM1 E.g., an expansionary MP  MP is completely ineffective Y = Y1 Y0

42. IS1 Y1 • Effectiveness of FP Vertical IS Cause of vertical IS:rEI = 0 r IS0 LM0 E.g., an expansionary FP  FP is most effective Y Y0

43. Effectiveness of FP Vertical IS Cause of vertical IS:YEs =  r IS0 = IS1 LM0 E.g., an expansionary FP  FP is completely ineffective Y = Y1 Y0

44. Horizontal LM • Effectiveness of MP Cause of horizontal LM:rEMa =  r E.g., an expansionary MP LM0 = LM1  MP is completely ineffective IS0 Y = Y1 Y0

45. Y1 • Effectiveness of MP Horizontal LM Cause of horizontal LM:YEMt = 0 r LM0 E.g., an expansionary MP LM1  MP is most effective IS0 Y Y0

46. Y1 • Effectiveness of FP Horizontal LM Cause of horizontal LM:YEMt = 0 orrEMa = r E.g., an expansionary FP LM0  FP is most effective IS1 IS0 Y Y0

47. LM1 Y1 • Effectiveness of MP Vertical LM r Cause of vertical LM:rEMa = 0 LM0 E.g., an expansionary MP  MP is most effective IS0 Y Y0

48. Effectiveness of MP Vertical LM r Cause of vertical LM:YEMt =  = LM1 LM0 E.g., an expansionary MP  MP is completely ineffective IS0 Y Y0 = Y1

49. Effectiveness of FP Vertical LM r Cause of vertical LM:YEMt = or rEMa = 0 LM0 E.g., an expansionary FP  FP is completely ineffective IS1 IS0 Y Y0 = Y1

50. Advanced Material 7.1 Interest rate versus money supply as an instrument of monetary policy • Money supply as an instrument of MP • Money supply is fixed & is adjusted deliberately. The LM curve is upward sloping. • An expansionary MP shifts the LM curve rightward or downward. • Ms is exogenous but interest rate is endogenous.