CHAPTER 9

Policy Analysis with the IS/LM Model

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Thread
What is the condition of the economy and what, if anything, should be done about it? Steps to deal with that fundamental question:
Measurement and policy objectives Conceptual and theoretical frameworks Monetary and fiscal policies

Its this last step we explore more thoroughly here

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Objectives: you should be able to

Explain the [conventional] limits of monetary and fiscal policies crowing out and the liquidity trap Explain how these policies can achieve policy targets in principle

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 A Closer Look at Monetary and Fiscal Policy

Fiscal Policy and Crowding Out Monetary Policy and the Liquidity Trap

Policy Analysis with the IS/LM Model

Real World Monetary and Fiscal Policy Problems of Using IS/LM in the Real World
Interpretation Problems Implementation Problems
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Effects of Monetary and Fiscal 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
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Fiscal Policy and Crowding Out

When government expenditures increase, output and income begin to increase. The increase in income increases the demand for money. The increase in money demand increases the interest rate. Higher interest rates cause a decrease in investment, offsetting some of the expansionary effect of the increase in government spending.
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1. The multiplier is 2 and government spending increases by $500, so the IS increases by $1000.

Partial Crowding Out

LM
2. The increase in income increases money demand which increases interest rates from 4% to 5%. 3. The increase in the interest rate causes a decrease in investment so that the increase in income is only $600, less that the full multiplier effect.

$1000
5%

4%

IS1

IS0 $6000
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$6600

$7000

Aggregate Output
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1. The multiplier is 2 and government spending increases by $500, so the IS increases by $1000.

Full Crowding Out

2. If the demand for money is totally insensitive to the interest rate, the interest rate increases from 4% to 9%. 3. The increase in the interest rate causes a decrease in investment that completely offsets the increase in government spending.

LM
9%

$1000
4%

IS1

IS0
$6000
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$7000

Aggregate Output
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Ineffective Fiscal Policy

When complete crowding out occurs, fiscal policy is ineffective, changing only interest rates, not output. Crowding out is greater if:
Money demand is very sensitive to income changes Money demand is not very sensitive to interest rate changes

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Monetary Policy in the IS/LM Model

The Fed increases the money supply which decreases interest rates and increases investment and output. In a liquidity trap, increases in the money supply do not decrease interest rates, so investment and output do not increase.

LM0 LM1

LM0 LM1

r0 r1

r0

IS Y1 Aggregate Output
Y0
Y0

IS

Aggregate Output
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Ineffective Monetary Policy

Investment is not sensitive to the interest rate
If investment does not respond to interest rate changes (the IS curve is steep), monetary policy in ineffective in changing output.

Liquidity trap
If increases in the money supply fail to lower interest rates, monetary policy is ineffective in increasing output.
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Short-Run Outcomes of Policy

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Examples of Monetary and Fiscal Policies

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Policy when the Economy is Above Potential

Contractionary monetary policy raises interest rates and reduces output. Contractionary fiscal policy decreases interest rates and decreases output.

LM1 LM0
r1

LM

r0

r0 r2

IS0 IS1
Y1 Y0 Aggregate Output potential output
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IS
Y1 Y potential 0 output
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Aggregate Output
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Accomodative Monetary Policy

2. Accomodative monetary policy increases output even further and offsets the rise in interest rates.

LM0 B r1 r0

LM1

IS0

IS1
1. Expansionary fiscal policy increases output and interest rates.

Y0

Y1

Y2

Aggregate Output
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Accomodative Fiscal Policy

1. Contractionary monetary policy lowers output and increases interest rates.

LM1 B r1 LM0
2. Contractionary fiscal policy further reduces output and offsets the increase in interest rates.

IS1 Y2 Y1
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r0

IS0

Y0 Aggregate Output
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Offsetting Policies
2. Expansionary monetary policy further reduces the interest rate and offsets the decline in output.

LM0 A

LM1

r0

B IS0
1. Contractionary fiscal policy lowers the interest rate and output.

r1

C IS1

Y1
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Aggregate Output
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U.S. Economic Policy in the 1940s

2. The Fed accomodated the expansionary fiscal policy to keep interest rates constant.

LM0 r1 r0

LM1

IS1
1. Government increased defense expenditures during World War II.

IS0 Y0 = potential
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Y1

Y2

Aggregate Output
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U.S. Economic Policy in the 1950s

LM1 r1 r0 IS0 The Fed uses contractionary monetary policy to fight inflation.

LMo

Y1= potential
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Y0 Aggregate Output
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U.S. Economic Policy in the 1980s

1. The Fed fought inflation by reducing the money supply.

LM1 r2

LM0

r1
r0

IS1
2. And government spending rose.

IS0
Y1 Y2
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Y0

Aggregate Output
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Group Exercises
P.269 1+

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Problems Using IS/LM in Real World Policy Analysis

Interpretation Problems
Problems in knowing how to interpret real-world events within the IS/LM framework

Implementation Problems
Problems encounter in undertaking policy
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Interpretation Problems
Interest Rate Problem Anticipation of Policy Problems Monetary Tools and Credit Condition Problems Interest Rate Target Problem Budget Problems
Cyclical and Structural Problems Accounting Methods
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The Interest Rate Problem

Which interest rate, nominal or real, is relevant?
When there is inflation, the nominal rate is greater than the real rate.

Which of many interest rates in the economy is relevant?

The Fed can control the Federal funds rate, but it is not the interest rate households and businesses pay to borrow money.
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Why Interest Rates Differ

Default risk
Interest rates differ according to the likelihood that the borrower will repay the loan.

Term to Maturity
The longer the term to maturity, the higher the interest rate that is paid because
Bonds with longer maturities are less liquid http://www.federalreserve.gov/releases/h15/update/ Differences in expected inflation

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Typical Yield Curve

6 5.5

Inverted Yield Curve

6 5.5

4.5

4.5

3.5 3 6 mos. 1 2 yr. 5 10 30 Maturities

3.5 3 6 mos. 1 2 yr. 5 10 30 Maturities

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Anticipation of Policy Problems

The IS/LM model does not take into account the effect of peoples expectations of policy actions. If investors expect the Fed to increase the money supply and decrease interest rates, they will buy bonds now. The increase in demand for bonds increases their price and decreases interest rates before the money supply is actually increased.
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Monetary Policy Tools and Credit Condition Problems

The IS/LM model assumes that interest rates are the only determinant of investment. Investment also depends on credit conditions, the willingness of banks to lend independent of interest rates. If banks raise their lending standards, investment may not respond to expansionary monetary policy.
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The Interest Rate Target Problem

To keep the interest rate at its target of 2%, the Fed offsets shifts in the IS curve with accomodating monetary policy. The Fed is maintaining an effective LM curve that is horizontal at the targeted interest rate of 2%.

Effective LM Curve

IS1 IS2 Y2 Y0 Y1 IS0

Aggregate Output
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Budget Problem: Cyclical and Structural Budgets

The structural budget surplus or deficit is the fiscal budget balance that would exist when the economy is at potential output. The cyclical budget surplus or deficit is that portion of the fiscal budget balance that exists because output is above or below potential output.
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Structural and Cyclical Deficits and Surpluses

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Implementation Problems of Monetary and Fiscal Policy

Uncertainty about Potential Output Information Lag Policy Implementation Lag
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Uncertainty About Potential Output

One macroeconomic policy goal is to keep output as close to potential as possible. In the real world, economists arent sure what potential output is. If policymakers use contractionary policy when the economy is actually below potential, they create unemployment. Using expansionary policy above potential output will cause inflation.
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Information Lag
The IS/LM model assumes that policymakers see what is happening in the economy and can instantly alter policies to fix any problem. In the real world there is an information lag, a delay between a change in the economy and knowledge of that change.

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Policy Implementation Lag

The policy implementation lag is the delay between the time policymakers recognize the need for a policy action and when the policy is instituted. Fiscal policy has a large implementation lag because policy must be formulated and legislation passed by Congress and the President. Monetary policy has a shorter implementation lag because the Federal Open Market Committee decides monetary policy.
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Automatic Stabilizers
Countercyclical Built-in Programs

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