Monetary and Fiscal

Policy in the IS-LM Model

Chapter 11 plus part of

Chapter 10
 Mathematical Derivations of
results
 IS curve equation: Y = α (A0 – bi)
where ‘α’ is the multiplier alpha
 LM: M/P = kY – hi
 Solve for interest ‘i’ and output ‘Y’
in terms of A0 and M/P. Note again
that government spending is a part
of autonomous spending A0:
 A0 = G + NX + I0 + cTR
 Solutions for Y and ‘i’:
 Solution for output and interest
rate
Y = γA0 + γ(b/h) (M/P)
 i = (k/h) γA0 – (1/hα) γ (M/P)
 Where γ = Keynesian multiplier ‘α’
 ----------------------------
 [1 + kα. (b/h)]

 Obviously,
γ is the multiplier dY/dG in the
IS-LM model, and is less than ‘α’, the basic
Keynesian multiplier.
 Solution for Output
 The fiscal policy multiplier here is then
 dY/dG = γ > α, the simple multipler
 Can see form the expression for gama γ that γ is
large when ‘h’ is large.
 In fact, γ = α when h approaches infinity. Now,
h is the response of money demand to interest
rates, and when h = infinity, the LM curve is
horizontal.
 Fiscal Policy Multiplier
 When h = infinity, any interest rate rise
shifts demand completely away from
money; to compensate, to keep money
demand = supply along the LM curve,
output Y has to increase by a large
amount. So, the LM curve is horizontal.
 Then the multiplier is the simple
multiplier.
 Multiplier: extra note
 Note:in fact, with LM horizontal and
interest rate unchanging, the
aggregate demand curve can be
shown to be vertical as in the simple
Keynesian model (next figure). This
is because when P changes, with
interest and income unchanged, the
demand curve has to be traced
along an unchanged ‘Y’ in the P-Y
space.
Supply-Demand: IS-LM with LM
horizontal = Simple Keynesian
figure
 LM vertical
A small value of ‘h’ means that with money
demand unchanged as interest changes, ‘Y’ does
not have to change to keep money supply =
demand. So LM becomes vertical.
 Then , a shift in IS due to an increase in G has no
effect on output. γ =0.
 So, fiscal policy is most effective in increasing ‘ Y’
when LM is horizontal, ineffective when LM is
vertical.
 Slope of IS and effectiveness of
fiscal policy
 Note: slope of IS = dY/di = -αb.
 So, large values of ‘b’ makes IS flat.
 Also, from the expression for multiplier
here, γ, large values of ‘b’ will make it
smaller, ‘Y’ rises little with increased
‘G’.
 Small values of ’b’ will make IS vertical,
increase γ, so output rises more with an
increase in ‘G’.
 Vertical IS & Horizontal LM
increase fiscal policy
effectiveness
 What we have seen is that the effect of an
increase in government spending ‘G’ on
output ‘Y’ is maximum when the IS curve is
vertical and the LM curve is horizontal.
***Note: A small value of ‘k’ also increases γ.
Then, as output increases money demand
increases little, requiring only a SMALL
increase in ‘i’ to keep money supply =
demand (= horizontal LM)
 Intuitive explanation
 LM horizontal: an increase in ‘G’
increases the interest rate by very little.
So, investment is not reduced much (a
large reduction in investment will work
to nullify the initial positive effect of the
govt. spending increase on output.
* Vertical IS: the elasticity of investment
(reduction here) with respect to ‘i’ is
very low, the fall in investment is not
much.
Monetary Policy Effectiveness
 Soln for Y: Y = γA0 + γ (b/h). (M/P)
 Monetary policy multiplier ( the effect of a
change in ‘M/P’ on ‘Y’) = γ.( b/h) = bα /
(h + kbα)
Large values of ‘b’ and ‘α’ – which mean a
FLAT IS curve – increase this multiplier.
Small values of ‘h’ and a large value of ‘k’
- which mean a steep LM – increase the
multiplier
 Horizontal IS and vertical LM
increase Mon.policy multiplier:
intuition:
A vertical LM reduces the interest
rate a lot as the LM shifts right
with an increase in money supply.
(Note that di/d(M/P)= k/h)

A horizontal IS means that with

this fall I interest rate, there is a
large increase in investment – and
thus in output.
 Getting the Aggregate Demand
Curve from IS and LM curves
 From the IS – LM curves, we can get the
effects of government spending or central
bank money supply change policies,
 An increase in govt. spending or a tax cut
shifts the IS curve to the right, increasing
output and interest rates. An increase in
the money supply – say, by an open market
operation – shifts the LM right, increasing
output and lowering interest.
 The Demand curve.
 But we need the demand curve to
get the price effects -when supply
curve slopes up
 The demand curve is obtained by
COMBINING the IS and LM curves.
 See figure (10-13) in the book.
IS-LM and AD (demand)
curves
 The AD curve
 When the price rises from P1 to P2, the
LM curve shifts left – since real money
supply M/P has fallen. Output falls, Y1 to
Y2, interest rises from i1 to i2. (Fall in P
shifts LM right)
 In the bottom P-Y figure (supply-
demand), mark out Y1. Y2 is dropped
down from the figure above, to meet the
new value P2 for the price. So we now
have two points for the AD curve.
Shits and movements ALONG
AD
 By the way, note that when P rises
and M/P falls, the LM curve shits left,
and the movement is along the AD
curve – since P is on one of the axes.
 But when ‘M” falls and M/P falls, LM
shifts left, and the AD curve will shift
left, to give the new Y on the X axis
in the P-Y diagram. This is because
‘M’ is not on any of the axes.
 The AD curve.
 So, the AD curve is got by drawing LM along the
length of the IS curve.
 Intuitively: when price rises, the interest rate
has to rise to balance the money market – since
real money supply has fallen, and money demand
has to fall. When interest falls, investment falls
and Y falls. So, the piece and output Y are
negatively related, AD has a negative slope.
 AD curve as a mathematical
solution for the IS-LM system:
 The schedule for the AD curve is the
solution we got earlier in this PPP for
output Y, from the IS and LM curve
functions:
 Y = γA0 + γ(b/h) (M/P)
 We can see from this solution that Y and
P are inversely related, thus
giving the negative slope for the
AD curve in the P-Y space.
 Fiscal and monetary policies in
the supply-demand diagram
 Initialshift = basic multiplier effect. Final
effect on Y is less due to interest rate rise and
investment reduction
 Look at the figure next page. Increased
government spending shifts the iS curve to the
right by α.dG = E3-E1. At unchanged interest,
E3 will be the new equilibrium, with Y3 the
new output level. But, interest rises (along
LM) as Y rises, increasing money demand, and
the final equilibrium is E2, with corresponding
Y2.
Fiscal policy effect diagram
 Fiscal Policy diagram
 In the lower panel, the AD curve shift
corresponds to the increase Y2-Y1 in the
diagram above, and to the multiplier
effect γ.dG < α.dG.
 With LM horizontal, the new equilibrium
WILL BE E3, and the new output level Y3
- corresponds to the basic Keynesian
model (with vertical demand, horizontal
supply) effect.
 Crowding out
 The rise in interest rates with fiscal
expansion, and the ensuing reduction
in investment is called ‘Crowding
out” – of private investment. So,
government sector expansion crowds
out private investment.
 Crowding out is maximum, complete,
when the LM is vertical.
Monetary policy in figures
 Monetary policy figure….
 TheLM curve shifts to the right by (1/k)(dM/P)
due to the money supply increase. The shift is
obtained from the money supply equilibrium
condition. The new equilibrium is at E2, with a
lower interest – and an output level
corresponding to the monetary policy multiplier
here , not equal to initial LM shift. In the lower
panel, the AD curve shifts to the right to give
Y2 as the new output level.
 Mon.policy in figures
 Clearly, the LM shift due to
money supply expansion gives
no output increase if the IS is
vertical. Then, the fall in interest
has no effect in increasing
investment – and so output.
 Liquidity trap: if LM is horizontal,
which is usually at very low interest
rates, an increase in money supply
has no effect on the interest rate;
mon.policy is ineffective.
 Mon. policy transmission to real
economy: when can it fail?
 Monetary policy works as follows:
“M’ increase  interest rate falls  more
lending and borrowing for investing  more
investment  output rises
This linkage can be broken a) because with
low interest rates, the interest does not fall
(no further demand for bonds, which raise
their price, lower interest)
Breaks in mon.policy chain
b)because banks may
not lend more, due to
bank crises or bad
reputation of – risky –
borrowers c) borrowers
may not borrow more due
to bad prospects for the
economy and for profits
Comparing effectiveness of fiscal
and monetary policies: Intuition
 Fiscal
policy is effective when IS is vertical,
LM horizontal. i.e., a) when investment
responds very little to changes in interest
(so does not fall when interest rises) b)
interest rate does not rise with an increase
in government spending. These conditions
may be present in developing countries with
undeveloped financial markets (and few
investment opportunities)
 Policy effectiveness intuition
 Monetary policy is effective a) when LM is vertical, b) IS
horizontal. b) means that investment should rise a lot when
interest falls. a) means demand for money is not responsive
to interest rates ( a large rise in ‘i’ is needed to neutralize
the money demand effect of a ‘Y’ rise). This is usually at
high ‘Y’ and with financial markets where investment
opportunities have been exhausted – corresponds to
developed countries in boom conditions.
 Note:
 Note that for the same country, LM is
more horizontal at low income levels
– with low interest rates – and more
vertical at high income levels and
boom conditions. So, in boom
conditions, monetary policy tends to
be more effective.
 Composition of output and the
policy mix
 Fiscalexpansion, moving IS up, increases
interest rate, so that even as Y rises, private
investment is CROWDED OUT. To prevent
this, money supply can also be increased
( “monetary accommodation”). Then, LM
also moves right, REDUCING interest. i.e,
when ‘G’ is increased, creating a budget
deficit, the RBI buys bonds in the open
market, “monetizing” the deficit.
 Policy Mix
 One way in which fiscal expansion
need not crowd out investment is if
the expansion is in the form of an
investment subsidy to private
sectors. Then, IS does shift right due
to an increase in I0 (investment not
dependent ion ‘i’), but this need not
reverse the original increase in
investment due to the subsidy.
 Whom does the Policy mix
benefit?
 Policies expanding the govt. sector: a) taX-
financed increases in govt. spending; b)
employer of last resort (providing employment to
unemployed – or to one in every unemployed
family)
 Policies favoring private sector: tax cuts, money
supply increases (though resulting inflation hurts
private sector), investment subsidies;
sometimes devaluation also.
 Policy mix..
 Policies favoring consumption:
tax cut, govt. spending increase,
especially by hiring labor.
 Policies favoring investment:
money supply increase,
investment subsidies.
 Policy Mix examples:
 Tight money and easy fiscal policy mix: in a
period of high inflation, reducing money
supply can bring down inflation – especially if
people believe this policy will continue. But
this tends to reduce output and employment;
to keep up output and employment, fiscal
policy can be expansionary – a tax cut or
increase in ‘G’. But this drives up interest
rates.
 Policy mix examples
 Tightmoney, easy fiscal (expansion)
policy drives up interest rates, even
though inflation is reduced, hurts
investment. This can be tackled by
investment subsidies. But one limitation
is the govt. deficit situation, which feeds
into the external deficit as well. One
example of this policy is the US policy
mix to come out of the 1980s recession.
 Tight money, easy fiscal…
 TheGerman policy mix at the time of the
German reunification was also of this
kind. Resulting highe interest rates
affected investment in Germany and rest
of Europe – with some countries opting
out of the exchange rate arrangement,
unable to maintain their rates against
the mark. (see chapter later on exchange
rates and the open economy).
 Easy money, tight fiscal
 Aswe saw earlier, easy fiscal policy
meets up with a constraint on the govt.
budget deficit level. If inflation is not a
pressing problem, recession can be
fought by an increase in money supply
and a fall in interest rates. Govt.
spending can be controlled then to keep
the govt. budget deficit low. Example US
recession and policies, early 1990s.
 Constraints on policy
 Expansionary govt. policies which
move out the demand curve can
increase employment and output –
but at the cost of inflation,
sometimes private investment, and
of higher external deficit (remember:
when priv. sector saving =
investment, an increase in govt.
deficit creates an equal trade deficit).
Technological advancements
 However, technology improvement
which shifts out the supply curve
(drawn sloping in the figure next
page) can increase output while
reducing inflation. In fact, when the
technological advance increases
labor productivity, this scenario is
consistent also with an increase in
real wages of labor.
Technology improvement :
diagram
 Consumption and Investment
Demand
 The specifications of consumption and
demand in the models discussed so far
are rudimentary.

 Ch 11B indicates some more complete

specifications for consumption and
investment demand.
 GO TO CH 11B now!