IS-LM Interaction

TR Pandey
Tripurari Pandey

Contractionary Policy Effects

Contractionary policy is any government policy aimed at reducing aggregate output (Y). Why would the government want to reduce Y? One purpose may be to fight inflation. Contractionary fiscal policy is either a decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y). Contractionary monetary policy is a decrease in the money supply aimed at decreasing aggregate output (income) (Y).
Tripurari Pandey

Contractionary Fiscal Policy

A decrease in government spending or an increase in net taxes would decrease aggregate expenditure (AE) and thus decrease equilibrium aggregate output (Y).

But this is not the end of the story. There will be feedback from the money market.
Tripurari Pandey

Contractionary Fiscal Policy: graphs

Tripurari Pandey

Contractionary Fiscal Policy

The decrease in Y due to the contractionary fiscal policy will decrease the money demand, which drives down the interest rate. A lower interest rate causes planned investment to increase. So the decrease in Y is less than it would be if we didnt taken into account the money market. The increase in I offsets some of the decrease in AE.

Tripurari Pandey

Contractionary Monetary Policy

A decrease

in Money supply pushes up interest rate (r), which decreases investment (I). The lower investment causes the equilibrium output (Y) to fall.

But this is not the end of the story.

Tripurari Pandey

Contractionary Monetary Policy

The decrease in Y due to the contractionary monetary policy will decrease the money demand, which drives down the interest rate. A lower interest rate causes planned investment to increase. So the decrease in Y is less than it would be if we didnt link the goods market and the money market. And the increase in interest rate is less than it would be if we did not take the goods market into account.

Tripurari Pandey

Contractionary Monetary Policy: graphs

Tripurari Pandey

Other Determinants of Planned Investment

Besides interest rate, planned investment depends on other factors:
Expectations of future sales
animal spirits: the forces of nature in human beings that make them take risks. Expectations of higher sales in the future encourage firms to invest more.

Capital utilization rates

Show the percentage of factory capacity being used in production. Firms invest less in new capital if their capital utilization rates are low.

Relative capital and labor costs

If capital (machine) is relatively more expensive than labor, firms tend to buy more machines.
Tripurari Pandey

The Macroeconomic Policy Mix

Fiscal policy and monetary policy can be used simultaneously. For example, government spending and money supply can be increased at the same time:
G Y , r M s Y , r

By combining these two policies, the government can increase Y without changing r. policy mix refers to the combination of monetary and fiscal policies in use at a given time. Then what are the effects of various combinations of policies on equilibrium Y Tripurari Pandey and r?

The IS-LM Diagram

The IS-LM diagram is a way of depicting graphically the equilibrium Y and equilibrium r in the goods and money markets. Each point on the IS curve is an equilibrium point in the goods market. Each point on the LM curve is an equilibrium point in the money market. We can see how changes in government policies, such as changes in G, T, Ms, would affect the equilibrium Y and the equilibrium r, by shifting the IS and LM curves in the IS-LM diagram.
Tripurari Pandey

The IS curve
In goods market, there is an equilibrium level of Y for each value of the interest rate r. (For given levels of C,G, and T) There is a negative relationship between the equilibrium Y and r. why?... We can draw this negative relationship onto graph. This curve is the IS curve. Changes in fiscal policies can shift IS curve. For example, an increase in government spending (G) shifts IS curve to the right.
Tripurari Pandey

The LM curve
In money market, there is an equilibrium level of r for each value of Y. (For given levels of Ms and prices) There is a positive relationship between the equilibrium r and Y. why?... We can draw this positive relationship onto graph. This curve is the LM curve.

Changes in monetary policies can shift LM curve. For example, an increase in money supply (Ms) shifts LM curve to the right.
Tripurari Pandey

The IS-LM Diagram: the intersection

The point at which the IS and the LM curves intersect corresponds to the point at which the goods market and the money market are both in equilibrium. Why? The intersection point represents an equilibrium in the goods market because it is on the IS curve. The intersection point represents an equilibrium in the money market because it is on the LM curve.

Tripurari Pandey

The IS-LM Diagram: fiscal policy effects

Changes in fiscal policy shift the IS curve. For example, An increase in government spending shifts the IS curve to the right. This increases the equilibrium level of both Y and r.
Tripurari Pandey

The IS-LM Diagram: monetary policy effects

Changes in monetary policy shift the LM curve. For example, An increase in money supply shifts the LM curve to the right. This increases the equilibrium level of Y and decreases the equilibrium r.
Tripurari Pandey

The IS-LM Diagram: policy mix effects

One can use the IS/LM diagram to see the effects of policy mix For example, an increase in the money supply accompanied by an increase in government spending leads to an increase in aggregate output. The effects on equilibrium r is ambiguous. (There could be no change in the interest rate.)
Tripurari Pandey