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Macroeconomics

Macroeconomics. Lecture 7 The IS-LM model Monetary Policy. Outline. Active monetary policy in the IS-LM model. Monetary rules: money versus interest rate control. Monetary Policy. Open market operation (OMO). Sell bonds. Central Bank. Buy bonds. Retire money. Inject money. A. C.

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Macroeconomics

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  1. Macroeconomics Lecture 7 The IS-LM model Monetary Policy

  2. Outline • Active monetary policy in the IS-LM model. • Monetary rules: money versus interest rate control.

  3. Monetary Policy Open market operation (OMO) Sell bonds Central Bank Buy bonds Retire money Inject money

  4. A C A’ ESM

  5. Non-neutrality of Money The IS-LM model. The classical model Money are neutral Money are non-neutral

  6. The Keynesian Transmission mechanism Money market Goods market i1 L2 MP If L2= or i1=0, then the transmission mechanism fails. L1 feedback small L2 large i1 effective transmission + =

  7. The Monetary Policy Multiplier The effect on Y when MS changes and the interest rate is allowed to adjust to its equilibrium level “The transmission mechanism” simple multiplier feedback

  8. Active Monetary Policy • An expansion of Ms can effectively stimulate the level of activity and employment if the Keynesian Transmission Mechanism is effective: • Real money demand is insensitive to R. • Investment demand is sensitive to R.

  9. Caveats • The IS-LM models shows that monetary policy is non-neutral in a closed economy ifthe price level can be taken as fixed and the Keynesian transmission mechanism works. • The transmission mechanism may not work, e.g., if the interest rate is very close to zero (liquidity trap). • The price level is unlikely to stay constant in response to a large and sustained expansion of MS and so inflation will eventually reduce the potency of monetary. • Monetary rules versus active monetary policy.

  10. Monetary policy instruments • Money supply control: The central bank increases/decreases cash in circulation by buying/selling government bonds in the financial markets. OMO = For given MS, the interest rate is allowed to clear the money market. • Interest rate control The base rate is the official rate at which banks can obtain cash from the central bank. The base rate = The central bank supplies money to the money market such that the market clears at the chosen interest rate.

  11. Money versus interest control The central bank is like a monopolistic firm facing a downwards sloping demand curve, so… it can either set the volume and let the market determine the price or it can set the price and let the market determine the volume R Money supply with fixed Ms Money supply with fixed R Option 2: Set R and let market determine Ms Option 1: Set Ms and let market determine R MD

  12. The choice of monetary policy instrument. If there is no uncertainty about the location of the LM and the IS curves, the two instruments can achieve equivalent outcomes. Uncertainty because of business cycle shocks: Real demand shocks: uncertainty about the location of the IS curve. Nominal demand shocks: uncertainty about the location of the LM curve. • Reaction time => fix a target based on expectations about shocks. • The central bank can either use a money target or an interest rate target. • Which of these instruments would cause the least fluctuations in output?

  13. Nominal demand shocks Monetary control Interest control No income fluctuation Income fluctuation Transmission. No transmission.

  14. Real demand shocks Monetary control Interest control Small income fluctuations Large income fluctuations but No counter cyclical crowding out of I. but counter cyclically!

  15. Summary • The “optimal” choice of monetary policy instrument (rule) depends on the source of business cycle fluctuations. • If the business cycle is mainly driven by real demand shock (IS), then money supply control is better at reducing fluctuations. • If the business cycle is mainly driven by nominal demand shocks (LM), then interest rate control is better at reducing fluctuations.

  16. What is next? • The great depression and the IS-LM model.

  17. Effectiveness of monetary policy Ineffective Effective Parameters Effect Transmission mechanism large small Keynesian multiplier small large Feedback effect large small steep Slope of IS shallow shallow Slope of LM steep

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