Strong and Weak Policy Effects in the IS-LM Model

1. Chapter 4 Strong and Weak Policy Effects in the IS-LM Model

2. The Definition of Money Money is defined as any good or asset that serves the following three functions: Medium of Exchange Store of Value Unit of Account The Money Supply (MS) is equal to currency in circulation plus checking accounts at banks and thrift institutions. The Fed is assumed to determine the money supply (see Chapter 13 for more details)

3. Money Demand The demand for money is determined by people’s need for money to facilitate transactions. If Income (Y) Md If the Price Level(P) Md Notice: Real money demand = is unaffected by P The demand for money also depends negatively on the cost of holding money, the interest rate(r). If r  Md as people switch out of money into interest-bearing savings accounts or other financial assets Algebraically, the general linear form of Md is:

4. Figure 4-1 The Demand for Money, the Interest Rate, and Real Income

5. The demand for real money balances (M/p)d = .5Y – 200r

6. Figure 4-2 Effect on the Money Demand Schedule of a Decline in Real Income

7. Effect on the Money Demand Schedule of a Decline in Real Income from $8,000 to $6,000 Billion

8. What Shifts Money Demand? The main shift factor for real Md is income (Y). Additional shift factors include: Wealth: If people become wealthier, some of the additional wealth may be held as money, so Md rises. Expected future inflation: If people expect P to rise quickly in the future, they will try to hold as little money as possible. Payment technologies: Any technological development that alters how people pay for goods and services, or the ease of switching between money and non-money assets can change Md Examples: Credit Cards and ATM’s

9. The LM Curve The LM Curve shows all the possible combinations of Y and r such that the money market is in equilibrium. Algebraic Derivation: At equilibrium, real MS equals real Md: Solving for r yields:

10. Figure 4-3 Derivation of the LM Curve

11. Figure 4-3 Derivation of the LM Curve

12. What shifts and rotates the LM Curve? Recall: Anything that only affects the intercept termwill shift the LM curve: If MS LM shifts → If P  LM shifts → Not captured by slope term: Md   LM shifts ← Anything that affects the slope termwill cause a rotation of the LM curve: If h  LM becomes steeper If f  LM becomes flatter

13. The General Equilibrium A General Equilibrium is a situation of simultaneous equilibrium in all of the markets of the economy. How does the economy adjust to the general equilibrium? If the goods market is out of equilibrium  involuntary inventory decumulation or accumulation occurs  firms respond by increasing or decreasing production  Y moves to equilibrium If the money market is out of equilibrium  pressure on interest rates will bring back monetary equilibrium

14. Figure 4-4 The IS and LM Schedules Cross at Last

15. The IS/LM Model and the Global Economic Crisis How can the Global Economic Crisis be modeled using the IS/LM model? During the crisis, the IS curve shifted left. Why? Household wealth and consumer optimism  Cα Business pessimism  I Greater difficulty in obtaining loans  Cα and I Summary: Private spending  IS shifts   Y, r

16. Monetary Policy An expansionary monetary policy is one that has the effect of lowering interest rates and raising GDP Suppose that desired (natural) level of Y = Y* (not Y). There is gap between actual and natural. To raise GDP the CB must increase money supply (expansionary monetary policy). A contractionary monetary policy is one that has the effect of raising interest rates and lowering GDP If natural real GDP is lower than actual real GDP, the CB must decrease MS (contractionary monetary policy).

17. Figure 4-5 The Effect of an Increase in the Money Supply With a Normal LM Curve

18. Fiscal Policy and “Crowding Out” An expansionary fiscal policy is one that has the effect of raising GDP, but also raising interest rates Note: r  Private Autonomous Spending  The reduction in the amount of consumption and/or investment spending due to an increase in G (or fall in T) is known as “Crowding Out”

19. Figure 4-6 The Effect on Real Income and the Interest Rate of an Increase in Government Spending

20. Can crowding out be avoided? • Yes! • If the Fed simultaneously MS r • If the IS is vertical. • If the LM is horizontal.

21. Strong effects of monetary expansion. • The answer depends on the slopes of the IS and LM curves. • If they have normal shapes (top frame). • Higher Ms boasts Y and lowers r, which boasts Md by the amount needed to match Ms. • If LM is steep (low Md responsiveness to r) (bottom frame), where LM curves are vertical, Y increases twice as much as the case in the top frame. Strong effects of monetary expansion

22. Figure 4-7 The Effect of an Increase in the Money Supply With a Normal LM Curve and a Vertical LM Curve

23. Weak effects of monetary policy. • Steep IS curve: • zero interest responsiveness of Ap to r. (top frame in figure). • Y does not change, the only effect is a lower r. Weak effects of monetary policy • Flat LM curve: • Md is extremely responsive to r. (bottom frame in figure 4-8). • The equilibrium of the economy hardly move at all. In the extreme case of horizontal LM, CB loses control over both Y and r. This case is called the liquidity trap.

24. Figure 4-8 Effect of the Same Increase in the Real Money Supply with a Zero Interest Responsiveness of Spending and with a High Interest Responsiveness of the Demand for Money

25. Strong and weak effects of fiscal policy • The fiscal policy stimulus on Y depends on the slope of IS and LM. • Fiscal policy is strong when the demand for money is highly interest-responsive. (look to top frame of figure). Note that there are no crowding out effect since r remains constant. • The opposite occurs when the interest responsiveness of money demand is zero. Look at the lower frame of the figure. as long as Ms is fixed, Y can’t be increased.

26. Figure 4-9 Effect of a Fiscal Stimulus when Money Demand Has an Infinite and a Zero Interest Responsiveness

27. Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (1 of 3)

28. Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (2 of 3)

29. Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (3 of 3)

30. Monetary and Fiscal Policy Effectiveness Monetary policy is strong when: The IS curve is relatively flat and/or The LM curve is steep Monetary policy is weak when: The IS curve is very steep and/or The LM curve is relatively flat Fiscal policy is strongwhen: The IS curve is very steep and/or The LM curve is relatively flat Fiscal policy is weak when: The IS curve is relatively flat and/or The LM curve is steep

31. The Liquidity Trap A Liquidity Trap occurs when investors are indifferent between holding money and short-term assets Why might investors be indifferent? Because the nominal interest rate on short-term assets is close to zero! Why is a liquidity trap a problem? Because the interest rate is close to zero, the Fed can no longer use monetary policy to lower the interest rate to boost output. How is a liquidity trap represented? The LM curve starts off horizontal at very low interest rates before having its normal upward slope

32. International Perspective Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”

33. International Perspective Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”