1 IS-LM Model Fiscal Policy & Monetary Policy. 2 Outline Introduction Revision Slope & Shift of IS curve Slope & Shift of LM curve Fiscal Policy Expansionary

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IS-LM Model

Fiscal Policy&

Monetary Policy

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Outline Introduction Revision

Slope & Shift of IS curve Slope & Shift of LM curve

Fiscal Policy Expansionary & Contrationary Fiscal Policy Crowding-Out Effect Effectiveness of Fiscal Policy

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Outline Monetary Policy

Expansionary & Contractionary Monetary Policy

Effectiveness of Monetary Policy Deflationary & Inflationary Income

Gap IS-LM model versus Simple Keynesian

Model

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Introduction Unemployment (when Y < Yf) is one of

the major economic problems The government always tries to attain

full employment Yf In the simple Keynesian model, the

government can adopt expansionary fiscal policy (G’ T’) when there is a deflationary / recessionary gap (Yf - Y)

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Introduction Y will then increase by the amount of k

EG’ OR k TT’ Since in a three-sector Keynesian

model Y= Y = OR Y =

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Introduction

Will income increase by the same amount as in the elementary Keynesian model when the government adopt a discretionary (fiscal / monetary) policy, when both interest rate and income are endogenous variables in the IS-LM model?

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Revision - IS Curve

r =

slope = r/Y =

Y =

x-intercept =

when r = 0

C = C’ + cYd = C’ - cT’ + cY

T = T’

I = I’ - br

G = G’

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Revision - IS Curve

IS1

r

Y

When b is smaller, the IS curve will be

When s is larger, the IS curve will be

But k E will be

Construct IS2

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Revision - IS Curve

b =

s =

k E =

r

Y

r

Y

b =

s =

k E =

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Revision - IS Curve

Y =

Y/G’ =

Y/T’ =

x-intercept =

when r = 0

r

Y

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Revision - LM CurveMs = Ms’

Mt = dY

Ma = Ma’ - er

r =

slope = r/Y =

Y =

x-intercept =

when r = 0

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Revision - LM CurveWhen e is larger, the LM curve will be

When d is smaller, the LM curve will be

But 1/d will be

LM1

Construct LM2

r

Y

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Revision - LM Curve

r

Y

r

Y

e =

d =

1/d =

e =

d =

1/d =

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Revision - LM Curve

Y =

Y/Ms’ =

x-intercept =

when r = 0

Y

r

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Expansionary Fiscal Policy+ve G’ OR -ve T’

r

Y

IS LM

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Contractionary Fiscal Policy-ve G’ OR +ve T’

r

Y

IS LM

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Crowding-Out EffectExpansionary Fiscal Policy G’

r

Y

IS1 LMIS2

r1 *

When r = r1, there is excess money _____ as Y rises and _____ rises

_____ has to decrease in order to restore equilibrium in the money market Ms = Mt + Ma

Y1 Y2

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When government expenditure increases, G’, IS curve will shift outward by k EG’.

If interest rate remains constant, when Y , there will be excess money demand, as transactions demand for money has increased

Mt = dY In order to restore equilibrium in the money

market Ms’ = Mt + Ma Interest rate has to increase r in order to

reduce the asset demand for money Ma = Ma’ - er

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But when r investment will decrease I

I = I’ - br Income will decrease Y through the

multiplier effect Y = k E I As a result, Y is less than that as in

the simple Keynesian model

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If interest rate will increase (How about e=?) and investment will decrease (How about b=0?), the effectiveness of an expansionary fiscal policy on income is reduced.

Crowding-out effect refers to the situation in which a rise in government expenditure raises interest rate, causing interest sensitive investment to fall.

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Zero Crowding OutExpansionary Fiscal Policy G’

r

Y

Horizontal LM

slope = r/Y = d/e =

e = Ma/r =

IS1

LM

IS2

When Y by k E G

Mt Ma to restore equilibrium

Since e = , r = 0 and I= 0.

Thus, NO Crowding-out Effect

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r

Y

Horizontal LM

slope = r/Y = d/e =

d = Mt/Y =

IS1

LM

IS2

When Y by k E G

Since d=0, Mt=0 and Ma=0,

in order to maintain equilibrium

Thus, r = 0 and I = 0.


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Zero Crowding Out ???Expansionary Fiscal Policy G’

r

Y

Vertical IS

slope = r/Y = -s/b =

s = = 1/k E k E =

Y = k E G’ =

IS LM

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r

Y

Vertical IS


b =I/r =

IS1LM

IS2

When Y by k E G

Mt Ma, in order to

maintain money mkt equilibrium

r but I = 0 since b = 0


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Full Crowding OutExpansionary Fiscal Policy G’

r

Y

Vertical LM

slope = r/Y = d/e =

e = Ma/r =0

Mt but as Ma= 0

r I Y in order

to reduce Mt to the

original level

IS1 IS2 LM

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r

Y

Vertical LM

slope = r/Y = d/e =

d = Mt/Y =

Mt Ma

r I Y in order

to reduce Mt to the

original level

IS1 IS2 LM

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r

Y

Horizontal IS


s = 0 = 1/k E k E =

b =

IS

LM

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Crowding-Out Effect Zero crowding-out effect occurs when

IS curve is vertical with b = 0 LM curve is horizontal with e = or d = 0

How about the case when IS curve is vertical with s=?

Full crowding-out effect occurs when IS curve is horizontal with b = LM curve is vertical with e = 0 or d =

How about the case when IS curve is vertical with s=0?

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1999 A#7 If consumption expenditure does not only depend

positively on income but also negatively on interest rate, the IS curve will become ___ and the crowding out effect of fiscal policy will be ___ (assuming that the LM curve is upward sloping)

A. flatter… smallerB. flatter… biggerC. steeper… smallerD. steeper… bigger

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1997 C#6 Use the IS-LM model to explain the meaning

of the crowding-out effect and how it affects the impact of government expenditure on national income. Illustrate your answer with a diagram. (5 marks)

Explain whether the crowding-out effect will definitely occur when an increase in government expenditure leads to an increase in the interest rate. Illustrate your answer with a diagram. (5 marks)

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1997 C#6 (a)r

Y

Crowding-out effect means that as

government increases its expenditure,

interest rate will be bid up, which in turn

will reduce investment. The reduction

in investment will reduce the impact

of government expenditure on income

IS1 IS2 LM

Y=k EG’

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1997 C#6 (b)Suppose investment is independent

of interest rate b = 0. IS curve will be

vertical. Increase in government

expenditure will shift the IS curve to

the right. The increase in interest rate

will not lead to any reduction in I.

There will be no crowding out effect.

IS1 LMr

Y

Many candidates argued that when the LM curve was horizontal, there would be

no crowding out effect. But the question specified that the interest rate will rise.

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Effectiveness of Fiscal Policy

G’ k E Y d Mt Excess Money Demand e r b I k E Y The effectiveness of fiscal policy depends on

k E d e b

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The greater the simple Keynesian multiplier k E (= Y/G’), the larger the multiplying effect & the more effective/ potent will be the fiscal policy

k E is larger when MPS is smaller / MPC is larger, proportional tax rate t is smaller, MPM is smaller

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The smaller income elasticity of money demand d (= Mt/Y), the more effective will be the fiscal policy.

Given any increase in Y, the increase in Mt will be smaller.

Smaller excess money demand means smaller increase in interest rate, which cuts back Ma, is enough

Smaller increase in interest rate means smaller decrease in investment, i.e., smaller crowding-out effect.

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The greater interest elasticity of money demand e (= Ma/r), the more effective will be the fiscal policy.

Given any excess money demand, smaller increase in interest rate is enough to cut back Ma to restore equilibrium in the money market.

Smaller increase in interest rate means smaller decrease in investment and smaller crowding out effect.

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Effectiveness of Fiscal Policy The smaller the interest elasticity

of investment b (= I/r), the more effective will be the fiscal policy.

Given any increase in interest rate, the reduction in investment is smaller, and hence a smaller crowding out effect.

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Effectiveness of Fiscal Policymore effective fiscal policy means less crowding-out effect, so compare with the cases of zero crowding-out

Fiscal policy will be more effective when simple Keynesian income multiplier rises k E income elasticity of money demand falls d interest elasticity of money demand rises e interest elasticity of investment falls b

Fiscal policy will be more effective when IS curve is steeper when b not because of s

s will affect the shift of the IS curve LM curve is flatter when e or d

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LM

r

Y

The increase in Y is greater when

the IS curve is steeper, i.e.,

smaller interest elasticity of

investment b

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The increase in Y is greater when the LM curve is flatter, i.e,

interest elasticity of money demand e greater

income elasticity of money demand d smaller

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Expansionary Monetary Policy+ve Ms’

r

Y

IS LM

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Contractionary Monetary Policy-ve Ms’

r

Y

IS LM

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Ms’ ESM r e Ma b I k E Y

d Mt

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A rise in money supply (Ms’) will lead to excess supply of money (ESM) initially.

Interest rate will fall (r ), the asset demand for money will increase (Ma) to absorb part of the excess money supply

Ma = Ma’ - er

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When interest rate falls (r ), investment will increase (I )

I = I’ - br Here, the adjustment in the money

market has already been transmitted to the goods market.

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The rise in investment (I )will cause income to increase (Y ) in a multiplying way.

Y = k E I When income increases, transaction

demand for money will also increase (Mt ). Mt = dY This will then help to absorb the excess

money supply

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Effectiveness of Monetary Policy

The effectiveness of monetary policy depends on e b k E d

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The smaller the interest elasticity of money demand e (= Ma/r), the more effective is the monetary policy

Given an increase in money supply, interest rate has to fall by a greater extent to stimulate sufficient Ma to absorb the excess money supply.

The greater the fall in interest rate, the greater the rise in investment and the greater the increase in income.

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The greater the interest elasticity of investment b (= I/r), the more effective is the monetary policy.

Given the excess money supply, interest rate will fall.

If investment is more elastic to interest rate, investment will then increase by a greater extent and so will the income

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The greater the income multiplier k E (=Y/E’), the more effective is the monetary policy.

Given any increase in money supply, interest rate will fall and investment will increase.

If the income multiplier is larger, income will increase by a greater extent.

k E is larger if the marginal leakage rate w (i.e. s, t, m) is smaller

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The smaller the income elasticity of money demand d (=Mt/Y), the more effective is the monetary policy.

Given any increase in money supply, interest rate will fall, investment and income will increase.

If the money demand is less income elastic, the rise in transaction demand will be smaller.

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Effectiveness of Monetary Policycont’d

Thus, interest rate has to fall by a greater extent in order to generate sufficient Ma to absorb the excess money supply.

With a greater fall in interest rate, the rise in investment and income will be larger.

The shift of the LM curve will be affected by d .

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Monetary policy will be more effective when interest elasticity of money demand rises e interest elasticity of investment falls b simple Keynesian income multiplier rises k E income elasticity of money demand falls d

Monetary policy will be more effective when IS curve is flatter when b or w LM curve is steeper when e not because of d

d will affect the shift of the LM curve

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r

Y

The increase in Y is greater when the IS curve is flatter, i.e.,

larger interest elasticity of investment b

smaller marginal leakage rate w

Flatter IS

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r

Y

The increase in Y is greater when LM is steeper, i.e.,

smaller interest elasticity of money demand e

BUT d has also to be small, otherwise the shift will be smaller

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Monetary Policy will be most effective with horizontal IS

r

Y

Horizontal IS: w/b = 0

when b =

OR

when w= 0

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Monetary Policy will be most effective with vertical LM

r

Y

Vertical LM: d/e =

when e = 0

!!!

BUT when d =

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Monetary Policy will be totally ineffective with vertical IS

r

Y

Vertical IS: w/b =

when b = 0

OR

when w =

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Monetary Policy will be totally ineffective with horizontal LM

r

Y

Horizontal LM: d/e = 0

when e =

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Monetary Policy will be totally ineffective with horizontal LM

If money demand is perfectly interest elastic, people are willing to hold whatever amount of money as asset demand Ma at the prevailing interest rate

Accordingly, any excess money supply caused by an expansionary monetary policy will then immediately be absorbed as asset demand without leading to a fall in interest rate.

With interest rate constant, no change in investment and income can then be conceived.

61

If money demand is perfectly elastic to interest rate e =

r

Ma

Mt

Y

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Expansionary Fiscal PolicyFull Employment

When government expenditure rises, aggregate expenditure increases.

Given flexible prices and full employment, the excess demand in the goods market will raise the price level, rather than output.

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The increase in the price level will lead to a fall in real money supply [refer IS-LM.model 2 slide 12]

Ms / P = ms Real interest rate will rise which leads

to a reduction in investment. The excess demand in the goods

market will be eliminated.

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Full crowding-out will occur. Since the subsequent fall in investment

must equal the initial rise in government spending for aggregate demand to fall back to the full employment level.

Hence, an expansionary fiscal policy will only cause the price level and real interest rate to rise but have no effect on income.

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Expansionary Monetary PolicyFull Employment

If an expansionary monetary policy is applied, interest rate will fall to stimulate investment, causing aggregate demand to rise.

Given flexible prices and full employment, the rise in aggregate demand will raise prices.

This will cause the real money supply to fall

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Expansionary Monetary PolicyFull Employment Interest rate will then increase and

cut back the aggregate demand for goods.

As a whole, real money supply, real interest rate and aggregate demand will return to the original level and income will remain unchanged. Only price level has risen.

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Deflationary Income Gap

Yf Yf

r r

Y Y

Expansionary Monetary PolicyExpansionary Fiscal Policy

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Inflationary Income Gap

Yf Yf

r r

Y Y

Contractionary Monetary PolicyContractionary Fiscal Policy

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Numerical Example C = 150 + 0.5Yd I = 100 - 400r G = 150 T = 100

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Numerical Example Mt = 0.25 Y Ma = 50 - 100r Ms = 180

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Numerical Example Yf = 1000 Ye = Inflationary / Deflationary Gap

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More on fiscal policy Refer Three-sector.model slide 61-68 Location of Effects Reversibility of Policy Time Lags

Recognition, Decision, Action/Executive, Outside Efficiency of Taxation

Total tax burden = Tax payment + Excess burden

Documents

1 IS-LM Model Fiscal Policy & Monetary Policy. 2 Outline Introduction Revision Slope & Shift of IS curve Slope & Shift of LM curve Fiscal Policy Expansionary