Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 25 Money and Economic Stability in the ISLM World

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter 25

Money and Economic Stability in the ISLM World

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 25-2

Learning Objectives

• Explain the circumstances under which fiscal or monetary policy is a more effective method of stabilizing GDP

• Understand the importance of crowding out and possible liquidity traps

• Define the role of prices and their impact on economic stability


Monetary Policy, Fiscal Policy, and Crowding Out

• Controversy within the ISLM framework relates to the relative effectiveness of monetary and fiscal policy

• Monetarists “special case” (Figure 25.1)– Demand for money is unresponsive to interest rates, depends

on income only

– Produces a vertical LM function

– Since velocity is constant and a fixed money supply, GDP cannot change


FIGURE 25.1 When the LM curve is vertical, an increase in the money supply increases income by ∆M times velocity.


Monetary Policy, Fiscal Policy, and Crowding Out (Cont.)

• Monetarists “special case” (Figure 25.1) (Cont.)– Increase in the money supply shifts the LM curve to

the right along a fixed IS curve– Income increases until all the increased money

supply is absorbed into increased transactions demand



• Figure 25.2– LM curve is not vertical, but is positively sloped

– Demand for money is somewhat responsive to rate of interest

– Increase in money supply will result in an increase in income, but less than in the monetarist’s case

– Smaller increase in income is due to lowering of interest rates inducing holding of money in “idle” balances rather than for transactions purposes

– Therefore velocity of the total money supply falls


FIGURE 25.2 When the LM curve is not vertical, an increase in the money supply is less powerful in increasing income.



• Keynesian reservations about monetary policy– Liquidity trap (Figures 25.3 and 25.4)

• Money demand is non-responsive to lowering of interest

• Therefore, the LM curve is perfectly horizontal and does not shift down following an increase in the money supply

• Increase in money supply does not lower the interest rate

• All the additional money is held as idle balances (hoarding) and equilibrium is unchanged

• Therefore, the velocity of the money supply has decreased


FIGURE 25.3 With a liquidity trap, an increase in the money supply from M to M does not shift the LM curve (see Figure 25.4).


FIGURE 25.4 With a liquidity trap, an increase in the money supply, because it does not shift the LM curve, does not change income.



• Keynesian reservations about monetary policy (Cont.)– Perfectly vertical IS curve (Figure 25.5)

• Investment spending is completely unresponsive to the rate of interest

• Therefore, changes in the money supply do not affect income even though it may change the rate of interest


FIGURE 25.5 When the IS curve is vertical, monetary policy is ineffective.



• Summary of monetary policy– Monetary stimulus works when both the IS and LM

curve are “normal”– Extreme cases of a horizontal LM curve and vertical

IS curve render monetary policy ineffective– However, the impact of monetary policy with

“normal” curve may be reduced if increased money supply causes a decline in the velocity



• Critique on Fiscal Policy (Figure 25.6)– Fiscal policy has zero impact with a vertical LM

curve and is completely effective with a horizontal LM curve

• Vertical LM curve– Increased money supply will be absorbed by a higher interest rate

with an increase in GDP

– This case represents total crowding-out due to higher interest rates


FIGURE 25.6 When the LM curve is vertical, fiscal policy is completely ineffective; when it is horizontal, it is totally effective.



• Critique on Fiscal Policy (Figure 25.6) (Cont.)• Horizontal LM curve

– Increased money supply would not increase interest rates and the impact would be entirely on GDP

– This case completely eliminates the crowding-out effect caused by higher interest rates



• In the general case of a positively sloped LM curve– The results lie between the two extremes described above

– While increased government spending will increase GDP, it will be less than the “full multiplier” of the simple Keynesian system

– The reduction in the ultimate impact in the increase of GDP is a result of some increase in interest rates (partial crowding-out)


Is the Private Sector Inherently Stable?

• Most economists agree that the LM curve is positively sloped, although there is disagreement as to magnitude of the slope

• These differences in the slope of the LM curve are sufficient to demonstrate the stability or instability of economic activity resulting from exogenous shifts in private investment


Is the Private Sector Inherently Stable? (Cont.)

• Figure 25.7– There are two alternative LM curves: LMsteep and LMflat with

two IS curves representing shifts in autonomous investment

– Shift of the IS curve will result in much greater variations in economic activity with a flat LM curve

– This is a result of greater variations in the rate of interest with the steep LM curve inducing a large change of endogenous investment to offset a large part of the change in exogenous investment


FIGURE 25.7 A flatter LM curve means wider fluctuations in GDP associated with exogenous shifts in investment.



• Figure 25.8– When the economy operates near full employment capacity,

fluctuations in the price level help provide self-correcting stability

– Starting at the intersection of IS and LM(P0)—E, the economy is operating at YFE which represents full employment

– An increase in autonomous spending shifts IS to IS and raises demand to Y, which is above full employment


FIGURE 25.8 At full employment, fluctuations in the price level help stabilize economic activity.



• Figure 25.8 (Cont.)– With the economy operating above capacity, there

will be an upward pressure on prices to P1

– If the supply of money is fixed, increased prices will reduce the real supply of money which pushes the LM curve back to LM(P1) reducing income to the full employment level



• Figure 25.8 (Cont.)– At the new equilibrium, E1, prices and interest rates

are higher, but output and employment revert to the original level

– Therefore, a condition with a fixed supply of money and flexibility of prices and interest rates indicates the economy will be insulated from changes in exogenous investment spending


Flexible Prices, The Natural Rate of Interest, and Real Crowding Out

• When economy is at or near full employment, the Keynesian interest rate mechanism supports the classical argument of automatic adjustments

• At full employment, the rate of interest is independent of movements in the money supply


Flexible Prices, The Natural Rate of Interest, and Real Crowding Out (Cont.)

• Figure 25.9– Initial equilibrium at YFE and rFE

– The interest rate is the real rate since there is an assumption of no inflationary pressure in the economy

– An increase in the money supply will initially push the LM curve rightward to LM, which reduces interest rates to r


FIGURE 25.9 An increase in money supply at full employment doesn’t lower the interest rate.



• Figure 25.9 (Cont.)– However, since the economy is operating above

full employment (Y), prices will rise which reduces the real supply of money

– As a result, the LM curve shifts leftward back to the original position, increasing the rate of interest back to rFE

– Therefore, at full employment, increases in the money supply cannot reduce the interest rate below rFE



• Natural rate of interest (rFE)– That rate which equates savings and investment

at full employment– At full employment, only saving and

investment (including government spending) determine the interest rate and money supply plays no role

– Since real rate is fixed at rFE, nominal rate will rise if inflationary expectations are generated by the increased money stock



• Fiscal policy under flexible prices– Refer back to Figure 25.8– Assume initial equilibrium of E and a positively

sloped LM curve – Additional government spending shifts the IS

curve to IS– Initial movement along LM(P0) will increase

interest rates which partially crowds investment spending



• Fiscal policy under flexible prices (Cont.)– Since the economy is now above YFE, there will

be an increase in prices pushing the LM curve left to LM(P1), where P1 > P0.

– The economy will move to equilibrium condition E, with even higher interest rates which reduces investment spending to a level equal to the increased government spending (complete crowding-out)



• Fiscal policy under flexible prices (Cont.)– Two important observations in the case of

increased government spending• Real Interest rates at full employment are affected

by shifts in the real sector of the economy—pushed upward by increased government spending

• Although real output returns to the full employment level, increased government spending will increase nominal output because of higher prices

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Appendix

INTEREST RATESVERSUS THE MONEYSUPPLY UNDERUNCERTAINTY


APPENDIX—INTEREST RATES VERSUS THE MONEY SUPPLY UNDER UNCERTAINTY

• Chapter 21 discussed the advantages and disadvantages of using the money supply versus interest rates as a target of monetary policy– Monetarists generally prefer money supply target– Keynesians prefer an interest rate objective

• The basic question is it always better for the Fed to specify a target for the money supply rather than the interest rate


APPENDIX—INTEREST RATES VERSUS THE MONEY SUPPLY UNDER UNCERTAINTY (Cont.)

• Figure 25A.1– The IS curve is shifting back and forth– In this case, the money supply target is superior—smaller variation in

GDP when the major source of instability is in the IS curve• Figure 25A.2

– The demand for money is highly unstable which results in a shift of the LM curve

– In this case, the interest rate target is superior—there is no instability in GDP

• Therefore, the choice between interest rate or money supply targets depends on where the instability comes from—the IS or the LM curve

• The authors suggest the demand for money is unstable (LM curve) which indicates that an interest rate target is best


FIGURE 25A.1 With an interest rate target, an unstable IS curve leads to wider variation in GDP than if the Fed had a money supply target.


FIGURE 25A.2 With a money supply target, an unstable LM curve leads to wider variation in GDP than if the Fed had an interest rate target.

Documents

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 25 Money and Economic Stability in the ISLM World