Efficacy of Stabilization Policies

Learning ObjectivesUnderstand how the interest sensitivity of spending affects the effectiveness of fiscal and monetary policy.Understand how the interest and income sensitivity of money demand affects the effectiveness of fiscal and monetary policy.Understand how the size of the multiplier affects the effectiveness of fiscal and monetary policy.

Fiscal Policy: Demand Side Transmission MechanismGovernment Spending Rises Taxes Decrease InvestmentSpending Falls ExportSpending FallsAggregate Spending IncreasesInterest Rates Rise DeficitIncreasesExpansionary Fiscal Policy

IS/LM: Expansionary Fiscal PolicyLMIS2 Y1 Y3 Y2 Yrr1IS1r2E2E1BAn increase in spending shifts theIS curve to the right. If interest rates do not rise, Y risesfrom Y1 to Y2. The change in Y equals the change in spending timesthe simple multiplier of the AE/ASmodel.

As interest rates rise, investment andexport spending are crowded out.

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Fiscal PolicyThe impact of fiscal policy on Y depends on:The slope of the IS curveThe slope of the LM curveThe steeper the IS curve and the flatter the LM curve, the more effective fiscal policy is in changing income.

IS Curve: SlopeThe slope of the IS curve depends on:The size of the multiplier.Determines the initial change in Y.The interest sensitivity of investment and other interest sensitive spending.Determines the amount of crowding out that occurs as interest rates rise.The interest sensitivity of net exports.Determines the decrease in net exports that occurs as rising interest rates cause the dollar to rise.

IS Curve: SlopeThe slope of the IS curve depends in part on the size of the MPC.Changes in aggregate spending are greater as the value of the MPC rises.Larger values of the MPC tend to make the slope of the aggregate expenditure line steeper and the slope of the IS curve flatter.Changes in aggregate spending are smaller as the value of the MPC falls.Smaller values of the MPC tend to make the slope of the aggregate expenditure line flatter and the slope of the IS curve steeper.

00Y1 Y2 Y3Y1 Y2 Y3AEASAE(r1)AE(r2)AE(r1)AE(r2)IS1IS2r1r2

IS EquationY = 11 b(1 t) + ma + I dr + G + X nr M mYAs the MPC (b) rises (falls), (1 b) falls (rises) and other things remaining the same the value of the multiplier rises (falls).

Therefore, any change in aggregate spending will result in a larger (smaller) change in Y.

IS Curve: SlopeThe slope of the IS curve depends in part on the interest elasticity of investment spending.As the economy expands, interest rates rise.If investment is interest elastic, the IS curve is flatter and rising rates cause more crowding out of private spending. If investment is interest inelastic, the IS curve is steeper and rising rates cause less crowding out of private spending.

00Y1 Y2 Y3Y1 Y2 Y3AEASAE(r1)AE(r2)AE(r1)AE(r2)IS1IS2r1r2

IS Curve: SlopeThe slope of the IS curve depends in part on the response of net exports to changes in the value of the dollar as interest rates rise.As the economy expands, interest rates rise, causing the dollar to rise.If net exports are sensitive to changes in the exchange rate, the IS curve is flatter and rising exchange rates cause more crowding out of exportsIf investment are less sensitive to changes in the exchange rate, the IS curve is steeper and rising exchange rates cause less crowding out of exports.

Net Exports and the ISNet exports are assumed to be determined by domestic interest rates and domestic GDP.Exports: X = X nrAs interest rates rise, the dollar rises, and exports fall by n times the change in r.Imports: M = M + mYAs GDP rises, imports rise by m times the change in Y.Net Exports: X M = X nr ( M + mY) = NX = X nr M mY

Explaining Exchange Rates with Interest Rate ParityInterest rate parity says that the higher domestic real rates of interest are relative to foreign real interest rates, the higher will be the value of the domestic currency, other things remaining the same.

IS EquationY = 11 b(1 t) + ma + I dr + G + X nr MdYdr= (d + n) 1 b(1 t) + mdrdY 1 b(1 t) + m (d + n)=

Monetary Policy: Interest Rate Channel Increase in the Decrease in Rise in Money Supply Interest Rates GDP Fall inExchange RatesExpansionary Monetary Policy

IS/LM: Expansionary Monetary PolicyLM1ISY1 Y2 Yrr1r2LM2An increase in the money supply,other things remaining the same,means that at r1 and Y1, moneydemand is less than money supply.

The excess supply puts downwardpressure on interest rates, and asr falls, interest sensitive spendingand Y rise.0

Monetary PolicyThe impact of monetary policy on Y depends on:The slope of the LM curveThe slope of the IS curveThe flatter the IS curve and the steeper the LM curve, the more effective monetary policy is in changing income.

LM Curve: SlopeThe slope of the LM curve depends on:The interest sensitivity of money demand. As the interest sensitivity of money demand increases, the money demand curve and the LM curve become flatter.The income sensitivity of money demand.As the income sensitivity of money demand increases, the LM curve becomes steeper.

ab Y0 Y1 Y Y0 Y1 YabccddLMLMMd(Y0)Md(Y1)0000MS Md, MSMS Md, MSMd(Y0)rrr0r0r1r1

LM: The AlgebraLMM/P = L(r,Y)L(r,Y) = eY fr where e and f >0M/P = eY frr = (e/f)Y (1/f) M/P

drdY=ef

LM Curve: SlopeA small (large) value for f means that as Y rises, large (small) changes in r are necessary to re-equilibrate the money market. A small (large) value for e means that as Y rises, small (large) changes in money demand occur that require small (large) changes in r to re-equilibrate the money market.

r0Y1 Y2 Y3 Y4 YLM1LM2r4r3r2r1

Fiscal PolicyFiscal policy is most effective when the IS curve is steep and the LM curve is flat.A steep IS ensures that crowding out of investment and exports is minimized.A flat LM ensures that the fiscal stimulus does not cause large increases in interest rates.

Monetary PolicyMonetary policy is most effective when the LM curve is steep and the IS curve is flat.A steep LM ensures that any change in monetary policy causes a large change in interest rates.A flat IS ensures that the change in interest rates have a significant impact on interest sensitive spending.