Is LM Model3

7/26/2019 Is LM Model3

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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 & Contrationary Fiscal Policy

Crowding-Out Effect

Effectiveness of Fiscal Policy



3

Outline Monetary Policy

Expansionary & Contractionary Monetary Policy

Effectiveness of Monetary Policy

Deflationary & Inflationary Income Gap

IS-LM model versus Simple KeynesianModel



4

Introduction Unemployment (when Y < Yf) is one of

the major economic problems

The government always tries to attain fullemployment Yf

In the simple Keynesian model, the

government can adopt expansionary fiscalpolicy (G’ T’) when there is a

deflationary / recessionary gap (Yf - Y)



5

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 =



6

Introduction Will income increase by the same

amount as in the elementary Keynesianmodel when the government adopt adiscretionary (fiscal / monetary) policy,when both interest rate and income are

endogenous variables in the IS-LMmodel?



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’



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



Revision - IS Curveb =

s =

k E =

r

Y

r

Y

b =

s =

k E =



Revision - IS Curve Y =

Y/ G’ =

Y/ T’ =

x-intercept =

when r = 0

r

Y



Revision - LM CurveMs = Ms’

Mt = dY

Ma = Ma’ - er

r =

slope = r/ Y =

Y =

x-intercept =

when r = 0



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



13

Revision - LM Curve

r

Y

r

Y

e =

d =

1/d =

e =

d =

1/d =



14

Revision - LM Curve Y =

Y/ Ms’ =

x-intercept =

when r = 0

Y

r



15

Expansionary Fiscal Policy

+veG’ OR -ve

T’

r

Y

ISLM



16

Contractionary Fiscal Policy

-veG’ OR +ve

T’

r

Y

ISLM



17

Crowding-Out Effect

Expansionary Fiscal PolicyG’

r

Y

IS1 LMIS2

r1 *

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

_____ has to decrease inorder to restoreequilibrium in the moneymarket Ms = Mt + Ma

Y1 Y2



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Crowding-Out Effect


When government expenditure increases, G’, IScurve 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 moneymarket Ms’ = Mt + Ma

Interest rate has to increase r in order toreduce the asset demand for money

Ma = Ma’ - er







21

Zero Crowding Out


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



22

Zero Crowding Out


r

Y

Horizontal LM


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.

Thus, NO Crowding-out Effect



23

Zero Crowding Out ???


r

Y

Vertical IS

slope = r/ Y = -s/b =

s =

= 1/k E

k E =

Y = k E G’ =

IS LM





25

Full Crowding Out


r

Y

Vertical LM


e = Ma/

r =0 Mt but as Ma= 0

r I Y in order

to reduce Mt to the

original level

IS1 IS2 LM



26

Full Crowding Out


r

Y

Vertical LM


d = Mt/

Y =

Mt Ma

r I Y in order

to reduce Mt to the

original level

IS1 IS2 LM



27

Full Crowding Out


r

Y

Horizontal IS

slope = r/ Y = -s/b =

s = 0 = 1/k E k E =

b =

IS

LM



28

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?



29

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 thecrowding out effect of fiscal policy will be ___(assuming that the LM curve is upward sloping)

A. flatter… smaller

B. flatter… bigger

C. steeper… smaller

D. steeper… bigger



30

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 onnational income. Illustrate your answer with adiagram. (5 marks)

Explain whether the crowding-out effect will

definitely occur when an increase ingovernment expenditure leads to an increasein the interest rate. Illustrate your answer witha diagram. (5 marks)



31

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 E G’



32

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 LM r

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.



33

Effectiveness of Fiscal PolicyG’ 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





35

Effectiveness of Fiscal Policy 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 besmaller.

Smaller excess money demand means smallerincrease in interest rate, which cuts back Ma, isenough

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

effect.



36

Effectiveness of Fiscal Policy 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.



37

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.



38

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



39

Effectiveness of Fiscal Policy

LM

r

Y

The increase in Y is greater when

the IS curve is steeper, i.e.,

smaller interest elasticity of

investment b



40

Effectiveness of Fiscal PolicyThe 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



41

Expansionary Monetary Policy

+veMs’

r

Y

IS LM



42

Contractionary Monetary Policy

-veMs’

r

Y

ISLM



43


+veMs’

Ms’ ESM r e Ma

b I k E Y

d

Mt



44


+veMs’

A rise in money supply (Ms’) will lead to

excess supply of money (ESM) initially.

Interest rate will fall (r ), the assetdemand for money will increase (Ma) toabsorb part of the excess money supply

Ma = Ma’ - er



45


+veMs’

When interest rate falls (r ), investment

will increase (I )

I = I’ - br

Here, the adjustment in the money markethas already been transmitted to the goods

market.



46


+veMs’

The rise in investment (I )will cause income

to increase (Y ) in a multiplying way.

Y = k E I

When income increases, transaction demandfor money will also increase (Mt ).

Mt = dY

This will then help to absorb the excessmoney supply



47

Effectiveness of Monetary Policy The effectiveness of monetary policy

depends on

e b

k E

d



48

Effectiveness of Monetary Policy 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 stimulatesufficient Ma to absorb the excess money

supply. The greater the fall in interest rate, the greater

the rise in investment and the greater theincrease in income.



49

Effectiveness of Monetary Policy 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 interestrate, investment will then increase by agreater extent and so will the income



50

Effectiveness of Monetary Policy 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 willincrease by a greater extent.

k E is larger if the marginal leakage rate w

(i.e. s, t, m) is smaller



51

Effectiveness of Monetary Policy 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.



52

Effectiveness of Monetary Policycont’d

Thus, interest rate has to fall by a greaterextent 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 affectedby d .



53


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



54


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



55


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



56

Monetary Policy will be most

effective with horizontal ISr

Y

Horizontal IS: w/b = 0

when b =

OR

when w= 0



57

Monetary Policy will be mosteffective with vertical LM

r

Y

Vertical LM: d/e =

when e = 0

!!!

BUT when d =



58

Monetary Policy will be totallyineffective with vertical IS

r

Y

Vertical IS: w/b =

when b = 0

OR

when w =



59

Monetary Policy will be totallyineffective with horizontal LM

r

Y

Horizontal LM: d/e = 0

when e =



60

Monetary Policy will be totallyineffective 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 prevailinginterest rate

Accordingly, any excess money supply caused byan expansionary monetary policy will then

immediately be absorbed as asset demandwithout leading to a fall in interest rate.

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

f f



61

If money demand is perfectlyelastic to interest rate e =

r

Ma

Mt

Y

l l



62

Expansionary Fiscal PolicyFull Employment

When government expenditure rises,aggregate expenditure increases.

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

i i l li



63


The increase in the price level will lead to afall in real money supply [refer IS-LM.model 2

slide 12]

Ms / P = m s Real interest rate will rise which leads to a

reduction in investment. The excess demand in the goods market

will be eliminated.

E i Fi l P li



64


Full crowding-out will occur.

Since the subsequent fall in investment

must equal the initial rise in governmentspending for aggregate demand to fallback to the full employment level.

Hence, an expansionary fiscal policy willonly cause the price level and real interestrate to rise but have no effect on income.

E i M t P li



65

Expansionary Monetary PolicyFull Employment

If an expansionary monetary policy isapplied, interest rate will fall to stimulate

investment, causing aggregate demand torise.

Given flexible prices and full employment,

the rise in aggregate demand will raiseprices.

This will cause the real money supply to fall

E i M t P li



66

Expansionary Monetary PolicyFull Employment

Interest rate will then increase and cutback the aggregate demand for goods.

As a whole, real money supply, realinterest rate and aggregate demand willreturn to the original level and income

will remain unchanged. Only price levelhas risen.



67

Deflationary Income Gap

Yf Yf

r r

Y Y

Expansionary Monetary Policy Expansionary Fiscal Policy



68

Inflationary Income Gap

Yf Yf

r r

Y Y

Contractionary Monetary Policy Contractionary Fiscal Policy



69

Numerical Example

C = 150 + 0.5Yd

I = 100 - 400r

G = 150

T = 100



70

Numerical Example

Mt = 0.25 Y

Ma = 50 - 100r

Ms = 180



71

Numerical Example

Yf = 1000

Ye =

Inflationary / Deflationary Gap



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

Is LM Model3