Monetary and Fiscal Policy in the IS-LM Model

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Chapter 4 Monetary and Fiscal Policy in the IS-LM Model

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The Definition of MoneyMoney 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).

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Money DemandThe 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:(where h, f > 0)

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What Shifts Money Demand?The main shift factor for real Md is income (Y). Additional shift factors include: Interest paid on money: If money pays more interest (which was not possible before 1978), Md rises 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 ATMs

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

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Figure 4-2 Effect on the Money Demand Schedule of a Decline in Real Income from $8,000 to $6,000 Billion

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The LM CurveThe 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:

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What shifts and rotates the LM Curve?Recall: Anything that only affects the intercept term will 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 term will cause a rotation of the LM curve: If h  LM becomes steeper If f  LM becomes flatter

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Figure 4-3 Derivation of the LM Curve

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The General EquilibriumA 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

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

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Monetary PolicyAn expansionary monetary policy is one that has the effect of lowering interest rates and raising GDP. A contractionary monetary policy is one that has the effect of raising interest rates and lowering GDP.

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How Monetary Policy Actually Worked in 2001–04

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Figure 4-5 The Effect of a $1,000 Billion Increase in the Money Supply with a Normal LM Curve

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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” Can crowding out be avoided? Yes! If the Fed simultaneously MS  r

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Figure 4-6 The Effect on Real Income and the Interest Rate of a $500 Billion Increase in Government Spending

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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 strong when: 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

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

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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

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

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Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (1 of 2)

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

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Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies

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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.

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

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

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Last Updated: 8th March 2018

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