Robert J. Gordon, Macroeconomics, 10th edition, 2006, Addison-Wesley Chapter 4: Monetary and Fiscal Policy in the IS-LM Model
Introduction: the power of monetary and fiscal policy • We know that at equilibrium when any of the determinants of Ap change, business firms will react by raising or reducing output, the economy will experience business cycles. • Since equilibrium real GDP equals Ap×k, the primary causes of business cycles are changes in Ap. The five components of Ap can cause equilibrium GDP to change. • In the last chapter we saw that along the IS curve the commodity market is in equilibrium and there is no unplanned inventory accumulation or depletion. The IS depends on the components of Ap and the multiplier, its slope depends on the multiplier and the responsiveness of Ap to changes in interest rate.
The IS curve can’t determine two unknown variables, real GDP and the interest rate. We can’t determine y without knowing r and vice versa. • To determine y and r simultaneously we need a second, separate relationship between them. This second relationship is the LM curve, is provided by the money market. The equilibrium real GDP is determined by the intersection of IS and LM. • Why people use money • A medium of exchange: • As a medium of exchange money enables people to overcome the problems of barter. Under barter exchange requires “double coincidence of wants”.
A barter society remains primitive, much time is spent on exchange, to avoid this they must be self sufficient, failing to take the advantages of specialization. Money eliminates the need for double coincidence of wants. • Which types of assets serve as a medium of exchange: ready acceptability, protection from counterfeiting, and divisibility. • A store of value • People need to store the purchasing power of their receipts of their receipts until later. Any assets that performs this function is a store of value. Money can be used as a store of value.
A unit of account • Money is used for accounting purposes. All transactions are recorded using a unit of account. This unit is money. • How the Central Bank controls the money supply. • The central bank controls the supply of currency through its control over the printing process. The C.B. controls checking accounts by requiring banks to keep a certain fraction of their checking deposits in a special account at the C.B. called “bank reserves”
How the central bank controls MS • The C.B.’s balance sheet • Table 4-1 is a simplified version of the CB balance sheet. The total of CB liabilities is the “monetary base”.
What action by the C.B. will raise MS • Since banks are to hold RR. (e.g., 10%), a 200 billion of currency supports 2000 billion of checking deposits. Total MS = 2200 billion. MS = money multiplier ×MB • Or in this example; 2200 = 5.5(400) • The multiplier =(1+C/D)/(RR+C/D). = (1+.1)/(.1+.1) = 5.5
Suppose that the CB is not satisfied with MS of 2200 billion, e.g., GDP is to low and to stimulate planned spending, the CB decided to raise MS by 550, the CB will raise MB by 100 billion, by purchasing government bonds by 100. MS will increase by 550 billion. • In the real world the CB buy and sell government securities to change MS, or sometimes to maintain MS if the multiplier changes e.g., from 5.5 to 5. the CB will buy extra 40 billion of bonds. • Income, interest rates and the demand for money • The demand for real money balances (M/P)d increases with real income. e.g., (M/p)d = .5Y
If real income is 8000, the demand for real money balances will be 4000, shown as the vertical line in figure 4-1, on the assumption that (M/p)d does not depend on r. (M/p)d is at 10% as it is at 0%. • Interest rate and the demand for money • If r paid on non-monetary assets is less than r on money, individuals would reduce their money holdings and vice versa. • In figure 4-2 if interest rate is zero and real income is 8000, (M/p)d=4000. if r rises from 0% to 5%, (M/p)d =3000 (point D), and 2000 at 10%...etc. • The new demand for money is: (M/p)d = .5Y – 200r
Figure 4-2 Effect on the Money Demand Schedule of a Decline in Real Income from $8,000 to $6,000 Billion
Note that a change in r moves the economy up or down the (M/p)d schedule but a change in Y shifts the schedule. In figure 4-2 there are two money demand curves based on two different levels of real income. • At any given r a change in (M/p)d due to a change in Y is given by: ∆(M/p)d = .5 ∆Y • The LM curve • The LM curve shows the equilibrium of the money market, which is achieved when (M/p)s equals(M/p)di.e., (M/p)s =(M/p)d = .5Y – 200r • If money supplied by the CB = 2000 and p = 1, then (M/p)s = 2000, shown as a vertical line in figure 4-3.
How to derive the LM curve. • Look at figure 4-3. If Y= 8000 and r=10%, money demand will be at F(i.e.,2000), which equals Ms. This combination is represented as point F in the right frame. If Y=6000, money demand will be at point G where r=5%. These two (and similar) combinations are plotted on the LM curve in the right frame. • What the LM curve shows. • Represents all combinations of Y and r where money market is in equilibrium. If money market is not in equilibrium money demand either exceeds money supply or vice versa. • If the economy is at D, r can rise from 5% to 10%, or Y falls to 6000, or some other combination of a rise in r and a fall in Y. which of these possibilities occur depends on the slope of the IS curve.
The IS meets the LM curve. • Equilibrium in the commodity market occurs only at the IS while LM shows all combinations of Y and r at which money market is in equilibrium. • The economy arrives at its general equilibrium at point E0. If the commodity market is out of equilibrium firms will step up or cut down production, pushing the economy back to E0. If the money market is out of equilibrium there will be pressures to adjust r through the sale (purchase) of stocks or bonds pushing the economy back to E0. • Note • We have two endogenous variables (Y,r) and three exogenous variables (MS, G, T). The model does not explain business and consumer optimism.
monetary policy in action. • Suppose that desired (natural) level of Y = 8000 (not 7000 as it is in figure 4-4). There is 1000 gap between actual and natural. To raise GDP the CB must increase money supply (expansionary monetary policy). If natural real GDP is lower than actual real GDP, the CB must decrease MS (contractionary monetary policy). • Normal effects of an increase in money supply • If money supply increase will real GDP increase, r decrease or both? If IS and LM have normal shapes, the answer is both. • Look at figure 4-5, if the CB raises MS to 3000, LM shifts to the RHS, there will be an excess MS of 1000. Individuals transfer some money into savings to buy bonds and stocks. This raises stock and bond prices and reduces r.
Figure 4-5: The Effect of a $1,000 Billion Increase in the Money Supply With a Normal LM Curve.
Desired Ca and Ip rises require an increase in production. Only at point E1 where Y=8000 and r=5%, where both money and commodity markets are in equilibrium. • If the economy is at general equilibrium at E1 and the desired Y is 7000, the CB must reduce Ms from 3000 to 2000, as a result LM shifts to the LHS and income declines to 7000. • How fiscal expansion can “crowd out” investment • Here we will shift the IS along a fixed LM curve, as shown in figure 4-6 below. The original IS is drawn on the assumption that autonomous spending at a zero interest rate is equal to 2500.
Figure 4-6 The Effect on Real Income and the Interest Rate of a $500 Billion Increase in Government Spending. Md=3000>Ms=200
Expansionary fiscal policy shifts the IS curve. • An expansionary fiscal policy taking the form of 500 increase in G shifts the IS to the RHS by 2000, the multiplier is still 4. • The full fiscal multiplier would shift the economy from E0 to E2. At E2 the money market is not in equilibrium, because (Md/p) would be high (because of high income, while Ms/P is still the same at 2000. • This raises r, which in turn reduces planned I and C. At E3 both money and commodity market is in equilibrium but the equilibrium real income will increase by 1000 only. • Higher interest rate (7.5% to 10%) accounts for reducing the fiscal multiplier to 2 instead of 4, as planned C and I are cut by 250. thus fully half of the original multiplier is “crowded out”
The crowding out effect • Crowding out effect is used to compare points E2 and E3. the 1000 difference in real income between the two points results from the I and C crowded out by higher r. The composition of private spending will change as a result of higher r. C will increase and autonomous spending will decrease as follows:
Can crowding out be avoided. • The cause of crowding out is an increase in r required whenever Y increases while Ms/p is constant, to offset the rise in Md/p. crowding out can be avoided if: • Ms/p increased (shifting LM to the RHS by the same amount as the IS) • IS is vertical. • LM is horizontal. • Strong and weak effects of monetary policy • Look at figure 4-7. following an increase in Ms/p • Does Y increase by all lot, a little of not at all? • Does r decline by all lot, a little of not at all?
Figure 4-7 The Effect of an Increase in the Money Supply With a Normal LM Curve and a Vertical LM Curve
Strong effects of monetary expansion. • The answer depends on the slopes of the IS and LM curves. • If they have normal shapes (top frame of 4-7). • Higher Ms boasts Y and lowers r, which boasts Md by the amount needed to match Ms. • If LM is steep (low Md responsiveness to r) (bottom frame of 4-7), where LM curves are vertical, Y increases twice as much as the case in the top frame. Strong effects of monetary expansion
Weak effects of monetary policy. • Steep IS curve: • zero interest responsiveness of Ap to r. (top frame in figure 4-8). • Y does not change, the only effect is a lower r. Weak effects of monetary policy • Flat LM curve: • Md is extremely responsive to r. (bottom frame in figure 4-8). • The equilibrium of the economy hardly move at all. In the extreme case of horizontal LM, CB loses control over both Y and r. This case is called the liquidity trap.
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
Strong and weak effects of fiscal policy • The fiscal policy stimulus on Y depends on the slope of IS and LM. • Fiscal policy is strong when the demand for money is highly interest-responsive. (look to top frame of figure 4-9). Note that there are no crowding out effect since r remains constant. • The opposite occurs when the interest responsiveness of money demand is zero. Look at the lower frame of figure 4-9. as long as Ms is fixed, Y can’t be increased.
Figure 4-9 Effect of a Fiscal Stimulus when Money Demand Has an Infinite and a Zero Interest Responsiveness
Using fiscal and monetary policy together • The types of policy (monetary and fiscal) do not work in isolation. Monetary policy may strengthen or dampen the fiscal policy. • The fiscal multiplier depends on the monetary policy • The basic idea is simple, the more the CB expands MS, the larger is the fiscal multiplier, the more the CB contracts MS, the smaller is the fiscal multiplier. • If the CB contracts MS enough, the fiscal multiplier could be negative. • Look at figure 4-10 • In the upper left frame, there is a crowding out effect since MS is constant.
In the upper right frame, as MS increased to the extend that r remains constant, fiscal stimulus is v. high. When the CB tries to stabilize r by allowing MS to respond to any changes in IS, it is said that the CB “accommodate” fiscal policy. • The monetary fiscal mix and economic growth. • Look at the bottom left frame of figure 4-10, note that the CB responds to fiscal stimulus by moving LM in the opposite direction such that Y remains constant. This is the “tight money easy fiscal” mix.
Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (1 of 2)
Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (2 of 2)
Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies
International Perspective Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”
International Perspective Monetary and Fiscal Policy Paralysis in Japan’s “Lost Decade”