Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 4 Strong and Weak Policy...

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 4

Strong and Weak Policy Effects in the IS-LM Model

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 4-2

The Definition of Money

• Money 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)


Money Demand

• The 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:

M

P⎛⎝⎜

⎞⎠⎟d

M

P⎛⎝⎜

⎞⎠⎟d

=hY − fr (where h, f > 0)


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


Figure 4-2 Effect on the Money Demand Schedule of a Decline in Real Income


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 ATM’s


The LM Curve

• The 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:

M S

P

⎛

⎝⎜⎞

⎠⎟=hY − fr

Yf

h

P

M

fr

S

⎟⎟⎠

⎞⎜⎜⎝

⎛+⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛−=

1


Figure 4-3 Derivation of the LM Curve


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

Yf

h

P

M

fr

S

⎟⎟⎠

⎞⎜⎜⎝

⎛+⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛−=

1


The General Equilibrium

• A 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


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


The IS/LM Model and the Global Economic Crisis

• How can the Global Economic Crisis be modeled using the IS/LM model?

• During the crisis, the IS curve shifted left. Why?– Household wealth and consumer optimism Cα

– Business pessimism I– Greater difficulty in obtaining loans Cα and I

• Summary: Private spending IS shifts Y, r


Monetary Policy

• An 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


Figure 4-5 The Effect of an Increase in the Money Supply With a Normal LM Curve


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


Figure 4-6 The Effect on Real Income and the Interest Rate of an Increase in Government Spending


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


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


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


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


Figure 4-10 The Effect on Real Income of a Fiscal Stimulus With Three Alternative Monetary Policies (1 of 3)


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


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

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 4 Strong and Weak Policy...

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