chapter 7 effectiveness of monetary policy and fiscal policy

© Pilot Publishing Company Ltd. 2005

Chapter 7 Effectiveness of

Monetary Policy and Fiscal Policy


Contents:

• More about the IS-LM model

• Effectiveness of monetary policy & fiscal policy

• Advanced Material 7.1: Interest rate vs. money supply as an instrument of monetary policy

• Advanced Material 7.2: Comparison between the IS-LM model and the Y-E model


More about the IS-LM Model


Determinants of the slope of the IS curve

The slope of the IS curve:

b

mcqctic 1

The slope is negative.

>0>0>0>0

<0<0<0<0


r

Y0

IS* (I is more interest elastic)

IS (I is less interest elastic)

The larger the interest elasticity

Interest elasticity of investment (rEI or b )

when r changes, the larger the change in I the larger the required change in Y (& W) to restore equilibrium, i.

e., the gentler the IS curve.

when r changes, the larger the change in I the larger the required change in Y (& W) to restore equilibrium, i.

e., the gentler the IS curve.


r

Y0

IS* (S is less income elastic)

IS (S is more income elastic)

The larger the income elasticity

when Y changes, the larger the change in S the larger the required change in r (& J) to restore equilibrium, i.e., t

he steeper the IS curve.

when Y changes, the larger the change in S the larger the required change in r (& J) to restore equilibrium, i.e., t

he steeper the IS curve.

Income elasticity of saving (YES or s or MPS)


Determinants of the extent of shift of the IS curve

Reason of the shift: (an autonomous ∆ in J or W)

e.g., an autonomous in J J > W

1. If r remains unchanged, Y has to to raise W until J=W,

IS curve shifts rightward.

2. If Y remains unchanged, r has to to lower J until J=W,

IS curve shifts upward.


As they have the same income elasticity, they require the same in Y to restore equilibrium.

As they have the same income elasticity, they require the same in Y to restore equilibrium.

r

Y0

IS* (I is more interest elastic)IS (I is less interest elastic)

Interest elasticity of investment Consider two IS curves with different rEI but equal YES

An auton. in J

The IS curve with a larger interest elasticity requires a smaller in r to restore equilibrium

An auton. in J

The IS curve with a larger interest elasticity requires a smaller in r to restore equilibrium


As they have the same interest elasticity, they require the same in r to restore the equilibrium.

As they have the same interest elasticity, they require the same in r to restore the equilibrium.

r

Y0

IS* (S is more income elastic)

IS (S is less income elastic)

Income elasticity of saving

Consider two IS curves with different YES but equal rEI

An auton. in J

The IS curve with a larger income elasticity requires a smaller in Y to restore equilibrium

An auton. in J

The IS curve with a larger income elasticity requires a smaller in Y to restore equilibrium


Extreme case

Shape of IS curve

Extent of shift of the IS curve (e.g., an autonomous J or W that J > W)

YEs = 0 Horizontal (∵ Y r = 0)

Upward shift: normal

Rightward shift: in Y cannot restore equilibrium

YEs = Vertical (∵ Y r = )

Upward shift: normal

Rightward shift: a negligible in r is enough to restore equil.


Extreme cases of the IS curve

Extreme

case

Shape of

IS curve

Extent of shift of the IS curve

(when autonomous J

or W that J > W)

rEI = 0 Vertical

(∵ Δr

ΔY = 0)

Upward shift: in r cannot

restore equilibrium

Rightward shift: normal

rEI = Horizontal

(∵ Δr

ΔY = )

Upward shift: a negligible

in r is enough to restore equil.



Determinants of the slope of the LM curve

The slope of the LM curve:

e

d

The slope is positive.

> 0> 0> 0> 0

< 0< 0< 0< 0


Q7.2:Given a two-sector economy, with S = 0.2Y – 100 and I = 10 – 20r.(a) Derive the IS equation.(b) Suppose there is an autonomous rise in I by 40. (i) What is the extent of rightward shift of the IS

curve? (ii) What is the extent of upward shift of the IS

curve?


r

Y0

LM* (Ma is more interest elastic)

LM (Ma is less interest elastic)

Interest elasticity of asset demand for money The larger the interest elasticity,

when r changes, the larger the change in Ma the larger the required change in Y (& Mt) to restore equilibrium, i.

e., the gentler the LM curve.

when r changes, the larger the change in Ma the larger the required change in Y (& Mt) to restore equilibrium, i.

e., the gentler the LM curve.


Income elasticity of transactions demand for money The larger the income elasticity,

r

Y0

LM* (Mt is more income elastic)

LM (Mt is less income elastic)

when Y changes, the larger the change in Mt the larger the required change in r (& Ma) to restore equilibrium, i.e., the steeper the LM curve.

when Y changes, the larger the change in Mt the larger the required change in r (& Ma) to restore equilibrium, i.e., the steeper the LM curve.


e.g., an autonomous in money supply Md < Ms

1. If r remains unchanged, Y has to to raise Mt until Md = Ms,

LM curve shifts rightward.

2. If Y remains unchanged, r has to to raise Ma until Md = Ms,

LM curve shifts downward.

Determinants of the extent of shift in the LM curve

Reason of the shift: (an autonomous Δ in Md or Ms)


r

Y0

LM0 (Ma is less interest elastic)

LM0* (Ma is more interest elastic)

Interest elasticity of asset demand for money

LM1*

LM1

Consider two LM curves with different rEMa but equal YEMt

An auton. in Ms

The LM curve with a larger interest elasticity requires a smaller Δ in r to restore equilibrium

An auton. in Ms

The LM curve with a larger interest elasticity requires a smaller Δ in r to restore equilibrium

As they have the same income elasticity, they require the same in Y to restore the equilibrium

As they have the same income elasticity, they require the same in Y to restore the equilibrium


r

Y0

Income elasticity of transactions demand for money

LM0*(Mt is more income elastic)

LM0 (Mt is less income elastic)

LM1*

LM1

Consider two LM curves with different YEMt but equal rEMa

An auton. in Ms

The LM curve with a larger income elasticity requires a smaller in Y to restore equilibrium

An auton. in Ms

The LM curve with a larger income elasticity requires a smaller in Y to restore equilibrium

As they have the same interest elasticity, they require the same in r to restore the equilibrium

As they have the same interest elasticity, they require the same in r to restore the equilibrium


Extreme cases of the LM curve

Extreme case

Shape of LM curve

Extent of shift of the LM curve (when autonomous Md or autonomous Ms)

rEMa = 0 Vertical (∵ Δr

ΔY = 0)

Downward shift: in r cannot restore the equil.


rEMa = Horizontal (∵ Δr ΔY= )

Downward shift: a negligible in r is enough to restore the equil.



Extreme case

Shape of LM curve

Extent of shift of the LM curve (when autonomous Md or autonomous Ms )

YEMt = 0 Horizontal (∵ ΔY Δr = 0)

Downward shift: normal

Rightward shift: in Y cannot restore equilibrium

YEMt = Vertical (∵ ΔY Δr = )

Downward shift: normal

Rightward shift: a negligible in Y is enough to restore equil.


Monetary policy (MP) is the government measure which achieves economic objectives through manipulating the money supply or interest rate.

Fiscal policy (FP) is the government measure which achieves economic objectives through manipulating the government revenue or expenditure.


Effectiveness of Monetary Policy and

Fiscal Policy


Effectiveness of monetary policy

Effect of monetary policy e.g., an expansionary monetary policy (Ms)

Md<MsMd<Ms rr MaMa

II J>WJ>W YY W W

until J=W & Md=Ma+Mt=Ms until J=W & Md=Ma+Mt=Ms

Mechanism:

Mt Mt


Determinants of the effectiveness of MP

1. Multiplier2. Interest elasticity of investment 3. Income elasticity of saving 4. Interest elasticity of asset demand for

money 5. Income elasticity of transactions

demand for money


Multiplier

ΔY = ΔI X MultiplierΔY = ΔI X Multiplier

The larger the multiplier

The larger the change in Y

The more effective the monetary policy


Interest elasticity of investment (rEI )

r

Y0

LM0

LM1

IS* (I is more interest elastic)

IS

Y0 Y1 Y*1

The larger the rEEII , the larger the in I & the larger the in Y.

The larger the rEEII , the larger the in I & the larger the in Y.

The more effective the MP



Income elasticity of saving (YES)

r

Y0

LM0

LM1

IS* (S is less income elastic)

IS

Y0 Y1 Y*1

The smaller the YEESS , the larger the required in Y to raise enough W to restore equil.

The smaller the YEESS , the larger the required in Y to raise enough W to restore equil.




Interest elasticity of asset demand for money (rEMa)

Y0

r

Y0

LM*0 (Ma is less interest elastic)

LM*1LM0

LM1

IS

Y1Y*1

The smaller the r

EMa , the larger the required in r to raise enough Ma to restore the equil.

Then the larger the in I & Y

The smaller the r

EMa , the larger the required in r to raise enough Ma to restore the equil.

Then the larger the in I & Y




Income elasticity of transaction demand for money (YEMt)

r

Y0

LM0*(Mt is less income elastic)

LM1

LM0IS

LM1*

Y0 Y1Y*1

The smaller the

YEMt , the larger the required in Y to raise enough Mt to restore the equil.

The smaller the

YEMt , the larger the required in Y to raise enough Mt to restore the equil.




Effectiveness of Fiscal Policy

Effect of fiscal policy

e.g., an expansionary fiscal policy (G)

MtMt rr

J>WJ>WJ>WJ>W YYYY

II

until J=W and Md=Ma+Mt=Ms until J=W and Md=Ma+Mt=Ms

WW

Md>MsMd>Ms

Mechanism:

MaMa


Determinants of the effectiveness of FP

1. Multiplier2. Interest elasticity of asset demand for

money 3. Income elasticity of transactions

demand for money 4. Interest elasticity of investment 5. Income elasticity of saving


Multiplier

ΔY = ΔG X G-MultiplierΔY = ΔG X G-Multiplier

ΔY = ΔT X T-MultiplierΔY = ΔT X T-Multiplier

The larger the multipliers

The larger the change in Y

Fiscal Policy is more effective


r

Y0

Interest elasticity of asset demand for money (rEMa)

LM* (Ma is more interest elastic)

LMIS0

IS1

Y0 Y1Y*1

The The larger the rEMa , t , t

he he smaller the required in r to restore the equi to restore the equil. and l. and the the smaller the crowding out effect. .

The The larger the rEMa , t , t

he he smaller the required in r to restore the equi to restore the equil. and l. and the the smaller the crowding out effect. .

The more effective the FP



Income elasticity of transactions demand for money (YEMt)

r

Y0

LM* (Mt is less income elastic)

LMIS0

IS1

Y0 Y1Y*1

The smaller the YEMt , the smaller the in Mt and the smaller the required in r to restore the equil. and the smaller the crowding out effect.

The smaller the YEMt , the smaller the in Mt and the smaller the required in r to restore the equil. and the smaller the crowding out effect.




Interest elasticity of investment (rEI )

r

Y0

LM

IS*0 (I is less income elastic) IS*1

IS0

IS1

Y0 Y1 Y*1

The smaller the The smaller the rEI , ,

the smaller the drop in I the smaller the drop in I and and the the smaller the crowding out effect.

The smaller the The smaller the rEI , ,

the smaller the drop in I the smaller the drop in I and and the the smaller the crowding out effect.




Income elasticity of saving (YES)

r

Y0

LM

IS*0 (S is less income elastic)

IS*1

Y0

IS0

IS1

Y*1Y1

The smaller the YES , the larger the required in Y to raise enough W to restore the equil.

The smaller the YES , the larger the required in Y to raise enough W to restore the equil.




Effectiveness of the policies in extreme cases

Extreme

case

Effectiveness of MP Effectiveness of FP

Horizontal

IS

Most effective rEI = totally ineffective

YES = 0 most effective

Vertical

IS

Totally ineffective rEI = 0 most effective

YES= totally ineffective

Horizontal

LMrEMa= totally ineffective

YEMt = 0 most effective

Most effective

Vertical

LMrEMa = 0 most effective

YEMt= totally ineffective

Totally ineffective


Horizontal IS

IS0

LM0 LM1

Y0 Y1

r

YY

Effectiveness of MP

Cause of horizontal IS: r

EI = or YEs = 0


EI = or YEs = 0

MP is most effective


E.g., an expansionary MPE.g., an expansionary MP


IS0

LM0

Y0

r

Y

Effectiveness of FP Horizontal IS

FP is completely ineffective


= Y1

= IS1


EI =


EI =

E.g., an expansionary FPE.g., an expansionary FP


IS0

LM0

Y0

r

Y

Effectiveness of FP

IS1

Y1

Horizontal IS

FP is most effective


Cause of horizontal IS: Y

Es = 0

Cause of horizontal IS: Y

Es = 0



Vertical IS

IS0 LM0

r

Y

Effectiveness of MP

LM1

Y0

Cause of vertical IS: rE

I =0 or YEs =

Cause of vertical IS: rE

I =0 or YEs =

MP is completely ineffective


= Y1



Vertical IS

IS0 LM0

r

Y

Effectiveness of FP

Y0



IS1

Y1

Cause of vertical IS: rEI = 0

Cause of vertical IS: rEI = 0



Vertical IS

IS0 LM0

r

Y

Effectiveness of FP

Cause of vertical IS:

YEs = Cause of vertical IS:

YEs =

Y0



= Y1

= IS1



Horizontal LM

IS0

LM0

r

Y

Cause of horizontal LM:

rEMa =


rEMa =

Y0

Effectiveness of MP



= LM1

= Y1



IS0

LM0

r

YY

Cause of horizontal LM: YEMt = 0

Cause of horizontal LM: YEMt = 0

Y1

Effectiveness of MP

LM1

Y0



Horizontal LM



Horizontal LM

IS0

r

Y


YEMt = 0 or rEMa = Cause of horizontal LM:

YEMt = 0 or rEMa =

Effectiveness of FP

LM0

Y0

IS1

Y1





Vertical LM

IS0

r

Y

Cause of vertical LM:

rEMa = 0


rEMa = 0

Effectiveness of MP

LM0

Y0 Y1

LM1





Vertical LM

IS0

r

Y


YEMt = Cause of vertical LM:

YEMt =

Effectiveness of MP

LM0

Y0



= LM1

= Y1



Vertical LM

IS0

r

Y

Effectiveness of FP

LM0

Y0

Cause of vertical LM: YEM

t = or rEMa = 0

Cause of vertical LM: YEM

t = or rEMa = 0

IS1



= Y1



Advanced Material 7.1Interest rate versus money supply as an

instrument of monetary policy

Money supply as an instrument of MPMoney supply is fixed & is adjusted deliberately. The LM curve is upward sloping.

An expansionary MP shifts the LM curve rightward or downward.

Ms is exogenous but interest rate is endogenous.


Advanced Material 7.1Interest rate versus money supply as an

instrument of monetary policy

Interest rate as an instrument of MP Interest rate is fixed & is adjusted deliberately. The LM curve is horizontal at that fixed rate.

An expansionary MP lowers the interest rate & shifts the LM curve downward to the new rate.

Interest rate is exogenous but Ms is endogenous.


Advanced Material 7.2Comparison between the IS-LM model and

the Y-E Model

Differences between the two models

The Y-E model considers the goods market only, while the IS-LM model considers both the goods market & the money market.

In the Y-E model, I is a constant independent of r, while in the IS-LM model, I is a variable negatively related to r.


Advanced Material 7.2Comparison between the IS-LM model and

the Y-E Model

Superiority of the IS-LM model

can investigate the effects of monetary forces (changes in Md & Ms)

can predict the value of the equil. interest rate

can give a more accurate prediction on the value of the equil. Y


The Y-E model is a special case of the IS-LM model

When rEMa = (horizontal LM), YEMt = 0 (horizontal LM) or rEI = 0 (vertical IS) No crowding-out effect

The Y-E model gives the same (& accurate) prediction as the IS-LM model on how real forces (in the goods market) affect the equil. Y.

Notice that when rEI = 0 and rEMa, monetary forces are neutral, having no effect on Y. In other words, the goods market & the money market are separated.


Correcting Misconceptions:

1. For the same amount of autonomous change in J or W causing J > W, the IS curve will shift rightward (upward) by the same amount.

2. For the same amount of autonomous change in Md or Ms causing Md < Ms, the LM curve will shift rightward (downward) by the same amount.


3. The flatter the IS curve, the more effective the monetary policy but the less effective the fiscal policy.

Correcting Misconceptions:

4. The steeper the LM curve, the less effective the fiscal policy but the more effective the monetary policy.

chapter 7 effectiveness of monetary policy and fiscal policy

Documents

larger income elasticity

lm curve

curve extent of shift

horizontal y r

horizontal r y

vertical y r

vertical r y

equilibrium rightward