LECTURE OUTLINE• Policy analysis with the IS-LM model

– Monetary policy– Fiscal policy

– Interaction between monetary and fiscal policies

– Shocks in the IS-LM model• From the short run to the long run

– Adjustment back to General equilibrium

• Temporary adverse supply shock• Derivation of aggregate demand curve

– Monetary policy and the AD curve– Fiscal policy and the AD curve

Monetary Policy, Activity,and the Interest Rate

•Monetary contraction, or monetary tightening, refers to a decrease in the money supply.•An increase in the money supply is called monetary expansion.•Monetary policy does not affect the IS curve, only the LM curve. For example, an increase in the money supply shifts the LM curve down.

Policy analysis with the IS -LM model (Short Run)

We can use the IS-LM model to analyze the effects of• fiscal policy: G and/or T• monetary policy: M

( ) ( )Y C Y T I r G

( , )M P L r Y

ISY

rLM

r1

Y1

A word of caution: the analysis in the following few slides is in the short run, at a given (fixed) price level: No clearing of labor markets is required at this stage)

2. …causing the interest rate to fall

IS

Monetary policy: An increase in M

1. M > 0 shifts the LM curve down(or to the right)

Y

r LM1

r1

Y1 Y2

r2

LM2

3. …which increases investment, causing output & income to

rise.

causing output &

income to rise.

IS1

An increase in government purchases

1. IS curve shifts right

Y

rLM

r1

Y1

1by

1 MPCG

IS2

Y2

r2

1.2. This raises money demand, causing the interest rate to rise…

2.

3. …which reduces investment, so the final increase in Y

1is smaller than

1 MPCG

3.

IS1

1.

A tax cut

Y

rLM

r1

Y1

IS2

Y2

r2

Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G… and the IS curve shifts by

MPC

1 MPCT

1.

2.

2.…so the effects on r and Y are smaller for T than for an equal G.

2.

Fiscal Policy, Activity,and the Interest Rate

The Effects of an Increase in Taxes

• An increase in taxes shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate.

Figure 5 - 9

Interaction between monetary & fiscal policy

• Model: Monetary & fiscal policy variables (M, G, and T ) are exogenous.

• Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.

• Such interaction may alter the impact of the original policy change.

The Central Bank’s response to G > 0

• Suppose the government increases G.• Possible central bank responses:

1. hold M constant

2. hold r constant

3. hold Y constant• In each case, the effects of the G

are different:

If the government raises G, the IS curve shifts right.

IS1

Response 1: Hold M constant

Y

rLM1

r1

Y1

IS2

Y2

r2If Central Bank holds M constant, then LM curve doesn’t shift.

Results:

2 1Y Y Y

2 1r r r

If government raises G, the IS curve shifts right.

IS1

Response 2: Hold r constant

Y

rLM1

r1

Y1

IS2

Y2

r2To keep r constant, central bank increases M to shift LM curve right.

3 1Y Y Y

0r

LM2

Y3

Results:

IS1

Response 3: Hold Y constant

Y

rLM1

r1

IS2

Y2

r2To keep Y constant, central bank reduces M to shift LM curve left.

0Y

3 1r r r

LM2

Results:

Y1

r3

If government raises G, the IS curve shifts right.

Estimates of fiscal policy multipliers

from the DRI macroeconometric model

Assumption about monetary policy

Estimated value of

Y / G

Fed holds nominal interest rate constant

Fed holds money supply constant

1.93

0.60

Estimated value of

Y / T

1.19

0.26

Shocks in the IS -LM model

IS shocks: exogenous changes in the demand for goods & services.

Examples: – stock market boom or crash

change in households’ wealth C

– change in business or consumer confidence or expectations I and/or C

Shocks in the IS -LM model

LM shocks: exogenous changes in the demand for money.

Examples:– a wave of credit card fraud increases

demand for money.– more ATMs or the Internet reduce money

demand.

Figure 9.9 Effects of a monetary expansion: the Adjustment Towards General

Equilibrium

Figure 9.9 Effects of a monetary expansion: Short Run and Long Run (cont’d)

So far we have simply taken the price level, P, as fixed. In Fig. 9.9(b), the short-run equilibrium point, F, lies on the IS curve, implyingthat the goods market is in equilibrium at that point with equal aggregate quantities of goods supplied and demanded. Recall our assumption that firms are willing to meet any increases in aggregate demand by producing more. In that sense, then, the aggregate quantity of goods supplied equals the aggregate quantity of goods demanded.

Figure 9.9 Effects of a monetary expansion: Short Run and Long Run (cont’d)

However, in another sense the goods market is not in equilibrium at point F. The problem is that, to meet the aggregate demand for goods at F, firms have to produce more output than their full-employment level of output, Y. Full-employment output, Y, is the level of output that maximizes firms' profits because that level of output corresponds to the profit-maximizing level of employment. Therefore, in meeting the higher level of aggregate demand, firms are producing more output than they would like. In the sense that, at point F, the production of goods by firms is not the level of output that maximizes their profits, the goods market isn't truly in equilibrium.

Figure 9.9 Effects of a monetary expansion: Short Run and Long Run (cont’d)

At point F the aggregate demand for goods exceeds firms' desired supply of output, Y, so we can expect firms to begin raising their prices, causing the price level, P, to rise. With the nominal money supply, M, set by the central bank, an increase in the price level, P, lowers the real money supply, M/P, which in turn causes the LM curve to shift up and to the left. Aggregate demand equals full-employment output only when the LM curve has returned to its initial position where it passes through the original general equilibrium point, E. At E all three markets of the economy again are in equilibrium, with output at its full-employment level.

Figure 9.8 Effects of a temporary adverse supply shock

• The inflation rate rises temporarily, not permanently• Summary: The real wage, employment, and output decline, while the real interest rate and price

level are higher• There is a temporary burst of inflation as the price level moves to a higher level• Since the real interest rate is higher and output is lower, consumption and investment must be

lower

Aggregate Demand Curve

•The aggregate demand relation captures the effect of the price level on output. It is derived from the equilibrium conditions in the goods and financial markets.

Y1Y2

Deriving the AD curve

Y

r

Y

P

IS

LM(P1)

LM(P2)

AD

P1

P2

Y2 Y1

r2r1

Intuition for slope of AD curve:

P (M/P )

LM shifts left

r I Y

Figure 9.10 Derivation of the aggregate demand curve

Figure 9.10 Derivation of the aggregate demand curve (cont’d)

Figure 9.11 The effect of an increase in government purchases on the aggregate

demand curve

Figure 9.11 The effect of an increase in government purchases on the aggregate

demand curve (cont’d)

Monetary policy and the AD curve

Y

P

IS

LM(M2/P1)

LM(M1/P1)

AD1

P1

Y1

Y1

Y2

Y2

r1r2

The Fed can increase aggregate demand:

M LM shifts right

AD2

Y

r

r

I Y at each value of P

Y2

Y2

r2

Y1

Y1

r1

Fiscal policy and the AD curve

Y

r

Y

P

IS1

LM

AD1

P1

Expansionary fiscal policy (G and/or T ) increases agg. demand:

T C IS shifts right

Y at each value of P

AD2

IS2

Figure 9.11 The effect of an increase in government purchases on the aggregate

demand curve

Figure 9.11 The effect of an increase in government purchases on the aggregate

demand curve (cont’d)

Aggregate Demand• Let’s summarize: Starting from the equilibrium conditions for the

goods and financial markets, we have derived the aggregate demand relation.

This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, called the aggregate demand curve.

Changes in monetary or fiscal policy – or more generally in any variable, other than the price level, that shifts the IS or the LM curves – shift the aggregate demand curve.