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CHAPTER Policy Analysis with the ISLM Model

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Title: CHAPTER Policy Analysis with the ISLM Model


1
CHAPTER Policy Analysis with the
IS/LM Model
9
2
Policy Analysis with the IS/LM Model
  • A Closer Look at Monetary and Fiscal Policy
  • Fiscal Policy and Crowding Out
  • Monetary Policy and the Liquidity Trap
  • Real World Monetary and Fiscal Policy
  • Problems of Using IS/LM in the Real World
  • Interpretation Problems
  • Implementation Problems

3
Effects of Monetary and Fiscal Policy in the
IS/LM Model
  • Fiscal Policy
  • Expansionary fiscal policy shifts the IS curve to
    the right
  • Contractionary fiscal policy shifts the IS curve
    to the left
  • Monetary Policy
  • Expansionary monetary policy shifts the LM curve
    to the right
  • Contractionary monetary policy shifts the LM
    curve to the left

4
Fiscal Policy and Crowding Out
  • When government expenditures increase, output and
    income begin to increase.
  • The increase in income increases the demand for
    money.
  • The increase in money demand increases the
    interest rate.
  • Higher interest rates cause a decrease in
    investment, offsetting some of the expansionary
    effect of the increase in government spending.

5
Partial Crowding Out
1. The multiplier is 2 and government spending
increases by 500, so the IS increases by 1000.
2. The increase in income increases money
demand which increases interest rates from 4 to
5.
LM
3. The increase in the interest rate causes a
decrease in investment so that the increase in
income is only 600, less that the full
multiplier effect.
1000
Real Interest Rate ()
5
4
IS1
IS0
6600
6000
7000
Aggregate Output
6
Full Crowding Out
1. The multiplier is 2 and government spending
increases by 500, so the IS increases by 1000.
2. If the demand for money is totally insensitive
to the interest rate, the interest
rate increases from 4 to 9.
LM
9
3. The increase in the interest rate causes a
decrease in investment that completely
offsets the increase in government spending.
Real Interest Rate ()
1000
4
IS1
IS0
6000
7000
Aggregate Output
7
Ineffective Fiscal Policy
  • When complete crowding out occurs, fiscal policy
    is ineffective, changing only interest rates, not
    output.
  • Crowding out is greater if
  • Money demand is very sensitive to income changes
  • Money demand is not very sensitive to interest
    rate changes

8
Monetary Policy in the IS/LM Model
In a liquidity trap, increases in the money
supply do not decrease interest rates, so
investment and output do not increase.
The Fed increases the money supply which
decreases interest rates and increases investment
and output.
LM0
LM0
Real Interest Rate ()
Real Interest Rate ()
LM1
LM1
r0
r0
r1
IS
IS
Y1
Y0
Y0
Aggregate Output
Aggregate Output
9
Ineffective Monetary Policy
  • Investment is not sensitive to the interest rate
  • If investment does not respond to interest rate
    changes (the IS curve is steep), monetary policy
    in ineffective in changing output.
  • Liquidity trap
  • If increases in the money supply fail to lower
    interest rates, monetary policy is ineffective in
    increasing output.

10
Short-Run Outcomes of Policy
11
Examples of Monetary and Fiscal Policies
12
Policy when the Economy is Above Potential
Contractionary fiscal policy decreases interest
rates and decreases output.
Contractionary monetary policy raises interest
rates and reduces output.
LM1
LM0
LM
Real Interest Rate ()
Real Interest Rate ()
r1
r0
r0
IS0
r2
IS
IS1
Y0
Y1 potential output
Y1 potential output
Y0
Aggregate Output
Aggregate Output
13
Accomodative Monetary Policy
2. Accomodative monetary policy increases output
even further and offsets the rise in interest
rates.
LM0
Real Interest Rate ()
r0
?
A
1. Expansionary fiscal policy increases
output and interest rates.
IS0
Y0
Aggregate Output
14
Accomodative Fiscal Policy
1. Contractionary monetary policy lowers output
and increases interest rates.
LM0
Real Interest Rate ()
2. Contractionary fiscal policy further reduces
output and offsets the increase in interest
rates.
A
IS0
?
r0
IS1
Aggregate Output
Y0
15
Offsetting Policies
2. Expansionary monetary policy further reduces
the interest rate and offsets the decline in
output.
LM0
A
Real Interest Rate ()
r0
?
IS0
1. Contractionary fiscal policy lowers the
interest rate and output.
r1
IS1
Aggregate Output
Y1
16
U.S. Economic Policy in the 1940s
2. The Fed accomodated the expansionary fiscal
policy to keep interest rates constant.
LM0
Real Interest Rate ()
r0
1. Government increased defense expenditures
during World War II.
IS0
Y0 potential
Aggregate Output
17
U.S. Economic Policy in the 1950s
The Fed uses contractionary monetary policy to
fight inflation.
LMo
Real Interest Rate ()
IS0
r0
Y0
Aggregate Output
18
U.S. Economic Policy in the 1980s
1. The Fed fought inflation by reducing the
money supply.
LM0
Real Interest Rate ()
2. And government spending rose.
r0
IS0
Y0
Aggregate Output
19
Problems Using IS/LM in Real World Policy Analysis
  • Interpretation Problems
  • Problems in knowing how to interpret real-world
    events within the IS/LM framework
  • Implementation Problems
  • Problems encounter in undertaking policy

20
Interpretation Problems
  • Interest Rate Problem
  • Anticipation of Policy Problems
  • Monetary Tools and Credit Condition Problems
  • Interest Rate Target Problem
  • Budget Problems
  • Cyclical and Structural Problems
  • Accounting Methods

21
The Interest Rate Problem
  • Which interest rate, nominal or real, is
    relevant?
  • When there is inflation, the nominal rate is
    greater than the real rate.
  • Which of many interest rates in the economy is
    relevant?
  • The Fed can control the Federal funds rate, but
    it is not the interest rate households and
    businesses pay to borrow money.

22
Why Interest Rates Differ
  • Default risk
  • Interest rates differ according to the likelihood
    that the borrower will repay the loan.
  • Term to Maturity
  • The longer the term to maturity, the higher the
    interest rate that is paid because
  • Bonds with longer maturities are less liquid
  • Differences in expected inflation

23
Typical Yield Curve Inverted Yield Curve
6
6
5.5
5.5
5
5
Yield()
Yield()
4.5
4.5
4
4
3.5
3.5
6
3
1
10 30
5
2
6
3
1
10 30
5
2
Maturities
mos. yr.
Maturities
mos. yr.
24
Anticipation of Policy Problems
  • The IS/LM model does not take into account the
    effect of peoples expectations of policy
    actions.
  • If investors expect the Fed to increase the money
    supply and decrease interest rates, they will buy
    bonds now.
  • The increase in demand for bonds increases their
    price and decreases interest rates before the
    money supply is actually increased.

25
Monetary Policy Tools and Credit Condition
Problems
  • The IS/LM model assumes that interest rates are
    the only determinant of investment.
  • Investment also depends on credit conditions, the
    willingness of banks to lend independent of
    interest rates.
  • If banks raise their lending standards,
    investment may not respond to expansionary
    monetary policy.

26
The Interest Rate Target Problem
To keep the interest rate at its target of 2,
the Fed offsets shifts in the IS curve with
accomodating monetary policy. The Fed is
maintaining an effective LM curve that is
horizontal at the targeted interest rate of 2.
Real Interest Rate ()
Effective LM Curve
IS1
IS0
IS2
Y1
Y0
Y2
Aggregate Output
27
Budget Problem Cyclical and Structural Budgets
  • The structural budget surplus or deficit is the
    fiscal budget balance that would exist when the
    economy is at potential output.
  • The cyclical budget surplus or deficit is that
    portion of the fiscal budget balance that exists
    because output is above or below potential output.

28
Structural and Cyclical Deficits and Surpluses
29
Budget Problem Accounting Methods
  • The U.S. budget is a cash flow budget, a budget
    where revenues and expenses are counted only when
    cash is received and spent.
  • An obligation budget includes the expected value
    of future expenditures and revenues.
  • Economists disagree whether the obligations
    budget or the cash flow budget is more
    appropriate for considering the fiscal impact of
    the deficit.
  • Ricardian equivalence says that increasing
    government debt has the same effect on
    consumption and aggregate output as does
    increasing taxes.

30
Implementation Problems of Monetary and Fiscal
Policy
  • Uncertainty about Potential Output
  • Information Lag
  • Policy Implementation Lag

31
Uncertainty About Potential Output
  • One macroeconomic policy goal is to keep output
    as close to potential as possible.
  • In the real world, economists arent sure what
    potential output is.
  • If policymakers use contractionary policy when
    the economy is actually below potential, they
    create unemployment.
  • Using expansionary policy above potential output
    will cause inflation.

32
Information Lag
  • The IS/LM model assumes that policymakers see
    what is happening in the economy and can
    instantly alter policies to fix any problem.
  • In the real world there is an information lag, a
    delay between a change in the economy and
    knowledge of that change.

33
Policy Implementation Lag
  • The policy implementation lag is the delay
    between the time policymakers recognize the need
    for a policy action and when the policy is
    instituted.
  • Fiscal policy has a large implementation lag
    because policy must be formulated and legislation
    passed by Congress and the President.
  • Monetary policy has a shorter implementation lag
    because the Federal Open Market Committee decides
    monetary policy.

34
Automatic StabilizersCountercyclical Built-in
Programs
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