Title: CHAPTER Policy Analysis with the ISLM Model
1 CHAPTER Policy Analysis with the
IS/LM Model
9
2Policy 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
3Effects 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
4Fiscal 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.
5Partial 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
6Full 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
7Ineffective 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
8Monetary 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
9Ineffective 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.
10Short-Run Outcomes of Policy
11Examples of Monetary and Fiscal Policies
12Policy 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
13Accomodative 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
14Accomodative 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
15Offsetting 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
16U.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
17U.S. Economic Policy in the 1950s
The Fed uses contractionary monetary policy to
fight inflation.
LMo
Real Interest Rate ()
IS0
r0
Y0
Aggregate Output
18U.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
19Problems 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
20Interpretation 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
21The 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.
22Why 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.
24Anticipation 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.
25Monetary 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.
26The 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
27Budget 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.
28Structural and Cyclical Deficits and Surpluses
29Budget 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.
30Implementation Problems of Monetary and Fiscal
Policy
- Uncertainty about Potential Output
- Information Lag
- Policy Implementation Lag
31Uncertainty 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.
32Information 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.
33Policy 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.
34Automatic StabilizersCountercyclical Built-in
Programs