ISLM,%20FISCAL%20AND%20MONETARY%20POLICY

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ISLM, FISCAL AND MONETARY POLICY

• Week 8
• SF Intermediate Economics
• Professor Dermot McAleese

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OUTLINE

• Derivation and Analysis of IS curve
• Derivation and Analysis of LM curve
• ? ISLM Equilibrium
• ? What happens if actual Y does not coincide
  potential (full employment) Y?
• ? Policy Implications

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Definition of IS curve

• The IS curve is an equilibrium locus showing
  combinations of interest rate (r) and
  output/expenditure (Y) that are consistent with
  equilibrium in the goods market. IS at all
  points along this curve. It is downward-sloping
  because complete in your own words.

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Derivation of LM

• ?Money Supply assumed exogenous, determined by
  Central Bank
• Money Demand determined by a) price level, b)
  level of Y and c) interest rate (r)
• Equilibrium condition Ms Md
• This maps into upward sloping LM curve, with r on
  vertical axis and Y on horizontal axis
• LM is upward sloping because as Y ()s, Md
  increases. But Ms is fixed, therefore
  equilibrium in money market can only be
  maintained if something happens elsewhere to
  reduce demand. The elsewhere is the interest
  rate. If r ()s, Md tends to fall. Hence for
  each () Y there is some () r that will restore
  equilibrium. The locus of such r,Y points is the
  LM curve.

T
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LM curve shifts outwards if

• ? Money supply increases
• ? Price level falls
• ? Interest rate sensitivity of demand increases
• ? Income elasticity of money falls
• ? Technology changes (ATMs, more use of credit
  cards etc)
• ?

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STABILITY OF MONEY DEMAND

• ? Money demand is stable if it changes in a
  predictable fashion, i.e. parameters of money
  demand are relatively constant over time
• ? Does NOT mean that money demand is fixed, does
  not change
• ?ECB view is that Md is reasonably stable so
  money supply targets are meaningful policy
  instrument
• ?Bank of England and Federal Reserve Bank more
  sceptical believe money demand inherently
  unstable
• ?If money demand unstable so is LM curve, thus
  limiting the possibility of activist monetary
  policy

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• NOW PLACE IS CURVE AND LM CURVE ON SAME GRAPH
  TO DERIVE EQUILIBRIUM POINT E

LM
r
E
IS
Ya
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IF Ya lt YF , WHAT HAPPENS?

• 1) Wages flexible, workers price themselves back
  into jobs, unemployment falls and IS shifts
  outwards
• 2) Price level will also decline, Ms/p will
  increase, consumer spending will increase. This
  is the REAL BALANCE EFFECT
• 3) As real money supply ()s, interest rate will
  fall, leading to () in total spending (see McA
  330-334)

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KEYNES RESPONSE TO CLASSICAL (CONVENTIONAL)
POSITION

• ? Automatic Adjustment mechanisms operate too
  slowly in the long run we are all dead
• ? Need for hands-on intervention to shift AD
  curve outwards
• Policies to shift IS outwards likely to be more
  effective than moving LM, because IS curve slopes
  downwards steeply. That is, fiscal policy more
  effective than monetary policy
• BIRTH OF THEORY AND PRACTICE OF COUNTER-CYCLICAL
  POLICY and EXTENDED ROLE OF STATE

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COUNTER-CYCLICAL FISCAL POLICY
The Keynesian Aggregate Supply (KAS) curve
KAS
Price level
E1
AD1
E2
E
AD
AD2
Y
Y2
Output
Keynesian economics applies up to Y (full
employment) after that point we are back to
vertical AS curve and the long run AS model
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Table. 3 Government spending (GDP)

• Source European Economy, Annual Report No 59,
  1995 European Economy, special Supplement,
  Spring 1995 OECD pre-Second World War figures
  taken from Vito Tanzi and Ludger Schuknecht, The
  Growth of Government and the Reform of the State
  in Industrial Countries, IMF Working Paper,
  December 1995 European Economy No. 68, 1999.

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Table. 4 General Government Net Debt (GDP)

• Source European Monetary Institute, First Annual
  Report, April 1995 OECD Economic Outlook,,
  various issues.

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For Interest A Recent Paper Comments on Total
Factor Productivity (TFP)

• A growing body of evidence suggests that, even
  after physical and human capital accumulation are
  accounted for, something else accounts for the
  bulk of cross country differences in the level
  and growth rate of GDP per head. Economists
  typically refer to the something else as total
  factor productivity
• Easterly and Levine What have we learned from a
  decade of empirical research on growth? The
  World Bank Economic Review No 2 2001

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3 pages of ISLM Equations

• For those who prefer equations to graphs, here is
  how equilibrium Y and r can be derived

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Deriving the IS curve

• Y C I
• C a bY
• I d f i
• ?Y a bY d f i

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Deriving the LM curve

• The LM curve summarises the relationship between
  real output and real interest rates such that the
  aggregate demand for money (L) is just equated
  with the money stock (M)

L M
gt LM equation
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IS-LM Equilibrium

• IS equation
• LM equation
• Equilibrium