Policy Analysis with the ISLM Model

1
Policy Analysis withthe IS/LM Model
CHAPTER
9
2
Thread

• What is the condition of the economy and what, if
  anything, should be done about it?
• Steps to deal with that fundamental question
• Measurement and policy objectives
• Conceptual and theoretical frameworks
• Monetary and fiscal policies
• Its this last step we explore more thoroughly
  here

3
Objectives you should be able to

• Explain the conventional limits of monetary and
  fiscal policies crowing out and the liquidity
  trap
• Explain how these policies can achieve policy
  targets in principle

4
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

5
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

6
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.

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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
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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
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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

10
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
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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.

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Short-Run Outcomes of Policy
13
Examples of Monetary and Fiscal Policies
14
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
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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
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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
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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
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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
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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
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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
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Group Exercises

• P.269 1

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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

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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

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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.

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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
• http//www.federalreserve.gov/releases/h15/update/
  
• Differences in expected inflation

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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.
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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.

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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.

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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
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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.

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Structural and Cyclical Deficits and Surpluses
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Implementation Problems of Monetary and Fiscal
Policy

• Uncertainty about Potential Output
• Information Lag
• Policy Implementation Lag

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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.

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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.

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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.

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Automatic StabilizersCountercyclical Built-in
Programs