Download Overall effect: Y

CHAPTER 12
MONETARY AND FISCAL POLICY IN THE VERY SHORT RUN
Chapter Outline
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Monetary Policy
Is There a Situation Where Monetary Policy Cannot Lower Interest Rates?
The Case of the Liquidity Trap
Can the LM Curve Be Vertical? Classical Economics Again
Fiscal Policy and Crowding Out
An Increase n Government Spending
Crowding Out
Is Crowding Out Important?
Monetary Policy and the Interest Rate Rule
Money Supply Rule and Interest Rate Rule:
When Would Policymakers Choose one over the Other?
Goods Market Shocks Only
Money Market Shocks Only
Working With Data
Changes from the Previous Edition
This chapter has been almost completely rewritten. We have introduced the liquidity trap in a
modern perspective and related this to recent events in the United States and Japan. We have also
modernized the section on the vertical LM curve and related it to the Classical model where it belongs.
The fiscal policy section has been rewritten and now follows a much more logical order. There is a new
section on conducting monetary policy according to an interest rate rule, and this policy stance is
compared to the money supply rule, in what could be termed an accessible “Poole” exercise.
Learning Objectives
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Students should understand the dynamics of adjustment in the IS-LM model following a fiscal or
monetary policy change.
Students should understand that the U.S. and Japanese economies have been described as being in a
liquidity trap in the recent past
Students should understand that a vertical LM curve implies a Classical model
Students should understand the concept of crowding out.
Students should be aware that crowding out is a matter of degree. In the IS-LM model, that degree
depends on the slopes of the IS- and LM-curves.
Students should be aware of the limitations of the static, short-run nature of the IS-LM model.
Students should understand how monetary policy can be conducted according to an interest rate rule
or according to a money supply rule, and the situations under which one may be superior to the other.
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Accomplishing the Objectives
We begin by discussing monetary policy in both comparative statics and dynamic frameworks.
The adjustment path of the economy after a money shock (see Figure 12-2) is that interest rates change
while income and output remain constant, and subsequently both income and interest rates increase.
Here, the money market is always in equilibrium, while the goods market can be out of equilibrium.
These adjustment assumptions mimic real world observations.
Two extreme cases in the operation of monetary policy are given special attention. Monetary
policy is powerless to affect interest rates (and thus the economy) in the liquidity trap (represented by a
horizontal LM-curve). The polar opposite is the Classical case (represented by a vertical LM-curve), in
which a given change in money supply cannot effect the level of real income.
The effectiveness of expansionary fiscal policy depends on the amount of crowding out that takes
place, that is, on the reduction in private spending (most notably investment) caused by rising interest
rates following fiscal expansion, and the extent of the crowding-out effect depends on the slopes of the
IS- and LM-curves. The flatter the IS-curve and the steeper the LM-curve, the larger the crowding-out
effect. The factors that determine the slopes of the IS- and LM-curves have already been discussed in the
previous chapter. Of course, crowding out can be avoided by coordinating monetary and fiscal policy.
This is illustrated in Figure 12-5.
Since different monetary and fiscal policy mixes vary in their effects on the different sectors of
the economy, actual policy choices are often determined by political preferences. Liberals often favor
increases in government spending on education, job training, or the environment, while conservatives
tend to favor tax cuts. Those advocating rapid economic growth favor investment subsidies and lower
interest rates.
We finish this chapter with a discussion of monetary policy conducted according to an interest
rate rule. This is especially relevant in today’s policy environment in both Canada and the U.S. In
Canada we now have fixed announcement dates for changes in the Bank rate, so monetary policy is well
described as running an interest rate rule. Students will find the section on comparing an interest rate rule
to a money supply rule very interesting, as this can be cast in terms of policy intervention (interest rate
rule) vs. no policy intervention (money supply rule).
Suggestions and Pitfalls
Students should be asked to work out several examples of either fiscal or monetary policy
changes, both graphically and with a written explanation of the adjustment processes that take place. In
doing these exercises, students should ask themselves the following three questions:
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Which sector is involved, the expenditure sector or the money sector? This will tell them which
curve will shift, the IS-curve or the LM-curve.
Will the policy change lead to an increase or decrease in national income? This will tell them
whether the respective curve will shift to the right or left.
Is it a parallel shift (caused by a change in autonomous spending or nominal money supply) or is
it a change in the slope? The only policy change discussed here that could cause a change in slope
is a change in the marginal income tax rate (t), which would change the size of the expenditure
multiplier () and therefore the slope of the IS-curve.
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The following simplified description of the adjustment process in response to an increase in
government purchases (G) may be used:
G up ==> Y up ==> the IS-curve shifts right ==> md up ==> i up ==> I down ==> Y down.
Effect: Y goes up, i goes up.
IS2
i
IS1
LM
i2
i1
0
Y1
Y2
Y
The following simplified description of the adjustment process following an increase in real
money supply may be used:
ms up ==> i down ==> I up ==> Y up ==> the LM-curve shifts right ==> md up ==> i up.
Effect: Y goes up, i goes down.
i
IS
LM1
LM2
i1
i2
0
Y1
Y2
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Y
When these simplified adjustment processes above are presented to students, they are often
confused. In order to help students get over his confusion, you may want to explain the difference
between comparative statics and dynamics. In terms of the above diagrams, the comparative statics are
fairly simple:
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An increase in government spending will increase booth the interest rate and income.
An increase in the money supply will lower the interest rate and increase income.
In order to discuss the dynamics, we need to impose an adjustment assumption: the money market
always clears quickly while the goods market clears slowly. In terms of the above diagrams, for the fiscal
policy adjustment, the movement is always along the LM curve. For the monetary adjustment, the
economy follows the path given in Figure 12-2 in the text.
Discussing actual events with which students should be at least somewhat familiar always makes
the theoretical material come to life and gets students to participate more actively in class. The IS/LM
model is a perfect model for discussing the policy interventions surrounding the events of September,
2001. In both Canada and the U.S., monetary policy became quite expansionary, so interest rates went
down. In Canada, this had the desired effect, as output went up. However, in the U.S. output did not
immediately respond. Consumer confidence may have been so badly shaken, that this IS curve could have
been (temporarily) vertical. In this case it would not matter how low interest rates were, output just
would not respond. Of course, this also leads to a discussion of the possibility that the U.S. was in a
liquidity trap at that time.
When discussing monetary accommodation of expansionary fiscal policy, the following point
should be made: Within an IS-LM framework, that is, as long as prices are assumed to be fixed, the Bank
of Canada can prevent crowding out fairly easily by expanding money supply. However, as soon as
prices are allowed to vary, such policy may lead to a higher price level. In this case, crowding out cannot
be avoided since a higher price level implies lower real money balances, which provide upward pressure
on interest rates.
It is also important that students understand why fiscal policy has a much smaller multiplier effect
in the IS-LM model than in the simple Keynesian model of income determination that was presented in
Chapter 10. In the IS-LM framework, the extent of crowding out clearly depends on the slopes of the ISand LM-curves. Even though the factors determining these slopes are covered in Chapter 11, it may be
beneficial to mention them here again. Instructors also may want to assign both Chapter 11 and Chapter
12, simultaneously, since Chapter 11 lays the theoretical framework for the IS-LM model, while Chapter
12 provides its practical application.
Students will find that Section 12-3 on the interest rate rule is very relevant. Monetary policy in
both Canada and the U.S. could be accurately described as following an interest rate rule. It is important
to point out the meaning of two different horizontal LM curves: for a liquidity trap, monetary policy
cannot affect the economy; for an interest rate rule, policy has chosen to make the LM curve horizontal,
and could just as easily choose another interest rate. Therefore, in the case of a horizontal LM curve due
to an interest rate rule, monetary policy is very effective.
Students will also find that the discussion of a money supply rule vs. an interest rate rule is very
relevant. This discussion can always be cast in terms of a “no intervention policy” (money supply rule)
vs. a “complete intervention policy” (interest rate rule). This could lead to interesting discussion
concerning the role of monetary policy in the short run.
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Solutions to the Problems in the Textbook:
Discussion Questions:
1. Technically, although it is difficult to show this at this level, the optimal policy will depend on the
relative slopes of the IS and LM curves. However, the general results could be applied here: if the
shocks to the goods market are relatively bigger, then a money supply rule is superior; if the shocks to
the money market are larger then an inters rate rule is superior. The better students may point out that
if you really do not know, then a policy where there is minimal intervention (money supply rule) is
probably the safest policy.
2. The IS-curve is vertical, if investment spending is totally interest insensitive. This is called
investment insufficiency; in this case the monetary multiplier is zero. Since the parameter b in the
investment equation equals zero, the equation changes from
I = Io - bi
to I = Io.
A horizontal LM-curve will also render monetary policy ineffective. This is called the liquidity
trap. In this case, money demand is totally interest elastic, and the parameter h in the money demand
equation is assumed to be infinitely large.
The fiscal policy multiplier is zero if the LM-curve is vertical. This case is called the classical
case, and money demand (and money supply) is assumed to be totally interest insensitive. Since the
parameter h in the money demand equation equals zero, the equation changes from
L = kY - hi
to
L = kY.
None of these three cases is very likely to occur. However, some economists assert that Japan in
the late 1990’s and Canada in the Great Depression were in, or close to, the liquidity trap.
3. A liquidity trap is a situation in which the public is willing to hold, at a given interest rate, as much
money as the Bank of Canada is willing to supply. In this case, the LM-curve is horizontal and
monetary policy is totally ineffective. Fiscal policy (which will shift the IS-curve) is clearly the better
choice to stimulate the economy in such a situation, since no crowding out will occur. This means that
fiscal policy will have its maximum effect.
4. Crowding out occurs when an increase in government spending raises interest rates, which reduces
private spending (especially investment). For example, an increase in government purchases (G) will
increase income (Y) and therefore consumption (C); but because the interest rate (i) will increase, the
level of investment spending (I), and most likely also net exports (NX), will decrease, changing the
composition of GDP. Some degree of crowding out will always occur as long as the LM-curve is
upward sloping, that is, in all cases except the liquidity trap. The steeper the LM-curve is, the greater
the degree of crowding out. This implies that if the LM-curve is steep monetary policy will be more
effective than fiscal policy in stimulating national income.
5. In this case, the LM-curve is vertical. Money demand and money supply would be completely interest
inelastic. The Keynesian IS/LM model is probably inappropriate for discussing this case. It is hard to
see how you can have a sensible equilibrium with two vertical curves. In a Classical model, fiscal
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policy would only change the allocation of income, and monetary policy would only change the price
level.
6. Assume the government finances an increase in government spending by borrowing from the public
(the Treasury sells government bonds to finance the increase in the budget deficit). The increase in
the demand for credit by the government will lead to an increase in interest rates. If the Bank of
Canada is worried about high interest rates, it may monetize the budget deficit, that is, buy the
government bonds that the public now holds. This will inject money into the economy, and interest
rates will drop again, so no crowding out of private spending may occur, at least in the short run.
In an IS-LM model, the expansionary fiscal policy will shift the IS-curve to the right, while the
Bank of Canada’s action will shift the LM-curve to the right. This means that the AD-curve will shift
further to the right than would have been the case if the Bank of Canada had not accommodated the
expansionary fiscal policy. But this causes more upward pressure on the price level. In a recession,
when there is little inflationary pressure, such a fiscal/monetary policy mix may be beneficial and
cause only a small increase in the price level. However, if the economy is close to full employment,
then we can expect a significant increase in the price level. In the long run, when the AS-curve is
vertical, there will be total crowding out, whether the Bank of Canada monetizes the increase in the
budget deficit or not.
7. A combination of restrictive fiscal policy and expansionary monetary policy will not significantly
affect aggregate demand or income, and neither will expansionary fiscal policy combined with
restrictive monetary policy. However, the first policy mix will decrease interest rates, while the latter
will increase interest rates. Therefore the composition of output will be different in each case.
The first combination will shift the IS-curve to the left and the LM-curve to the right, in which
case income will remain roughly the same while interest rates will be reduced. A tax increase will
lower consumption while increasing investment spending due to lower interest rates. The second
combination will shift the IS-curve to the right and the LM-curve to the left, leaving income roughly
the same, while increasing interest rates. This will decrease the level of investment spending, while
either government spending or consumption (through a tax cut) will increase.
Other considerations may involve the effect of a given policy mix on the budget surplus and the
value of the dollar (and therefore net exports). The first policy mix will increase the budget surplus.
Lower interest rates may also lead to an outflow of funds, which will lower the value of the dollar,
leading to an increase in net exports. The second policy mix will decrease the budget surplus. Higher
interest rates may lead to an inflow of funds, which will increase the value of the dollar, leading to a
decrease in net exports.
Application Questions:
1. If the government wants to change the composition of GDP towards investment and away from
consumption without changing the level of aggregate demand, it needs to implement a combination of
restrictive fiscal policy and expansionary monetary policy. An increase in personal income taxes or a
decrease in transfer payments will reduce consumption and thus aggregate demand. The IS-curve will
shift to the left, leading to a decrease in the level of output and the interest rate. To increase output to
its original level, the Bank of Canada can undertake expansionary monetary policy. This will shift the
LM-curve to the right, leading to a further decrease in the interest rate, thus stimulating investment,
and, in turn, aggregate demand. If the intersection of the new IS- and LM-curves is at the same
income level as previously, then the decrease in the interest rate will have stimulated investment
spending sufficiently to exactly offset the decrease in consumption. (Note: The tax increase can be
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combined with an investment subsidy. In this case, the IS-curve will not shift as far to the left as
before.)
The following diagram shows the effect of a decrease in transfer payments (TR) that is combined
with an increase in money supply (M/P). The adjustment process is as follows:
1-->2: TR ==> C  ==> Y == md  ==> i  ==> I  ==> Y . Effect: Y  and i .
2-->3: (M/P) up ==> i  ==> I  ==> Y  ==> md  ==> i  Effect: Y  and i .
Combined effect: Y about the same and i .
i
IS1
LM1
IS2
LM2
1
i1
2
i2
3
i3
0
Y2
Y1
Y
2. A cut in the income tax rate will flatten the IS-curve and shift it to the right. Both the level of
income and the interest rate will increase. If the Bank of Canada increases money supply to keep
the interest rate constant, then the LM-curve will also shift to the right, maximizing the multiplier
effect, since no crowding out will take place. However, if money supply is held constant, then the
LM-curve will not shift and the overall effect of this fiscal expansion on income will be
weakened, since the increase in the interest rate will crowd out investment.
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i
IS2
IS1
LM1
LM2
2
i2
1
3
i1
0
Y1
Y2
Y3
Y
The adjustment process is as follows:
1-->2: t  ==> C  ==> Y  == md  ==> i up ==> I  ==> Y down.
2-->3: (M/P)  ==> i  ==> I  ==> Y  ==> md  ==> i 
Effect: Y  and i .
Effect: Y  and i .
Combined effect: Y  and i about the same.
Additional Problems:
1. True or false? Why?
"Fiscal policy is more effective when the interest sensitivity of money demand is lower."
False. If money demand is totally independent of interest rates, the LM-curve is vertical. This is the
classical case. A change in government spending has no effect on output, since there is complete
crowding out. Clearly, in the case of a normal (upward-sloping) LM-curve, less crowding out will occur
and income will go up as government spending increases. But the more interest insensitive money
demand is, that is, the steeper the LM-curve is, the smaller the increase in income will be, due to a larger
crowding out effect.
2. Comment on the following statement:
"Crowding out is complete when money demand is perfectly interest inelastic."
Crowding out refers to the fact that an increase in public spending may lead to a decrease in private
spending, thus dampening the output expansion. An increase in government spending raises interest rates,
which leads to a reduction in investment spending. When money demand is perfectly interest inelastic, the
LM-curve is vertical at the level of real output that clears the money market. An increase in government
spending will stimulate income and encourage people to hold more money balances. The excess demand
for money will cause interest rates to rise to the level at which equilibrium in the money market is
restored. If money demand is perfectly interest inelastic, the rise in interest rates will not lower the
quantity of money demanded. Instead, income will have to go back to its original level before the money
market is back in equilibrium. This means that interest rates will have to increase until the level of
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investment spending has been reduced by the same amount as government spending has been increased.
Therefore the level of output demanded is unchanged and crowding out is complete.
3. True or false? Why?
"Expansionary monetary policies reduce bond prices in the liquidity trap."
False. Expansionary monetary policies generally reduce interest rates and thus increase bond prices. In the
liquidity trap, however, interest rates do not change, since the LM-curve is horizontal. If the Bank of
Canada increases the money supply through an open market purchase, the public is willing to hold all the
money the Bank of Canada supplies at the prevailing interest rate. Nobody wants to shift into bonds and
thus bond prices do not change.
4. True or false? Explain your answer.
"Expansionary fiscal policy is more effective when it is financed by borrowing from the public
than when it is monetized."
False. If the government finances an increase in its spending by selling bonds to the public, no change in
the supply of money will occur, and the IS-curve will shift without a corresponding shift in the LM-curve.
On the other hand, if an increase in the budget deficit is monetized, then money supply will increase, as
the central bank buys government bonds from the public. Therefore, the LM-curve will also shift to the
right, leading to lower interest rates than in the first case. Less crowding out will occur and the overall
effect on income will be greater--at least in the IS-LM model, that is, the short run. In the long run, when
prices are allowed to be flexible, then crowding out cannot be avoided by monetizing the debt, since an
increase in the price level will lead to lower real money balances and therefore higher interest rates.
5. True or false? Why?
"Crowding out is complete in the liquidity trap."
False. In the liquidity trap the public is prepared to hold whatever money is supplied at any given interest
rate. This implies that the LM-curve is horizontal. If government spending rises, the IS-curve will shift to
the right. Income will rise but interest rates will not increase. This means that there will be no crowding
out.
i
IS1
IS2
i1
LM
0
Y1
Y2
Y
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6. Assume the government wants to increase output without changing interest rates. What kind of
policy mix would you recommend and how would your policy mix affect the composition of GDP?
Explain your answer and the adjustment processes that take place with the help of an IS-LM
diagram.
A combination of expansionary fiscal and monetary policy will increase output without affecting interest
rates. Expansionary fiscal policy will shift the IS-curve to the right and income and interest rates will both
increase. Expansionary monetary policy will shift the LM-curve to the right and interest rates will
decrease while income increases. Thus we will have an increase in income without a change in interest
rates.
Since income will increase, consumption will also increase, but since interest rates will not change,
induced investment will not be affected (Note: In a more advanced model, an increase in sales
expectations may actually increase the overall investment level. See Chapter 14). Therefore the level of
investment as a fraction of GDP will decrease, while consumption and government purchases will have a
greater share. (A more balanced growth can be achieved if investment subsidies are given.)
1-->2: G up ==> Y up ==> money demand up ==> i up ==> I down ==> Y up
Effect: Y up and i up
2-->3: (M/P) up ==> i down ==> I up ==> Y up ==> money demand up ==> i up.
Effect: i down and Y up
Overall effect: Y up and i constant.
i
IS2
LM1
IS1
LM2
2
i2
i1
1
3
0
Y1
Y2 Y3
Y
7. Discuss the effect of an investment subsidy on consumption. In your answer, indicate whether
the effect on consumption would differ if money demand were more interest sensitive.
An investment subsidy will stimulate investment spending and therefore income, which will lead to an
increase in consumption. If money demand were more interest sensitive, then the LM-curve would be
flatter and the shift of the IS-curve to the right would have a larger effect on income (and thus
consumption). As income increases, so does money demand, but if money demand were more interest
sensitive, then a smaller increase in the interest rate would be required to bring the money sector back to
148
equilibrium. Thus, less crowding out would occur and the overall increase in income or consumption
would be greater.
i
IS1
IS2
LM1
i3
i2
LM2
i1
0
Y1 Y3 Y2
Y
8. "Monetary policy cannot change real output as long as investment is independent of interest
rates." Comment on this statement.
When investment spending is not affected by changes in the interest rate but is determined solely by
changes in business expectations, then monetary policy is ineffective. In this case, the transmission
mechanism breaks down and monetary policy will not bring about changes in real output. Expansionary
monetary policy may reduce interest rates, but this will not increase the level of investment spending and
the economy will not be stimulated. In the IS-LM framework, we would have a vertical IS-curve. Thus,
when the LM-curve shifts, we simply see a change in the interest rate, while the output level remains
constant.
9. Assume investment is very interest inelastic and money demand is very interest elastic. With the
help of an IS-LM diagram, explain the effect of a cut in the income tax rate (t) on investment
(I), money demand (md), and the budget surplus (BuS) and briefly explain the adjustment
process.
Investment is interest inelastic so the IS-curve is steep; money demand is interest elastic so the LM-curve
is flat. An income tax cut will shift the IS-curve to the right and make it flatter. Income and the interest
rate will increase. Since the LM-curve is flat, the interest rate will not increase by much, so investment
will decrease only a little. The budget deficit will increase due to the tax cut. Higher income will lead to
more money demand but a higher interest rate will lead to lower money demand. Overall, money demand
will remain constant, since money supply hasn't changed. The adjustment process can be described a
follows:
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t  C  Y md i
I Y
effect: Y and i
i
LM
i2
i1
IS1
IS2
0
Y1
Y2
Y
10. Assume money demand is very interest inelastic and investment is very interest elastic. Explain
how the level of savings (S), money demand (md) and investment (I) would be affected if the
government increased welfare spending.
If money demand is very interest inelastic, the LM-curve is very steep, and if investment is very interest
elastic, the IS-curve is very flat. With a steep LM-curve and a flat IS-curve, fiscal policy is not very
effective, since most of it is crowded out. An increase in government transfer payments (TR) shifts the IScurve to the right and income and the interest rate increase. Since income has increased, saving has
increased and since the interest rate has increased, investment has decreased. In the end, money demand
cannot be affected since money supply has not changed. The increase in income increases money
demand, but the increase in the interest rate brings it back to its original level, that is, in equilibrium with
money supply. The adjustment process that takes place is as follows:
TR 
Y
md 
i 
I
Y 
Effect: Y  i 
Since i increases a lot, the effect on I is large, as is the offsetting effect (the crowding out effect) on output
(Y). This means that the overall effect on Y is small.
i
LM
i1
io
IS1
ISo
0
Yo Y1
Y
150
11. Use the formal IS-LM model derived in Chapter 10 to show algebraically how the degree of
crowding out that is associated with an increase in government spending (G) is determined by
the different parameters in the fiscal policy multiplier (b, k, h and ).
The equilibrium interest rate for the IS-LM model was derived in Equation (9) of Chapter 10 as
i = (k/h)Ao - [1/(h + kb)](M/P).
If we substitute this equation into the equation for investment, we get
I = Io - bi = Io - b{(k/h)Ao - [1/(h + kb)](M/P)},
and therefore we get
I = - (bk/h)(Ao) = - (bk/h){/[1 + k(b/h)]}(Ao) = - [(bk)/(h + kb)](Go).
From this we can see the following:
 If the interest sensitivity of investment (b) goes up, then we have more crowding out.
 If the interest sensitivity of money demand (h) goes up, then we have less crowding out.
 If the income elasticity of money demand (k) goes up, then we have more crowding out.
 If the multiplier () goes up, then we have more crowding out.
Note: Since b, k, and  are in both the numerator and the denominator of the factor preceding (G) in the
equation above, some students may have difficulty deciding whether this factor goes up or down as these
parameters increase. An easy way to find out is to calculate the inverse of this factor, which is
(h + kb)/(kb) = h/(kb) + 1.
As either k, , or b increases, then this inverse decreases and the factor will increase.
12. If the government increased the income tax rate (t) and the Bank of Canada responded by
increasing the money supply, how would investment (I), savings (S) and money demand (md) be
affected?
1.->2. A higher income tax rate decreases the expenditure multiplier. The IS-curve becomes steeper and
shift to the left, so both income and the interest rate increase.
2.->3. An increase in money supply shifts the LM-curve to the right. The interest rate decreases, leading
to an increase in investment and thus income.
Overall, the interest rate will decrease, but it is unclear what will happen to income. A lower interest
rate means an increase in investment. Since income has not changed much, savings hasn't been affected
much, although it will change in the same direction as income. Since the tax rate is lower, most likely
savings will increase. Money demand has increased, since money supply has been increased (the money
sector has to be in equilibrium).
The adjustment processes that take place can be described as follows:
1.->2. t 
C 
Y
md 
i
I 
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Y  effect: Y  i 
2.->3. ms 
i
Overall effect: Y ?
I 
Y
md 
i 
effect: Y  i 
i 
i
IS1
LM1
LM2
IS2
1
i1
2
i2
i3
3
0
Y1 Yo
Y
13. "Combining income tax cuts with restrictive monetary policy is counterproductive, since it will
lead to a higher budget deficit and higher interest rates. What we need instead is a tax increase
in combination with expansionary monetary policy, since the tax increase will lower the budget
deficit while the money expansion stimulates the economy." Comment on this statement.
Neither policy mix described above is likely to significantly affect the level of output. A combination of
expansionary fiscal policy and restrictive monetary policy will lead to an increase in interest rates but it
will not significantly affect output. The IS-curve will become flatter and shift to the right, and the LMcurve will shift to the left. The budget deficit will increase due to the tax cut.
Restrictive fiscal policy that is combined with expansionary monetary policy will also not
significantly affect output, but it will reduce interest rates. (The IS-curve will become steeper and shift to
the left, and the LM-curve will shift to the right.) The tax increase will lead to a decrease in consumption,
but the decrease in interest rates will lead to an increase in investment and a higher potential for future
economic growth. The budget deficit will decrease due to the higher tax rates. Lower interest rates will
also help to finance the existing national debt and may stimulate net exports, since a capital outflow may
occur that will reduce the value of the dollar.
14. “If investment is very interest inelastic, then most of an income tax rate cut will be crowded out;
therefore the Bank of Canada should always supplement a tax cut with an increase in money
supply.” Comment on this statement with the help of an IS-LM diagram and explain the
adjustment process.
If investment is very interest inelastic, then the IS-curve is very steep. An income tax cut will shift the IScurve to the right and make it flatter. Therefore income and the interest rate increase. The increase in the
interest rate will crowd out only a small part of investment, since investment is very inelastic. If the Bank
of Canada increases money supply, the LM-curve will shift to the right and income will increase, while
interest rates will go down. Overall, we have an increase in income, but interest rates will be largely
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unaffected. Therefore, we do not have to worry about the crowding out of investment. The adjustment
processes that take place can be described as follows:
1.->2. t  C  Y
md
I  Y
2.->3. ms i
i I Y
effect: Y and i
md i 
effect: Y and i
Overall Effect: Y and i unchanged
i
LM1
i2
2
LM2
1
i1
3
IS1
IS2
0
Y1
Y2
Y3
Y
15. "A cut in the income tax rate is not an effective way to stimulate the economy if money demand
is very interest elastic, since most of the tax cut will be crowded out." Comment on this
statement.
A situation in which money demand is extremely interest elastic comes very close to the so-called
liquidity trap (the LM-curve will be almost horizontal). A decrease in the income tax rate (t) will
stimulate consumption and increase national income. The size of the expenditure multiplier () will
increase and the IS-curve will become flatter and shift to the right. The increase in income will initially
induce people to hold more money balances and thus provide upward pressure on interest rates. But since
money demand is extremely interest sensitive, it will take only a very small increase in interest rates to
bring the money sector back to equilibrium. Therefore, the crowding out effect on investment will be
minimal and the tax cut will prove to be very effective in stimulating national income.
16. "Expansionary monetary policy becomes more effective as the interest sensitivity of investment
increases." Comment on this statement.
One of the ways monetary policy affects the level of output demanded is by changing interest rates and
thereby the level of investment spending. The adjustment can be described as follows: An increase in
money supply lowers the interest rate. If investment is very interest elastic, a large increase in investment
spending will follow. This means that, given a certain size of the expenditure multiplier, income will
change by more than in the case when investment does not respond much to a change in interest rates. In
other words, if investment is very interest sensitive, then we have a flat IS-curve. For the same change in
money supply, the flatter the IS-curve is, the larger the change in real output will be.
The formal analysis of Chapter 10 shows that, if investment becomes more interest sensitive, then the
value of b increases. This leads to an increase in the monetary policy multiplier, which is defined as
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(Y)/(M/P) = (b/h).
Note: b is also in the denominator of the equation for , and therefore an increase in b will lower the value
of . But the change in  is proportionally less than the change in b and thus the value of the monetary
policy multiplier will actually increase as b gets larger.
17. Assume that the marginal propensity to save increases. If the Bank of Canada wants to keep the
level of output from fluctuating, should it undertake open market purchases or sales? In your
answer discuss the combined effect of these changes on the composition of GDP.
An increase in the marginal propensity to save (s = 1 - c) will decrease the size of the expenditure
multiplier () and therefore the IS-curve will shift to the left and become steeper. If people save more and
spend less, then firms will experience an increase in unintended inventories. Firms will respond to this by
decreasing production and national income will decrease. Therefore, the Bank of Canada will have to
stimulate the economy by increasing the supply of money via open market purchases (which will shift the
LM-curve to the right). As a result of these two shifts we will have lower interest rates. This means that
investment as a fraction of GDP will increase, while consumption's share of GDP will decrease. (Lower
interest rates may also cause an outflow of capital, which will lower the value of the domestic currency,
leading to an increase in net exports.)
18. "In 1991, the transmission mechanism broke down, since banks were still suffering from having
made bad real estate loans and were unwilling to increase their lending in response to the Bank
of Canada's expansionary monetary policy." Comment on this statement.
It is true that many banks had made bad loans in the late 1980s and were therefore extremely cautious in
their lending in 1991. They preferred to buy virtually risk-free government bonds. Thus, even though the
Bank of Canada's money expansion led to lower interest rates, private firms had little access to bank
loans and the economy was not significantly stimulated. But it would be an exaggeration to say that the
transmission mechanism had broken down, since bank lending finally picked up in 1992 after the Bank of
Canada increased its expansionary monetary policy effort. One can argue that, given the economic
situation at the time, the Bank of Canada's initial policy measure simply was not sufficient to achieve the
desired result.
19. "If investment is very interest elastic and money demand is very interest inelastic, then fiscal
policy is less effective than monetary policy." Comment on this statement.
The more interest elastic investment is, the flatter the IS-curve will be. Expansionary fiscal policy (a shift
of the IS-curve to the right) becomes less effective, since the crowding-out effect becomes larger.
Expansionary monetary policy (a shift of the LM-curve to the right) becomes more effective, since the
decrease in the interest rate will now stimulate investment to a larger degree.
The more interest inelastic money demand is, the steeper the LM-curve will be, since any increase in
money demand due to an increase in income now has to be offset by a larger increase in the interest rate.
Expansionary fiscal policy becomes less effective, since any increase in income will increase money
demand and this will have to be offset by a larger increase in the interest rate, leading to a larger
crowding-out effect. Expansionary monetary policy becomes more effective, since the increase in money
demand needed to bring the money sector back into equilibrium must be achieved primarily through an
increase in income.
The formal analysis in Chapter 10 introduces the fiscal and monetary policy multipliers as
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(Y)/(G) =  = /[1 + k(b/h)]
and
(Y)/(M/P) = (b/h)
respectively. Therefore, if investment becomes more interest elastic, the value of b increases and the value
of the fiscal policy multiplier decreases, while the value of the monetary policy multiplier increases. But
if money demand becomes less interest elastic, then the value of h and the fiscal policy multiplier become
smaller, while the monetary policy multiplier becomes larger.
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