Download LM Curve

Chapter 4
Strong and Weak
Policy Effects in the
IS-LM Model
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The Definition of Money
• Money is defined as any good or asset that serves the following
three functions:
– Medium of Exchange
– Store of Value
– Unit of Account
• The Money Supply (MS) is equal to currency in circulation plus
checking accounts at banks and thrift institutions.
– The Fed is assumed to determine the money supply (see
Chapter 13 for more details)
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Money Demand
• The demand for money is determined by people’s need for
money to facilitate transactions.
– If Income (Y)  Md
– If the Price Level (P)  Md
M
• Notice: Real money demand =  
P
d
is unaffected by P
• The demand for money also depends negatively on the cost of
holding money, the interest rate (r).
– If r  Md as people switch out of money into interest-bearing savings
accounts or other financial assets
• Algebraically, the general linear form of Md is:
d
M
   hY  fr
P
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Figure 4-1 The Demand for Money, the
Interest Rate, and Real Income
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The demand for real money balances
(M/p)d = .5Y – 200r
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Figure 4-2 Effect on the Money Demand
Schedule of a Decline in Real Income
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Effect on the Money Demand Schedule of a Decline in
Real Income from $8,000 to $6,000 Billion
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What Shifts Money Demand?
• The main shift factor for real Md is income (Y).
• Additional shift factors include:
– Wealth: If people become wealthier, some of the additional
wealth may be held as money, so Md rises.
– Expected future inflation: If people expect P to rise quickly
in the future, they will try to hold as little money as possible.
– Payment technologies: Any technological development that
alters how people pay for goods and services, or the ease of
switching between money and non-money assets can change Md
• Examples: Credit Cards and ATM’s
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The LM Curve
• The LM Curve shows all the possible combinations of Y and r
such that the money market is in equilibrium.
• Algebraic Derivation:
At equilibrium, real MS equals real Md:
 MS 
 P   hY  fr
Solving for r yields:
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 1  M S
r   
 f  P
 h
   Y
 f
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Figure 4-3 Derivation of the LM Curve
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Figure 4-3 Derivation of the LM
Curve
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What shifts and rotates the LM Curve?
 1  M S   h 
   Y
r   
 f  P   f 
• Anything that only affects the intercept term will shift the LM
curve:
• Recall:
– If MS  LM shifts →
– If P  LM shifts →
– Not captured by slope term: Md   LM shifts ←
• Anything that affects the slope term will cause a rotation of the
LM curve:
– If h  LM becomes steeper
– If f  LM becomes flatter
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The General Equilibrium
• A General Equilibrium is a situation of simultaneous
equilibrium in all of the markets of the economy.
• How does the economy adjust to the general equilibrium?
– If the goods market is out of equilibrium  involuntary
inventory decumulation or accumulation occurs  firms
respond by increasing or decreasing production  Y moves
to equilibrium
– If the money market is out of equilibrium  pressure on
interest rates will bring back monetary equilibrium
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Figure 4-4 The IS and LM Schedules
Cross at Last
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The IS/LM Model and the Global
Economic Crisis
• How can the Global Economic Crisis be modeled using the
IS/LM model?
• During the crisis, the IS curve shifted left. Why?
– Household wealth and consumer optimism  Cα
– Business pessimism  I
– Greater difficulty in obtaining loans  Cα and I
• Summary: Private spending  IS shifts   Y, r
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Monetary Policy
• An expansionary monetary policy is one that has the effect of
lowering interest rates and raising GDP
• Suppose that desired (natural) level of Y = Y* (not Y). There is
gap between actual and natural. To raise GDP the CB must
increase money supply (expansionary monetary policy).
• A contractionary monetary policy is one that has the effect of
raising interest rates and lowering GDP
• If natural real GDP is lower than actual real GDP, the CB must
decrease MS (contractionary monetary policy).
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Figure 4-5 The Effect of an Increase in
the Money Supply With a Normal LM
Curve
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Fiscal Policy and “Crowding Out”
• An expansionary fiscal policy is one that has the effect of
raising GDP, but also raising interest rates
– Note: r  Private Autonomous Spending 
• The reduction in the amount of consumption and/or investment
spending due to an increase in G (or fall in T) is known as
“Crowding Out”
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Figure 4-6 The Effect on Real Income
and the Interest Rate of an Increase in
Government Spending
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• Can crowding out be avoided?
– Yes!
– If the Fed simultaneously MS  r
– If the IS is vertical.
– If the LM is horizontal.
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•
•
•
•
Strong effects of monetary expansion.
The answer depends on the slopes of the IS and LM curves.
If they have normal shapes (top frame).
Higher Ms boasts Y and lowers r, which boasts Md by the
amount needed to match Ms.
• If LM is steep (low Md responsiveness to r) (bottom frame),
where LM curves are vertical, Y increases twice as much as the
case in the top frame. Strong effects of monetary expansion
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Figure 4-7 The Effect of an Increase in the Money
Supply With a Normal LM Curve and a Vertical LM Curve
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•
•
•
•
Weak effects of monetary policy.
Steep IS curve:
zero interest responsiveness of Ap to r. (top frame in figure).
Y does not change, the only effect is a lower r. Weak effects of
monetary policy
• Flat LM curve:
• Md is extremely responsive to r. (bottom frame in figure 4-8).
• The equilibrium of the economy hardly move at all. In the
extreme case of horizontal LM, CB loses control over both Y and
r. This case is called the liquidity trap.
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Figure 4-8 Effect of the Same Increase in the Real
Money Supply with a Zero Interest Responsiveness of
Spending and with a High Interest Responsiveness of the
Demand for Money
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• Strong and weak effects of fiscal policy
• The fiscal policy stimulus on Y depends on the slope of IS and
LM.
• Fiscal policy is strong when the demand for money is highly
interest-responsive. (look to top frame of figure). Note that there
are no crowding out effect since r remains constant.
• The opposite occurs when the interest responsiveness of money
demand is zero. Look at the lower frame of the figure. as long
as Ms is fixed, Y can’t be increased.
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Figure 4-9 Effect of a Fiscal Stimulus when
Money Demand Has an Infinite and a Zero
Interest Responsiveness
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Figure 4-10 The Effect on Real Income
of a Fiscal Stimulus With Three Alternative
Monetary Policies (1 of 3)
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Figure 4-10 The Effect on Real Income
of a Fiscal Stimulus With Three Alternative
Monetary Policies (2 of 3)
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Figure 4-10 The Effect on Real Income
of a Fiscal Stimulus With Three Alternative
Monetary Policies (3 of 3)
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Monetary and Fiscal Policy
Effectiveness
• Monetary policy is strong when:
– The IS curve is relatively flat and/or
– The LM curve is steep
• Monetary policy is weak when:
– The IS curve is very steep and/or
– The LM curve is relatively flat
• Fiscal policy is strong when:
– The IS curve is very steep and/or
– The LM curve is relatively flat
• Fiscal policy is weak when:
– The IS curve is relatively flat and/or
– The LM curve is steep
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The Liquidity Trap
• A Liquidity Trap occurs when investors are indifferent between
holding money and short-term assets
– Why might investors be indifferent?
• Because the nominal interest rate on short-term assets is close to zero!
– Why is a liquidity trap a problem?
• Because the interest rate is close to zero, the Fed can no longer use
monetary policy to lower the interest rate to boost output.
• How is a liquidity trap represented?
– The LM curve starts off horizontal at very low interest rates
before having its normal upward slope
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International Perspective Monetary and
Fiscal Policy Paralysis in Japan’s “Lost Decade”
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International Perspective Monetary and
Fiscal Policy Paralysis in Japan’s “Lost Decade”
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