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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
d
M
 
• Notice: Real money demand =  P  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 interestbearing savings accounts or other financial assets
• Algebraically, the general linear form of Md is:
d
M
   hY  fr
P
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(where h, f > 0)
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Figure 4-1 The Demand for Money, the
Interest Rate, and Real Income
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Figure 4-2 Effect on the Money Demand
Schedule of a Decline in Real Income
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What Shifts Money Demand?
• The main shift factor for real Md is income (Y).
• Additional shift factors include:
– Interest paid on money: If money pays more interest
(which was not possible before 1978), Md rises
– 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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What shifts and rotates the LM Curve?
S

 h


1
M
• Recall: r   
 f  P    f Y
 
  
• Anything that only affects the intercept term will
shift the LM curve:
– 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
• A contractionary monetary policy is one that
has the effect of raising interest rates and lowering
GDP
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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”
• Can crowding out be avoided?
– Yes! If the Fed simultaneously MS  r
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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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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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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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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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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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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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