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Chapter 4
Monetary and
Fiscal Policy 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
• Notice: Real money demand =
M 


 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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(where h, f > 0)
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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 ATMs
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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 from $8,000 to $6,000 Billion
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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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What shifts and rotates the LM
Curve?
• Recall:
 1  M S
r   
 f  P
 h
   Y
 f
• 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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Figure 4-3 Derivation of the LM
Curve
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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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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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How Monetary Policy
Actually Worked in 2001–04
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Figure 4-5 The Effect of a $1,000
Billion 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 a $500 Billion
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 2)
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Figure 4-10 The Effect on Real
Income of a Fiscal Stimulus With Three
Alternative Monetary Policies (2 of 2)
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Figure 4-10 The Effect on Real
Income of a Fiscal Stimulus With Three
Alternative Monetary Policies
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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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Chapter Equations
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Chapter Equations
d
Ms  M 
    0.5Y  200r
P  P
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(4.1)
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Appendix Equations
1
1
multiplier  k 

marginal leakage rate MLR
General Linear Form Numerical Example
Y  kAp
Y  4.0 Ap
General Linear Form Numerical Example
Ap  A ' p  br
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Ap  A ' p  100rp
(1)
(2)
(3)
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Appendix Equations
General Linear Form Numerical Example
Y  k ( Ap ' br )
General Linear Form
Y  4.0( A ' p  100r )
Numerical Example
M  M 
 Ms

     hY  fr 
 P
 P   P
s
d
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(4)

  0.5Y  200r

(5)
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Appendix Equations
General Linear Form Numerical Example
Ms
 fr
Y P
h
2, 000  200r
Y
0.5
Ms
hY 
P
r
f
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(6)
(6a)
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Appendix Equations

bhY b  M s
Y  k ( A0  br )  k  A ' p 


f
f
 P

b Ms 
A'p 
f  P 
Y
1 bh

k f
(8)
Ms 
Y  k1 A ' p  k2 

P


(9)
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


(7)
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Appendix Equations
General Linear Form
Numerical Example
1
1
k1 
k1 
 2.0
1 bh
1 100(0.5)


k f
4.0
200
General Linear Form Numerical Example
b/ f
b
100(2.0)
k2 
 k1
k2 
 1.0
1 bh f
200

k f
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(10)
(11)
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Appendix Equations
Ms 
Y  k1 A ' p  k2 

P


 2.0(2,500)  1.0(2, 000)
(12)
 7, 000
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