Download IS-LM Model: How Monetary Policy Shifts the LM Curve

IS-LM Model: How Monetary
Policy Shifts the LM Curve
• Monetary policy is a change in the money supply
(i.e. an increase or decrease in the money
supply) and it shifts the LM curve
• Consider an increase in the money supply:
– An increase in M leads to an increase in M/P because
P is fixed in the short run
– Theory of Liquidity Preference tells us for any given
level of income, an increase in money supply leads to
a lower interest rate
– Therefore, the LM curve shifts downward (or to the
right)
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
1
IS-LM Model: How Monetary Policy
Shifts the LM Curve
• Consider an increase in the money
supply (cont’d):
– Equilibrium in the economy moves from
point A to point B (see next graph)
– At equilibrium point B , there are lower
interest rates and higher income
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
2
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
3
IS-LM Model: How Monetary Policy
Shifts the LM Curve
• Why do interest rates go down and income go
up as a result of an increase in money supply?
– Answer: This time we begin with the money market:
– When the central bank increases the money supply,
people have more money than they want to hold at
the prevailing interest rate and they lodge the money
in deposit account. As a result the interest rate falls
(money market: money supply increases, new money
supply line hits money demand curve with lower
interest rates)
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
4
IS-LM Model: How monetary policy
shifts the LM curve
• Why do interest rates go down and
income go up as a result of an increase
in money supply? (cont’d):
– Why does income increase? Because the
lower interest rate stimulates investment in
the goods market. This higher investment
increases expenditure and thus income in
the economy increases.
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
5
IS-LM Model: The Interaction
between Monetary and Fiscal Policy
• When analysing any change in monetary and
fiscal policy, it is important to remember that
the policy makers who control these policy
tools are aware of what the other
policymakers are doing.
• Suppose the government increases taxes –
this will cause the IS curve to shift to the left
by the amount of the tax multiplier
• The way the central bank responds will
determine where the economy ends up.
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
6
IS-LM Model: The Interaction
between Monetary and Fiscal Policy
•
•
If there is an increase in taxes, the IS curve
shifts to the left
There are three possible responses from the
central bank:
1. Central bank does nothing i.e. holds the money
supply constant. In this case the shift to the left of
the IS curve results in lower income and lower
interest rates in the economy (Note: income falls
because as a result of tax increase, disposable
income falls, which means consumption falls, thus
expenditure and equilibrium income falls. Interest
rates fall because the lower income means demand
to hold money falls and the money demand curve
shifts to the left. Thus, the tax hike causes a
recession (see first graph on slide with 3 graphs)
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
7
IS-LM Model: The Interaction
between Monetary and Fiscal Policy
• There are three possible responses from the
central bank (cont’d):
2. The Central Bank may want to hold interest rates
constant. Therefore, when the tax increase shifts the
IS curve to the left, the Central Bank decreases the
money supply to keep the interest rate at its original
level. The fall in the money supply shifts the LM curve
to the left. The interest rate remains at the same rate
but income falls. Income falls by an even larger
amount than if the Central Bank did nothing. Central
Bank causes an even deeper recession (see 2nd
graph on slide with 3 graphs)
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
8
IS-LM Model: The Interaction
between Monetary and Fiscal Policy
• There are three possible responses from the
central bank (cont’d):
3. The central bank may want to prevent the tax
increase from lowering income. Therefore, it raises
the money supply and the LM curve shifts to right
to offset the shift in the IS curve. This causes a
large fall in the interest rate. Income does not
change because the higher tax depresses
consumption, while the lower interest rate
stimulates investment. These two effects exactly
balance (see 3rd graph on slide with three graphs)
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
9
Source: "Marcoeconomics", Mankiw, 4th Edition: Chapter 11, 5th
Edition: Chapter 11
10