Download Chapter 26 Money and Economic Stability in the ISLM World

Chapter 26
Money and Economic Stability in the ISLM World
CHAPTER OUTLINE
I. Monetary Policy, Fiscal Policy, and Crowding Out.
II. Is the Private Sector Inherently Unstable?
III. Flexible Prices, the Natural Rate of Interest, and Real Crowding Out.
Appendix: Interest Rates Versus the Money Supply Under Uncertainty.
CHAPTER SUMMARY
In this chapter, the IS-LM model is used to discuss the fundamental difference
between noninterventionists (Monetarist-New Classicals) and interventionists
(Keynesians). Noninterventionists believe the economy is inherently stable, or at least
that policy makers do not have the information or the skill to make it more stable. In
contrast, Keynesians believe that the economy is sufficiently unstable that, although
policy cannot make it work perfectly, it can surely improve how it works.
This chapter provides some historical perspective on the
intervention- nonintervention debate. It focuses on the factors that shift the IS and LM
curves and determine their slopes. The economy becomes less stable in response to
autonomous spending shocks as the IS curve steepens and the LM curve flattens. These
shifts reflect an increasing marginal propensity to consume, a decreased sensitivity on
investment to interest rate changes, and an increased sensitivity of money demand to
interest rate changes. Under these conditions, a positive spending shock would induce a
large increase in consumption; the resulting increase in output and money demand would
not cause the interest rate to rise much; and the rise in the interest rate would not cause
investment to fall much. Thus, the shock would have the maximum effect on aggregate
demand. By similar reasoning, a shock would have the minimum effect on aggregate
demand if the LM curve were steep and the IS curve flat. The stability discussion in this
chapter focuses on the stability of the aggregate demand curve. Much of the current
debate on this subject has shifted to discussions of price and wage flexibility and the
importance of expectations. Discussion of these subjects begins in the real crowding out
section of this chapter and continues in the next two chapters.
When the LM curve is vertical, an increase in the
money supply increases income by M times velocity
© 2000 Addison Wesley Longman
Figure 26.1
When the LM curve is not vertical, an increase in the
money supply is less powerful in increasing income
© 2000 Addison Wesley Longman
Figure 26.2
With a liquidity trap, an increase in the money supply
from M to M ‘ does not shift the LM curve (see Fig 26.4)
© 2000 Addison Wesley Longman
Figure 26.3
With a liquidity trap, an increase in the money supply,
because it does not shift the LM curve, does not
change income
© 2000 Addison Wesley Longman
Figure 26.4
When the IS curve is vertical, monetary policy is
ineffective
© 2000 Addison Wesley Longman
Figure 26.5
When the LM curve is vertical, fiscal policy is completely
ineffective; when it is horizontal, it is totally effective
© 2000 Addison Wesley Longman
Figure 26.6
A flatter LM curve means wider fluctuations in GDP
associated with exogenous shifts in investment
© 2000 Addison Wesley Longman
Figure 26.7
At full employment, fluctuations in the price level help
stabilize economic activity
© 2000 Addison Wesley Longman
Figure 26.8
An increase in money supply at full employment
doesn’t lower the interest rate
© 2000 Addison Wesley Longman
Figure 26.9
With an interest rate target, an unstable IScurve leads
to wider variation in GDP than if the Fed had a money
supply target
© 2000 Addison Wesley Longman
Figure 26A.1
With a money supply target, an unstable LM curve
leads to wider variation in GDP than if the Fed had an
interest rate target
© 2000 Addison Wesley Longman
Figure 26A.2