Unformatted text preview: Intermediate
Macroeconomics I
Macroeconomics
EC21A (Econ 2002)
Explaining Fluctuations
Explaining
with the ISLM
with Questions you should be able to
answer Why is the IS curve insufficient by itself.
What is the LM curve?
What theory is used to derive the LM curve?
Explain the Money Demand function.
Explain the Money Supply function.
Derive the LM curve.
Explain the reason for slope of the LM curve.
How does monetary policy affect the LM curve?
Explain equilibrium in the ISLM model. Explaining Fluctuations with ISLM
Model
Recall: Intersection of IS and LM curve
determines the level of national income. Shifts in IS or LM curve changes the SR
equilibrium in economy and national income
fluctuates. In this section, we examine how changes in
policy and shocks to the economy can
cause these curves to shift. Fiscal Policy in the ISLM Model
Fiscal Government can pursue a contractionary or
Government
an expansionary fiscal policy.
an An expansionary policy (increased G) will
An
cause:
cause:
the IS curve to shift to the right (upwards)
the
an increase in both income and interest rate. Expansionary Fiscal Policy
R 1. IS curve shifts
1. IS
right by 1
MLR LM ×∆
G causing Y to rise. R2 2. R1 2. Increased Y raises
2.
Md, causing R to
causing
rise.
rise. 3. Higher R reduces I and
3.
NX, so the final increase
in Y is smaller than
1
×∆
G
MLR 1. IS1
Y1 Y2 Y3
3. IS2
Y Fiscal Policy in the ISLM Model
Fiscal The crowdingout effect
The crowdingout effect
Reduction in private investment and net exports
Reduction
resulting from an increase in government spending.
resulting
When income increases the interest rate will
When
increase.
An increased interest rate causes firms to invest
An
less and net exports to fall.
less Fiscal Policy in the ISLM Model
Fiscal The crowdingout effect
The crowdingout effect
Reduction in private investment and net exports
Reduction
resulting from an increase in government
spending.
spending. ↑ G →↑ AE →↑ Y →↑ MD →↑ R →
↓ ( I , NX ) →↓ AE →↓ Y Monetary Policy in the ISLM Model
Monetary The monetary authority can pursue a
The
contractionary or an expansionary policy.
contractionary An expansionary policy (increased M) will cause:
(increased the LM curve to shift to the right (downwards)
the a decrease in interest rate and an increase income. Expansionary Monetary Policy
1. Increase in M shifts
1.
the LM curve to
LM
the right.
the R LM1
LM2 R1 2. The interest rate
2. The
falls.
3. This causes I and
This
NX to rise and
hence Y increases.
hence R2 IS
Y1 Y2 Y Monetary Policy in the ISLM Model
Monetary An expansionary monetary policy results
in a decrease in interest rate and an
increase in income.
increase ↑ MS →↓ R →↑ ( I , NX ) →↑ AE →↑ Y Monetary Policy Response to an
Expansionary Fiscal Policy
Expansionary Suppose government decides to increase G.
Suppose Possible responses by monetary authority:
1. Hold M constant
2. Hold R constant
3. Hold Y constant In each case, the effect of the ∆ G
In
is different: Response 1: Hold M constant
Response
R
If government raises G,
the IS curve shifts right.
IS
If BOJ holds M constant,
If LM1 R2
R1 IS2 the LM curve does not
LM
shift.
shift. IS1
Y1 Y2 Results: Y increases
R increases
increases Y Response 2: Hold R constant
R LM1 If government raises G,
If
the IS curve shifts right.
IS LM2 R2
R1 To keep R constant,
To
BOJ increases M
to shift LM curve right.
to
Results: Y increases
R is constant
is
No crowding out
No
because R is constant
because IS2 IS1
Y1 Y2 Y3 Y Response 3: Hold Y constant
Response
If government raises G,
If
the IS curve shifts
IS
right.
right.
To keep Y constant,
To
BOJ reduces M
to shift LM curve left.
LM
Results: R increases
Y is constant
is LM2
LM1 R
R3
R2
R1 IS2 IS1
Y1 Y2 Y Effectiveness of Fiscal and
Monetary Policy
Monetary By effectiveness we mean how much does income change
By
in response to a policy change.
in An effective fiscal policy means: A relatively small increase in G results in a large increase in Y
relatively
OR
OR A relatively small decrease in G results in a large decrease in Y
relatively An effective monetary policy means: A relatively small increase in M results in a large increase in Y
relatively
OR
OR A relatively small decrease in M results in a large decrease in Y
relatively Effectiveness of Fiscal Policy
Effectiveness Recall that the path of an expansionary fiscal policy is: ↑ G →↑ AE →↑ Y →↑ MD →↑ R →↓ ( I , NX ) →↓ AE →↓ Y If the multiplier is high Y will increase substantially when G
If
increases.
increases. If R increases significantly when Y increases (steeper MD and
LM curve) then Y would fall back significantly. Therefore, the
flatter the LM curve the more effective fiscal policy would be.
flatter The less responsive investment and net exports are to changes
The
in the interest rate (steeper IS) the less Y will fall when interest
rate increase. Therefore, the steeper the IS curve the more
effective fiscal policy will be.
effective Effectiveness of Fiscal Policy
Effectiveness
↑G →
↑Y, ↑R
Y,
Assume now a flatter LM curve
resulting from a flatter MD curve
resulting
Same results as above R LMS
LMF R2
R3 R1 IS2 ↑G → ↑Y, ↑R
Except that ↑Y is now more,
↑R is now less IS1
Y1 Y2 Y3 Y Effectiveness of Monetary Policy
Effectiveness Recall that the path of an expansionary monetary policy is: ↑ MS →↓ R →↑ ( I , NX ) →↑ AE →↑ Y ↓ R →↑ ( I , NX ) determines the slope of the IS curve.
IS The more responsive I and NX is to changes in the interest
rate the flatter the IS curve. Therefore, monetary policy is
IS
monetary
more effective when the IS curve is flatter.
more The steeper the LM curve (steeper MD curve) the more
The steeper
effective monetary policy will be. This is so because the
effective
expansion in money supply will lead to a greater decrease
in interest rate. Quick Quiz
Quick If the demand for money is independent of
If
the interest rate, is the LM curve vertical or
horizontal?
horizontal? Does an increase in the money supply have
Does
strong or weak effects when the LM curve is
steep than normal?
steep When it is flatter than normal? Shocks in the ISLM model Changes in fiscal and monetary policy shifts
the IS and LM curve respectively. Other disturbances which are exogenous to
the model can be grouped into two
categories: shocks to the IS and shocks to
the LM curve. Shocks in the IS LM model
IS
IS shocks: exogenous changes in the aggregate
exogenous
expenditure. This would affect the equilibrium in the
goods & services market .
Examples: Stock market boom or crash ⇒ change in households’ wealth
⇒ ∆ Ca
⇒∆ C Change in business or consumer
Change
confidence or expectations
⇒ ∆ Ia ⇒ ∆ I and/or
⇒ ∆ Ca ⇒ ∆ C Shocks in the IS LM model
IS
LM shocks: exogenous changes in the
exogenous
demand for money. This would affect the
equilibrium in the money market .
Examples:
Examples: Households lose confidence in financial
Households
institutions.
institutions.
⇒ rightward shift of the MD curve.
rightward households demand more money at all
households
interest rate ⇒ LM curve shifts left.
shifts Please Attempt Your
Problem Sets
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Full Document
 Fall '09
 GeorgiaMcleod
 Macroeconomics, Fiscal Policy, Monetary Policy, lm curve

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