   A Closer Look at Policy    • Fiscal Policy and Crowding Out    • Monetary Policy and the Liquidity Trap   Real World ...
   Fiscal Policy    • Expansionary fiscal policy shifts the IS      curve to the right    • Contractionary fiscal policy ...
1. The multiplier is 2 andgovernment spending increases by                          2. The increase in income$500, so the ...
   When government expenditures increase,    output and income begin to increase.   The increase in income increases the...
1. The multiplier is 2 andgovernment spending increases by$500, so the IS increases by $1000.       2. If the demand for m...
   When complete crowding out    occurs, fiscal policy is ineffective,    changing only interest rates, not    output.  ...
The Fed increases the                                                In a liquidity trap, increases                       ...
   Investment is not sensitive to the    interest rate    • If investment does not respond to interest     rate changes (...
   Interpretation Problems (what is    happening?)    • Problems in knowing how to interpret     real-world events within...
   Interest Rate Problem   Credit Conditions Problems   Budget Problems    • Cyclical and Structural Problems    • Acco...
   Which interest rate, nominal or    real, is relevant?   Which of many interest rates in the    economy is relevant?  ...
   Default risk    • Interest rates differ according to the      likelihood that the borrower will repay the      loan. ...
6                                             6           5.5                                           5.5           5   ...
   The IS-LM model assumes that interest    rates are the only determinant of    investment.   Investment may also depen...
   The structural budget surplus or deficit is    the fiscal budget balance that would exist    when the economy is at po...
   Uncertainty about Potential    Output   Information Lag   Policy Implementation Lag
   One macroeconomic policy goal is to    keep output as close to potential as    possible. But, what is potential output...
   The IS-LM model assumes that    policymakers see what is happening in    the economy and can instantly alter    polici...
   The policy implementation lag: the delay    between the time policymakers recognize the    need for a policy action an...
06 isl mpolicy
06 isl mpolicy
06 isl mpolicy
06 isl mpolicy
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06 isl mpolicy

  1. 1.  A Closer Look at Policy • Fiscal Policy and Crowding Out • Monetary Policy and the Liquidity Trap Real World Monetary and Fiscal Policy Problems of Using IS-LM in the Real World • Interpretation Problems • Implementation Problems
  2. 2.  Fiscal Policy • Expansionary fiscal policy shifts the IS curve to the right • Contractionary fiscal policy shifts the IS curve to the left Monetary Policy • Expansionary monetary policy shifts the LM curve to the right • Contractionary monetary policy shifts the LM curve to the left
  3. 3. 1. The multiplier is 2 andgovernment spending increases by 2. The increase in income$500, so the IS increases by $1000. increases money demand which increases interest LM Real Interest Rate (%) rates from 4% to 5%. $1000 3. The increase in the interest rate causes a decrease in investment so that the increase 5% in income is only $600, less that the full multiplier effect. 4% IS1 IS0 $6000 $6600 $7000 Aggregate Output
  4. 4.  When government expenditures increase, output and income begin to increase. The increase in income increases the demand for money. The increase in money demand increases the interest rate. Higher interest rates cause a decrease in investment, offsetting some of the expansionary effect of the increase in government spending.
  5. 5. 1. The multiplier is 2 andgovernment spending increases by$500, so the IS increases by $1000. 2. If the demand for money is totally insensitive to the interest rate, the interest rateReal Interest Rate (%) LM increases from 4% to 9%. 9% 3. The increase in the interest rate causes a decrease in investment that completely offsets the increase in government spending. $1000 4% IS1 IS0 $6000 $7000 Aggregate Output
  6. 6.  When complete crowding out occurs, fiscal policy is ineffective, changing only interest rates, not output. Crowding out is greater if: • Money demand is very sensitive to income changes • Money demand is not very sensitive to interest rate changes
  7. 7. The Fed increases the In a liquidity trap, increases money supply which in the money supply do not decreases interest rates decrease interest rates, so and increases investment investment and output doReal Interest Rate (%) Real Interest Rate (%) and output. not increase. LM0 LM0 LM1 LM1 r0 r0 r1 IS IS Y0 Y1 Y0 Aggregate Output Aggregate Output
  8. 8.  Investment is not sensitive to the interest rate • If investment does not respond to interest rate changes (the IS curve is steep), monetary policy in ineffective in changing output. Liquidity trap • If increases in the money supply fail to lower interest rates, monetary policy is ineffective in increasing output.
  9. 9.  Interpretation Problems (what is happening?) • Problems in knowing how to interpret real-world events within the IS-LM framework Implementation Problems (how to deal with it?) • Problems encountered in undertaking policy
  10. 10.  Interest Rate Problem Credit Conditions Problems Budget Problems • Cyclical and Structural Problems • Accounting Methods
  11. 11.  Which interest rate, nominal or real, is relevant? Which of many interest rates in the economy is relevant? • The Federal funds rate? • The interest rate households and businesses pay to borrow money?
  12. 12.  Default risk • Interest rates differ according to the likelihood that the borrower will repay the loan. Term to Maturity • The longer the term to maturity, the higher the interest rate that is paid because  Bonds with longer maturities are less liquid  Differences in expected inflation  More uncertainty
  13. 13. 6 6 5.5 5.5 5 5Yield(%) Yield(%) 4.5 4.5 4 4 3.5 3.5 3 6 1 2 5 10 30 3 6 1 2 5 10 30 mos. yr. Maturities mos. yr. Maturities
  14. 14.  The IS-LM model assumes that interest rates are the only determinant of investment. Investment may also depends on credit conditions, the willingness of banks to lend independent of interest rates. If banks raise their lending standards, investment may not respond to expansionary monetary policy. Mexico after 1994, Japan in the 90s.
  15. 15.  The structural budget surplus or deficit is the fiscal budget balance that would exist when the economy is at potential output. The cyclical budget surplus or deficit is that portion of the fiscal budget balance that exists because output is above or below potential output.
  16. 16.  Uncertainty about Potential Output Information Lag Policy Implementation Lag
  17. 17.  One macroeconomic policy goal is to keep output as close to potential as possible. But, what is potential output? If policymakers use contractionary policy when the economy is actually below potential, they create ‘unnecessary’ unemployment. Using expansionary policy above potential output will cause inflation.
  18. 18.  The IS-LM model assumes that policymakers see what is happening in the economy and can instantly alter policies to fix any problem. In the real world there is an information lag, a delay between a change in the economy and knowledge of that change. • Example: are we in a recession or a boom right now?
  19. 19.  The policy implementation lag: the delay between the time policymakers recognize the need for a policy action and when the policy is actually instituted. U.S. fiscal policy has a large implementation lag because policy must be formulated and legislation passed by Congress and signed by the President. Monetary policy has a much shorter implementation lag because the Federal Open Market Committee decides monetary policy and implements it immediately.

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