Combined effect of both

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Combined effect of both

  1. 1. 9 1
  2. 2. Policy Analysis with the IS/LM Model A Closer Look at Monetary and Fiscal 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
  3. 3. Effects of Monetary and Fiscal Policy in the IS/LM Model 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
  4. 4. Fiscal Policy and Crowding Out 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. 4
  5. 5. Real Interest Rate (%) 1. The multiplier is 2 and government spending increases by $500, so the IS increases by $1000. 2. The increase in income increases money demand which increases interest rates from 4% to 5%. LM 3. The increase in the interest rate causes a decrease in investment so that the increase in income is only $600, less that the full multiplier effect. $1000 5% 4% IS1 IS0 $6000 $6600 $7000 Aggregate Output 5
  6. 6. Real Interest Rate (%) 1. The multiplier is 2 and government spending increases by $500, so the IS increases by $1000. LM 9% $1000 2. If the demand for money is totally insensitive to the interest rate, the interest rate increases from 4% to 9%. 3. The increase in the interest rate causes a decrease in investment that completely offsets the increase in government spending. 4% IS1 IS0 $6000 $7000 Aggregate Output 6
  7. 7. Ineffective Fiscal Policy 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
  8. 8. The IS-LM model shows that monetary policy influences income by changing the interest rate. supply raises income. But we didn’t discuss how a monetary expansion induces greater spending on goods and services—a process called the monetary transmission mechanism. The IS-LM model shows that an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services.
  9. 9. +∆ M Consider an increase in the money supply. r IS LM LM′ A B Y The LM curve shifts downward and lowers the interest rate which raises income. Why? Because when the Fed increases the supply of money, people have more money than they want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or use it to buy bonds. The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate, in turn, has ramifications for the goods market. A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income Y.
  10. 10. Real Interest Rate (%) The Fed increases the money supply which decreases interest rates and increases investment and output. LM0 LM1 r0 r1 IS Y0 Y1 Aggregate Output 10
  11. 11. Ineffective Monetary Policy 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. 11
  12. 12. 12
  13. 13. 13
  14. 14. Contractionary fiscal policy decreases interest rates and decreases output. LM1 LM0 r1 r0 Real Interest Rate (%) Real Interest Rate (%) Contractionary monetary policy raises interest rates and reduces output. LM r0 IS0 r2 IS Y1 Y0 Aggregate Output potential output IS1 Y1 Y0 Aggregate Output potential output 14
  15. 15. Real Interest Rate (%) 2. Accomodative monetary policy increases output even further and offsets the rise in interest rates. LM0 LM1 B • r1 r0 C • IS0 • IS1 1. Expansionary fiscal policy increases output and interest rates. A Y0 Y1 Y2 Aggregate Output 15
  16. 16. Real Interest Rate (%) 1. Contractionary monetary policy lowers output and increases interest rates. LM1 LM0 B • r1 A C r0 • • IS1 Y2 Y1 IS0 2. Contractionary fiscal policy further reduces output and offsets the increase in interest rates. Y0 Aggregate Output 16
  17. 17. Real Interest Rate (%) 2. Expansionary monetary policy further reduces the interest rate and offsets the decline in output. LM0 A • r0 B IS0 • r1 LM1 • C Y1 IS1 1. Contractionary fiscal policy lowers the interest rate and output. Aggregate Output 17
  18. 18. Real Interest Rate (%) 2. The Fed accomodated the expansionary fiscal policy to keep interest rates constant. LM1 LM0 r1 IS1 r0 1. Government increased defense expenditures during World War II. IS0 Y0= potential Y1 Y2 Aggregate Output 18
  19. 19. Real Interest Rate (%) LM1 LMo r1 The Fed uses contractionary monetary policy to fight inflation. IS0 r0 Y1= potential Y0 Aggregate Output 19
  20. 20. Real Interest Rate (%) 1. The Fed fought inflation by reducing the money supply. LM1 LM0 r2 r1 IS1 2. And government spending rose. r0 IS0 Y1 Y2 Y0 Aggregate Output 20
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  22. 22. You probably noticed from the IS and LM diagrams that r and Y were on the two axes. Now we’re going to bring a third variable, the price level (P) into the analysis. We can accomplish this by linking both two-dimensional graphs. LM(P2) To derive AD, start at point A in the top r IS LM(P1) graph. Now increase the price level from P1 to P2. B An increase in P lowers the value of real money A balances, and Y, shifting LM leftward to point B. Notice that r increased. Since r increased, we know Y that investment will decrease, as it just got more P costly to take on various investment projects. This B P2 sets off a multiplier process since -∆ I causes a –∆ Y A P1 The - ∆ Y triggers -∆ C as we move up the IS curve AD The +∆ P triggers a sequence of events that end Y with a -∆ Y, the inverse relationship that defines the downward slope of AD.
  23. 23. + ∆G Y = C (Y-T) + I(r) + G Suppose there is a +∆ G. This translates into a rightward shift of the IS and AD curves. r In the short run, we move along SRAS from point A to point B. But as the output market clears, in the long-run, the price level will increase from P0 to P2. This +∆ P decreases the value of real money P balances, which translates into a leftward shift of the LM curve. P2 P0 M/ P = L (r, Y) Finally, this leaves us at point C in both diagrams. LM (P2) LM(P0) IS IS´ C A B LRAS C B A Y SRAS A AD´ D Y
  24. 24. Remember that SR is the movement from A to B. Now it’s time to determine the effects on the variables in the economy. For the variables Y, P, and r, you can read the effects right off the diagrams Y +, because Y moved from Y* to Y´ P 0, because prices are sticky in the SR. r +, because a +∆ Y leads to a rise in r as IS slides along the LM curve. C +, because a +∆ Y increases the level of consumption (↑ C=C(↑ Y-T)). I – , since r increased, the level of investment decreased. r IS IS´ C P2 P0 LM(P0) B A P LM(P2) LRAS C A B Y SRAS AD´ AD Y* Y´ Y
  25. 25. or the variables Y, P, and r, you can read the effects right off the diagrams. Remember that LR is the movement from A to C. LM(P2) IS IS´ r LM(P0) C Y 0, because rising P shifts LM to left, returning Y to Y* as required by long-run LRAS. B A P +, in order to eliminate the excess demand at P . 0 r +, reflecting the leftward shift in LM due to +∆ P LRAS Y C 0, since both Y and T are back to their initial P levels (C=C(Y-T)) I – – , since r has risen even more due to the C P2 B +∆ P. SRAS P0 A A AD´ D Y* Y´ Y
  26. 26. Suppose there is a M/ P = L (r, Y) +∆ M. Look at the appropriate equation that that M/ was M term: Notice captures theincreased, thus increasing the value of the real mone supply which translates into a rightward shift of the LM and AD curves LM(P ) In the short run, we move along SRAS from r IS 0 LM′ point A to point B. A= C But as the output market clears, in the long run, B the price level will increase from P0 to P2. This +∆ P decreases the value of the real money supply which translates into a P leftward shift of the LM curve. P2 P0 M/ P = L (r, Y) Finally, this leaves us at point C in both diagrams. LRAS C A Y B SRAS AD´ AD Y
  27. 27. Remember that SR is the movement from A to B. Now it’s time to determine the effects on the variables in the economy. For the variables Y, P, and r, you can read the effects right off the diagrams Y +, because Y moved from Y* to Y´. P 0, because prices are sticky in the SR. r –, because a +∆ Y leads to a decrease in r as LM slides along the IS curve. C +, because a +∆ Y increases the level of consumption (↑C=C(↑ Y-T)). I + , since r increased, the level of investment decreased. r IS A= C (P2) LM (P0) LM ′ B P LRAS P2 P0 C A Y B SRAS AD´ AD Y* Y´ Y
  28. 28. Remember that LR is the movement from A to C. or the variables Y, P, and r, you can read the effects right off the diagrams. Y 0, because rising P shifts LM to left, returning r Y to Y* as required by LRAS. P +, in order to eliminate the excess demand at P . 0 r 0, reflecting the leftward shift in LM due to +∆ P, restoring r to its original level. C 0, since both Y and T are back to their initial levels (C=C(Y-T)). I 0, since Y or r has not changed. P Notice that the only LR impact of an increase in the money supply was an increase in the price level. P2 P0 IS A= C LM (P0) LM′ B LRAS C A Y B SRAS AD´ AD Y* Y´ Y
  29. 29. C • Β• Α • P P2 P0 Y = C (Y-T) + I(r) + G 2) This leads to a rightward shift in AD to AD’. Short Run: Move from A to B. Y Long Run: LRAS Market clears at P0 to P2 C • from B to C. 3) +∆ P causes LM(P0) to shift Α SRAS leftward to LM(P2) due to the • Β • lowering of the real value of the money supply. AD AD' M/ P = L (r, Y) Y LM IS LM(P2) 1) +∆ C causes the IS curve to shift LM(P0) right to IS‘. IS - r IS '
  30. 30. r IS LM(P2) LM(P0) IS' C • Β• Α• Short Run: Y P r C I Y P P2 C • P0 Α• Β• LRAS SRAS AD AD' Y Long Run: + 0 + + - 0 + ++ + --
  31. 31. The spending hypothesis suggests that perhaps the cause of the decline may have been a contractionary shift of the IS curve. The money hypothesis attempts to explain the effects of the historical fall of the money supply of 25 percent from 1929 to 1933, during which time unemployment rose from 3.2 percent to 25.2 percent. Some economists say that deflation worsened the Great Depression. They argue that the deflation may have turned what in 1931 was a typical economic downturn into an unprecedented period of high unemployment and depressed income. Because the falling money supply was possibly responsible for the falling price level, it could very well have been responsible for the severity of the depression. Let’s see how changes in the price level affect income in the IS-LM model.
  32. 32. A Mankiw A Mankiw Macroeconomics Macroeconomics Case Study Case Study The Financial Crisis and the Economic Downturn of 2008 and 2009 In 2008, the economy experienced a financial crisis stemming mainly from the 20% fall in housing prices across the nation. This had four main repercussions: 1) Rise in mortgage defaults and house foreclosures 2) Large losses at the various financial institutions that owned Mortgage-backed securities 3) Rise in stock market volatility, which led to a decline in consumer confidence In January 2009, President Barack Obama proposed to increase he proposed to increase government spending to stimulate AD.This is almost surely not going to prevent the economy from dipping further into a downward spiral.

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