Policy Analysis with the IS/LM Model Notes- Part C

Policy Analysis with the IS/LM Model

Policy When the Economy is Above Potential

• Contractionary Fiscal Policy:
  • Decreases interest rates and decreases output.
• Contractionary Monetary Policy:
  • Raises interest rates and reduces output.
• Diagram:
  • Two graphs illustrating the effects of contractionary fiscal and monetary policies on aggregate output (Y) and real interest rate (%).
  • Graph 1 (Contractionary Fiscal Policy):
    • Initial equilibrium: $Y<em>0$, $r</em>0$ (IS0, LM)
    • Potential output: $Y_1$
    • After contractionary fiscal policy: $Y<em>2$, $r</em>2$ (IS1)
  • Graph 2 (Contractionary Monetary Policy):
    • Initial equilibrium: $Y<em>0$, $r</em>0$ (IS, LM0)
    • Potential output: $Y_1$
    • After contractionary monetary policy: $Y<em>2$, $r</em>1$ (LM1)

Accommodative Monetary Policy

• Expansionary fiscal policy increases output and interest rates.
• Accommodative monetary policy further increases output and offsets the rise in interest rates.
• Diagram:
  • Initial equilibrium: $Y<em>0$, $r</em>0$ (IS0, LM0)
  • Expansionary fiscal policy: $Y<em>1$, $r</em>1$ (IS1)
  • Accommodative monetary policy: $Y<em>2$, with interest rates potentially returning to near $r</em>0$ (LM1)
  • Points A, B, and C represent the shifts in equilibrium.

Accommodative Fiscal Policy

• Contractionary monetary policy lowers output and increases interest rates.
• Contractionary fiscal policy further reduces output and offsets the increase in interest rates.
• Diagram:
  • Initial equilibrium: $Y<em>0$, $r</em>0$ (IS0, LM0)
  • Contractionary monetary policy: $Y<em>1$, $r</em>1$ (LM1)
  • Accommodative fiscal policy: $Y<em>2$, with interest rates potentially returning to near $r</em>0$ (IS1)
  • Points A, B, and C represent the shifts in equilibrium.

Offsetting Policies

• Contractionary fiscal policy lowers the interest rate and output.
• Expansionary monetary policy further reduces the interest rate and offsets the decline in output.
• Diagram:
  • Initial equilibrium: $Y<em>0$, $r</em>0$ (IS0, LM0)
  • Contractionary fiscal policy: $Y<em>1$, $r</em>1$ (IS1)
  • Expansionary monetary policy shifts LM: The new equilibrium moves towards the original output level but at an even lower interest rate (LM1).
  • Points A, B, and C represent the shifts in equilibrium.

Reaction to Fiscal Policy

• Government increases expenditure leading to excess demand. Output rises and income rises.
• As Y rises, $M<em>d$ (money demand) increases leading to higher i (interest rate) so long as $M</em>s$ (money supply) is constant. Economy moves towards new equilibrium.
• Diagram:
  • Initial equilibrium: $Y<em>0$, $r</em>0$ (IS0, LM0)
  • Government increases expenditure: IS shifts right (IS1)
  • The economy moves from A to B to C towards a new equilibrium at $Y<em>1$, $r</em>1$.

Reaction to Monetary Policy

• Central Bank increases $M_s$. i falls to B. Monetary sector is in equilibrium, but not the goods & services sector. Economy moves from A to B.
• Fall in i creates excess demand for goods and services. Output rises, income rises, $M_d$ rises, i rises. Economy moves from B to C to D.
• Diagram:
  • Initial equilibrium: $Y<em>0$, $r</em>0$ (IS0, LM0)
  • Central Bank increases $M_s$: LM shifts right (LM1)
  • The economy moves from A to B to C to D, illustrating the adjustment process towards a new equilibrium.

Sudden Increase in Demand for Cash

• Scenario: Everyone suddenly becomes less secure, wanting to keep extra cash on hand.
• Diagram:
  • Initial equilibrium: $Y<em>0$, $r</em>0$ (IS0, LM0)
  • Increase in demand for cash: LM shifts left (LM1), leading to a new equilibrium at $Y<em>1$, $r</em>1$.

Policy Tools and Exogenous Shocks

• Monetary authorities have a choice between two policy tools:
  1. Keep the money supply constant.
  2. Adjust the money supply so as to keep the interest rate constant.
• Questions:
  • Under which rule would exogenous shocks affecting the expenditure sector lead to the smallest fluctuations in income?
  • Under which rule would exogenous shocks affecting the monetary sector lead to the smallest fluctuations in income?

Random Shocks in AD (Aggregate Demand)

• Diagram:
  • Multiple IS curves (IS0, IS1, IS2) showing random shocks in AD.
  • LM curve remains constant.
  • Equilibrium points and corresponding output levels (Y0, Y1, Y2, Y3, Y4) vary depending on the IS curve.

Conclusion (Random Shocks in AD)

• Keeping the interest rate constant gives larger fluctuations in income when the economy is hit by random shocks in AD.
• In contrast, keeping the money supply constant gives smaller fluctuations in income.
• A better alternative would be to increase $M_s$ when IS shifts left and vice versa.

Random Shocks in $M_d$ (Money Demand)

• Diagram:
  • Multiple LM curves showing random shocks in $M_d$.
  • IS curve remains constant.
  • Equilibrium points and corresponding output levels (Y0, Y1, Y2, Y3, Y4) vary depending on the LM curve.

Conclusion (Random Shocks in $M_d$)

• Keeping the interest rate constant gives smaller fluctuations in income when the economy is hit by random shocks in the monetary sector.
• In contrast, keeping the money supply constant gives larger fluctuations in income.

Flows versus Stocks

• Flow Variable:
  • Measures something occurring per unit of time. Example: income.
• Stock Variable:
  • Measures something at a point in time. Example: supply of money.
• Flow variables can affect the size of stock variables over time, thereby potentially affecting the economy.

Flows versus Stocks: Government Spending and Bonds

• Statement: Because most government spending is a flow, an increase in this flow financed by selling bonds implies that bonds must be sold in every succeeding period to finance this increase in government spending.
  • Answer: True.
• Question: Does the preceding result mean that the interest rate must rise in every succeeding period?
  • Answer: No.
• Explanation: The higher interest rate has diverted more funds from private savings to government expenditure (crowding-out).
• Diagram: An increase in government spending financed by selling bonds results in the IS curve shifting to the right, increasing both Y and i.
  • IS curve shifting to the right: IS1 to IS2.
  • Crowding out is occurring.
  • LM curve held constant.

Financing Government Spending: Taxes & Printing Money

• Diagram: An increase in government spending financed by raising taxes.
  • The tax hike shifts the IS curve to the left, partially offsetting its shift to the right caused by the increase in government spending.
  • LM is held constant.
  • IS curve shifts to the right: IS1. Then to the left: IS2.
• Question: If the increased spending is financed by printing money, does this mean that more money must be printed in each time period?
  • Answer: Yes.
• However, the increased tax revenue will reduce the amount of money needed to be printed in each succeeding period.
• Diagram: Financing an increase in Government spending by printing money results in both IS and LM curves shifting.
  • Both shifting to the right.