23831448 Monetary Fiscal Policy is LM Macro 2008

8/8/2019 23831448 Monetary Fiscal Policy is LM Macro 2008

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Mathematical Derivations ofMathematical Derivations of

resultsresults

IS curve equation: Y =IS curve equation: Y = (A(A00 bi) bi)

where where is the multiplier alpha is the multiplier alphaLM: M/P = kY hiLM: M/P = kY hi

Solve for interest i and output YSolve for interest i and output Yin terms of A0 and M/P. Note againin terms of A0 and M/P. Note againthat government spending is a partthat government spending is a partof autonomous spending A0:of autonomous spending A0:

A0 = G + NX + IA0 = G + NX + I00 + cTR+ cTR

Solutions for Y and i:Solutions for Y and i:


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Solution for output and interestSolution for output and interest

raterate

Y =Y = A0 +A0 + (b/h) (M/P)(b/h) (M/P)

i = (k/h)i = (k/h) A0 (1/hA0 (1/h)) (M/P)(M/P)

WhereWhere = Keynesian multiplier = Keynesian multiplier

-------------------------------------------------------- [1 + k[1 + k. (b/h)]. (b/h)]

Obviously,Obviously, is the multiplier dY/dG in theis the multiplier dY/dG in theIS-LM model, and is less than IS-LM model, and is less than , the basic, the basic

Keynesian multiplier.Keynesian multiplier.


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Solution for OutputSolution for Output

The fiscal policy multiplier here is thenThe fiscal policy multiplier here is then

dY/dG =dY/dG = >> , the simple multipler, the simple multipler

Can see form the expression for gamaCan see form the expression for gama thatthat isis

large when h is large.large when h is large. In fact,In fact, == when h approaches infinity. Now,when h approaches infinity. Now,

h is the response of money demand to interesth is the response of money demand to interest

rates, and when h = infinity, the LM curve isrates, and when h = infinity, the LM curve is

horizontal.horizontal.


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Fiscal Policy MultiplierFiscal Policy Multiplier

When h = infinity, any interest rate riseWhen h = infinity, any interest rate rise

shifts demand completely away fromshifts demand completely away from

money; to compensate, to keep moneymoney; to compensate, to keep money

demand = supply along the LM curve,demand = supply along the LM curve,

output Y has to increase by a largeoutput Y has to increase by a large

amount. So, the LM curve is horizontal.amount. So, the LM curve is horizontal.

Then the multiplier is the simpleThen the multiplier is the simple

multiplier.multiplier.


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Multiplier: extra noteMultiplier: extra note

Note: in fact, with LM horizontal andNote: in fact, with LM horizontal and

interest rate unchanging, theinterest rate unchanging, the

aggregate demand curve can beaggregate demand curve can be

shown to be vertical as in the simpleshown to be vertical as in the simpleKeynesian model (next figure). ThisKeynesian model (next figure). This

is because when P changes, withis because when P changes, with

interest and income unchanged, theinterest and income unchanged, the

demand curve has to be traceddemand curve has to be traced

along an unchanged Y in the P-Yalong an unchanged Y in the P-Y

space.space.


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Supply-Demand: IS-LM with LMSupply-Demand: IS-LM with LM

horizontal = Simple Keynesianhorizontal = Simple Keynesian

figurefigure


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LM verticalLM vertical

A small value of h means that with moneyA small value of h means that with money

demand unchanged as interest changes, Y doesdemand unchanged as interest changes, Y does

not have to change to keep money supply =not have to change to keep money supply =

demand. So LM becomes vertical.demand. So LM becomes vertical.

Then , a shift in IS due to an increase in G has noThen , a shift in IS due to an increase in G has noeffect on output.effect on output. =0.=0.

So, fiscal policy is most effective in increasing YSo, fiscal policy is most effective in increasing Y

when LM is horizontal, ineffective when LM iswhen LM is horizontal, ineffective when LM is

vertical.vertical.


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Slope of IS and effectiveness ofSlope of IS and effectiveness of

fiscal policyfiscal policy

Note: slope of IS = dY/di = -Note: slope of IS = dY/di = -b.b.

So, large values of b makes IS flat.So, large values of b makes IS flat.

Also, from the expression for multiplierAlso, from the expression for multiplier

here,here, , large values of b will make it, large values of b will make it

smaller, Y rises little with increasedsmaller, Y rises little with increased

G.G.

Small values of b will make IS vertical,Small values of b will make IS vertical,increaseincrease , so output rises more with an, so output rises more with an

increase in G.increase in G.


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Vertical IS & Horizontal LMVertical IS & Horizontal LM

increase fiscal policyincrease fiscal policy

effectivenesseffectivenessWhat we have seen is that the effect of anWhat we have seen is that the effect of anincrease in government spending G onincrease in government spending G on

output Y is maximum when the IS curve isoutput Y is maximum when the IS curve is

vertical and the LM curve is horizontal.vertical and the LM curve is horizontal.

******Note:Note:A small value of k also increasesA small value of k also increases ..Then, as output increases money demandThen, as output increases money demand

increases little, requiring only a SMALLincreases little, requiring only a SMALL

increase in i to keep money supply =increase in i to keep money supply =

demand (= horizontal LM)demand (= horizontal LM)


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Intuitive explanationIntuitive explanation

LM horizontal: an increase in GLM horizontal: an increase in Gincreases the interest rate by very little.increases the interest rate by very little.So, investment is not reduced much (aSo, investment is not reduced much (alarge reduction in investment will worklarge reduction in investment will work

to nullify the initial positive effect of theto nullify the initial positive effect of thegovt. spending increase on output.govt. spending increase on output.

* Vertical IS: the elasticity of investment* Vertical IS: the elasticity of investment(reduction here) with respect to i is(reduction here) with respect to i is

very low, the fall in investment is notvery low, the fall in investment is notmuch.much.


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Monetary Policy EffectivenessMonetary Policy Effectiveness

Soln for Y: Y =Soln for Y: Y = A0 +A0 + (b/h). (M/P)(b/h). (M/P)

Monetary policy multiplier ( the effect of aMonetary policy multiplier ( the effect of a

change in M/P on Y) =change in M/P on Y) = .( b/h) = b.( b/h) = b //

(h + kb(h + kb))Large values of b and Large values of b and which mean a which mean a

FLAT IS curve increase this multiplier.FLAT IS curve increase this multiplier.

Small values of h and a large value of kSmall values of h and a large value of k

- which mean a- which mean a steep LMsteep LM increase the increase themultipliermultiplier


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Horizontal IS and vertical LMHorizontal IS and vertical LM

increase Mon.policy multiplier:increase Mon.policy multiplier:

intuition:intuition:A vertical LM reduces the interestA vertical LM reduces the interestrate a lot as the LM shifts rightrate a lot as the LM shifts rightwith an increase in money supply.with an increase in money supply.

(Note that di/d(M/P)= k/h)(Note that di/d(M/P)= k/h)

A horizontal IS means that withA horizontal IS means that with

this fall I interest rate, there is athis fall I interest rate, there is alarge increase in investment andlarge increase in investment andthus in output.thus in output.


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Getting the Aggregate DemandGetting the Aggregate Demand

Curve from IS and LM curvesCurve from IS and LM curves

From the IS LM curves, we can get theFrom the IS LM curves, we can get the

effects of government spending or centraleffects of government spending or central

bank money supply change policies,bank money supply change policies,

An increase in govt. spending or a tax cutAn increase in govt. spending or a tax cut

shifts the IS curve to the right, increasingshifts the IS curve to the right, increasing

output and interest rates. An increase inoutput and interest rates. An increase in

the money supply say, by an open marketthe money supply say, by an open market

operation shifts the LM right, increasingoperation shifts the LM right, increasing

output and lowering interest.output and lowering interest.


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The Demand curve.The Demand curve.

But we need the demand curve toBut we need the demand curve to

get the price effects -when supplyget the price effects -when supply

curve slopes upcurve slopes up

The demand curve is obtained byThe demand curve is obtained by

COMBINING the IS and LM curves.COMBINING the IS and LM curves.

See figure (10-13) in the book.See figure (10-13) in the book.


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IS-LM and AD (demand)IS-LM and AD (demand)

curvescurves


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The AD curveThe AD curve

When the price rises from P1 to P2, theWhen the price rises from P1 to P2, the

LM curve shifts left since real moneyLM curve shifts left since real money

supply M/P has fallen. Output falls, Y1 tosupply M/P has fallen. Output falls, Y1 to

Y2, interest rises from i1 to i2. (Fall in PY2, interest rises from i1 to i2. (Fall in P

shifts LM right)shifts LM right)

In the bottom P-Y figure (supply-In the bottom P-Y figure (supply-

demand), mark out Y1. Y2 is droppeddemand), mark out Y1. Y2 is dropped

down from the figure above, to meet thedown from the figure above, to meet thenew value P2 for the price. So we nownew value P2 for the price. So we now

have two points for the AD curve.have two points for the AD curve.


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Shits and movements ALONGShits and movements ALONG

ADADBy the way, note that when P risesBy the way, note that when P rises

and M/P falls, the LM curve shits left,and M/P falls, the LM curve shits left,and the movement is along the ADand the movement is along the AD

curve since P is on one of the axes.curve since P is on one of the axes.

But when M falls and M/P falls, LMBut when M falls and M/P falls, LMshifts left, andshifts left, and the AD curve will shiftthe AD curve will shiftleftleft, to give the new Y on the X axis, to give the new Y on the X axis

in the P-Y diagram. This is becausein the P-Y diagram. This is becauseM is not on any of the axes.M is not on any of the axes.


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The AD curve.The AD curve.

So, the AD curve is got by drawing LM along theSo, the AD curve is got by drawing LM along the

length of the IS curve.length of the IS curve.

Intuitively: when price rises, the interest rateIntuitively: when price rises, the interest rate

has to rise to balance the money market sincehas to rise to balance the money market since

real money supply has fallen, and money demandreal money supply has fallen, and money demandhas to fall. When interest falls, investment fallshas to fall. When interest falls, investment falls

and Y falls. So, the piece and output Y areand Y falls. So, the piece and output Y are

negatively related, AD has a negative slope.negatively related, AD has a negative slope.


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AD curve as a mathematicalAD curve as a mathematical

solution for the IS-LM system:solution for the IS-LM system:

The schedule for the AD curve is theThe schedule for the AD curve is thesolution we got earlier in this PPP forsolution we got earlier in this PPP foroutput Y, from the IS and LM curveoutput Y, from the IS and LM curvefunctions:functions:

Y =Y = AA00 ++ (b/h) (M/P)(b/h) (M/P)

We can see from this solution thatWe can see from this solution that Y andY andP are inversely related, thusP are inversely related, thus

giving the negative slope for thegiving the negative slope for theAD curve in the P-Y space.AD curve in the P-Y space.


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Fiscal and monetary policies inFiscal and monetary policies in

the supply-demand diagramthe supply-demand diagram Initial shift = basic multiplier effect. FinalInitial shift = basic multiplier effect. Final

effect on Y is less due to interest rate rise andeffect on Y is less due to interest rate rise andinvestment reductioninvestment reduction

Look at the figure next page. IncreasedLook at the figure next page. Increased

government spending shifts the iS curve to thegovernment spending shifts the iS curve to theright byright by .dG = E3-E1. At unchanged interest,.dG = E3-E1. At unchanged interest,E3 will be the new equilibrium, with Y3 theE3 will be the new equilibrium, with Y3 thenew output level. But, interest rises (alongnew output level. But, interest rises (alongLM) as Y rises, increasing money demand, andLM) as Y rises, increasing money demand, andthe final equilibrium is E2, with correspondingthe final equilibrium is E2, with corresponding

Y2.Y2.


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Fiscal policy effect diagramFiscal policy effect diagram


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Fiscal Policy diagramFiscal Policy diagram

In the lower panel, the AD curve shiftIn the lower panel, the AD curve shift

corresponds to the increase Y2-Y1 in thecorresponds to the increase Y2-Y1 in the

diagram above, and to the multiplierdiagram above, and to the multiplier

effecteffect .dG


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Crowding outCrowding out

The rise in interest rates with fiscalThe rise in interest rates with fiscal

expansion, and the ensuing reductionexpansion, and the ensuing reduction

in investment is called Crowdingin investment is called Crowding

out of private investment. So,out of private investment. So,government sector expansion crowdsgovernment sector expansion crowds

out private investment.out private investment.

Crowding out is maximum, complete,Crowding out is maximum, complete,when the LM is vertical.when the LM is vertical.


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Monetary policy in figuresMonetary policy in figures


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Monetary policy figure.Monetary policy figure.

The LM curve shifts to the right by (1/k)(dM/P)The LM curve shifts to the right by (1/k)(dM/P)

due to the money supply increase. The shift isdue to the money supply increase. The shift is

obtained from the money supply equilibriumobtained from the money supply equilibrium

condition. The new equilibrium is at E2, with acondition. The new equilibrium is at E2, with a

lower interest and an output levellower interest and an output levelcorresponding to the monetary policy multipliercorresponding to the monetary policy multiplier

here , not equal to initial LM shift. In the lowerhere , not equal to initial LM shift. In the lower

panel, the AD curve shifts to the right to givepanel, the AD curve shifts to the right to give

Y2 as the new output level.Y2 as the new output level.


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Mon.policy in figuresMon.policy in figures

Clearly, the LM shift due toClearly, the LM shift due tomoney supply expansion givesmoney supply expansion givesno output increase if the IS isno output increase if the IS isvertical. Then, the fall in interestvertical. Then, the fall in interesthashasno effect in increasingno effect in increasinginvestmentinvestment and so outputand so output..

Liquidity trap:Liquidity trap: if LM is horizontalif LM is horizontal,,which is usually at very low interestwhich is usually at very low interestrates, an increase in money supplyrates, an increase in money supplyhas no effect on the interest ratehas no effect on the interest rate;;

mon.policy is ineffectivemon.policy is ineffective..


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Mon. policy transmission to realMon. policy transmission to real

economy: when can it fail?economy: when can it fail?

Monetary policy works as follows:Monetary policy works as follows:

M increaseM increase interest rate fallsinterest rate falls moremore

lending and borrowing for investinglending and borrowing for investing moremore

investmentinvestment output risesoutput risesThis linkage can be broken a) because withThis linkage can be broken a) because with

low interest rates, the interest does not falllow interest rates, the interest does not fall

(no further demand for bonds, which raise(no further demand for bonds, which raise

their price, lower interest)their price, lower interest)


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Breaks in mon.policy chainBreaks in mon.policy chain

b) because banks mayb) because banks may

not lend more, due tonot lend more, due to

bank crises or badbank crises or bad

reputation of risky reputation of risky borrowers c) borrowersborrowers c) borrowers

may not borrow more duemay not borrow more due

to bad prospects for theto bad prospects for theeconomy and for profitseconomy and for profits


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Comparing effectiveness of fiscalComparing effectiveness of fiscal

and monetary policies: Intuitionand monetary policies: Intuition

Fiscal policy is effectiveFiscal policy is effective when IS is vertical,when IS is vertical,

LM horizontal. i.e., a) when investmentLM horizontal. i.e., a) when investment

responds very little to changes in interestresponds very little to changes in interest

(so does not fall when interest rises) b)(so does not fall when interest rises) b)

interest rate does not rise with an increaseinterest rate does not rise with an increasein government spending.in government spending. These conditionsThese conditions

may be present in developing countries withmay be present in developing countries withundeveloped financial markets (and fewundeveloped financial markets (and few

investment opportunities)investment opportunities)


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Policy effectiveness intuitionPolicy effectiveness intuition

Monetary policy is effective a) when LM is vertical, b) ISMonetary policy is effective a) when LM is vertical, b) IS

horizontal. b) means that investment should rise a lot whenhorizontal. b) means that investment should rise a lot when

interest falls. a) means demand for money is not responsiveinterest falls. a) means demand for money is not responsive

to interest rates ( a large rise in i is needed to neutralizeto interest rates ( a large rise in i is needed to neutralize

the money demand effect of a Y rise). This is usually atthe money demand effect of a Y rise). This is usually at

high Y and with financial markets where investmenthigh Y and with financial markets where investmentopportunities have been exhausted corresponds toopportunities have been exhausted corresponds to

developed countries in boom conditions.developed countries in boom conditions.


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Note:Note:

Note that for the same country, LM isNote that for the same country, LM is

more horizontal at low income levelsmore horizontal at low income levels

with low interest rates and more with low interest rates and more

vertical at high income levels andvertical at high income levels andboom conditions. So, in boomboom conditions. So, in boom

conditions, monetary policy tends toconditions, monetary policy tends to

be more effective.be more effective.


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Policy MixPolicy Mix

One way in which fiscal expansionOne way in which fiscal expansion

need not crowd out investment is ifneed not crowd out investment is if

the expansion is in the form of anthe expansion is in the form of an

investment subsidy to privateinvestment subsidy to privatesectors. Then, IS does shift right duesectors. Then, IS does shift right due

to an increase in Ito an increase in I00 (investment(investmentnotnot

dependent ion i), but this need notdependent ion i), but this need notreverse the original increase inreverse the original increase in

investment due to the subsidy.investment due to the subsidy.


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Whom does the Policy mixWhom does the Policy mix

benefit?benefit?

Policies expanding the govt. sector: a) taX-Policies expanding the govt. sector: a) taX-

financed increases in govt. spending; b)financed increases in govt. spending; b)

employer of last resort (providing employment toemployer of last resort (providing employment to

unemployed or to one in every unemployedunemployed or to one in every unemployed

family)family)Policies favoring private sector: tax cuts, moneyPolicies favoring private sector: tax cuts, money

supply increases (though resulting inflation hurtssupply increases (though resulting inflation hurts

private sector), investment subsidies;private sector), investment subsidies;

sometimes devaluation also.sometimes devaluation also.


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Policy mix..Policy mix..

Policies favoring consumption:Policies favoring consumption:

tax cut, govt. spending increase,tax cut, govt. spending increase,

especially by hiring labor.especially by hiring labor.

Policies favoring investment:Policies favoring investment:

money supply increase,money supply increase,

investment subsidiesinvestment subsidies..


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Policy Mix examples:Policy Mix examples:

Tight money and easy fiscal policy mix: in aTight money and easy fiscal policy mix: in a

period of high inflation, reducing moneyperiod of high inflation, reducing money

supply can bring down inflation especially ifsupply can bring down inflation especially if

people believe this policy will continue. Butpeople believe this policy will continue. But

this tends to reduce output and employment;this tends to reduce output and employment;

to keep up output and employment, fiscalto keep up output and employment, fiscal

policy can be expansionary a tax cut orpolicy can be expansionary a tax cut or

increase in G. But this drives up interestincrease in G. But this drives up interest

rates.rates.


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Policy mix examplesPolicy mix examples

Tight money, easy fiscal (expansion)Tight money, easy fiscal (expansion)

policy drives up interest rates, evenpolicy drives up interest rates, even

though inflation is reduced, hurtsthough inflation is reduced, hurts

investment. This can be tackled byinvestment. This can be tackled byinvestment subsidies. But one limitationinvestment subsidies. But one limitation

is the govt. deficit situation, which feedsis the govt. deficit situation, which feeds

into the external deficit as well. Oneinto the external deficit as well. One

example of this policy is the US policyexample of this policy is the US policymix to come out of the 1980s recession.mix to come out of the 1980s recession.


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Tight money, easy fiscalTight money, easy fiscal

The German policy mix at the time of theThe German policy mix at the time of the

German reunification was also of thisGerman reunification was also of this

kind. Resulting highe interest rateskind. Resulting highe interest rates

affected investment in Germany and restaffected investment in Germany and restof Europe with some countries optingof Europe with some countries opting

out of the exchange rate arrangement,out of the exchange rate arrangement,

unable to maintain their rates againstunable to maintain their rates against

the mark. (see chapter later on exchangethe mark. (see chapter later on exchangerates and the open economy).rates and the open economy).


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Easy money, tight fiscalEasy money, tight fiscal

As we saw earlier, easy fiscal policyAs we saw earlier, easy fiscal policy

meets up with a constraint on the govt.meets up with a constraint on the govt.

budget deficit level. If inflation is not abudget deficit level. If inflation is not a

pressing problem, recession can bepressing problem, recession can befought by an increase in money supplyfought by an increase in money supply

and a fall in interest rates. Govt.and a fall in interest rates. Govt.

spending can be controlled then to keepspending can be controlled then to keep

the govt. budget deficit low. Example USthe govt. budget deficit low. Example USrecession and policies, early 1990s.recession and policies, early 1990s.


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Constraints on policyConstraints on policy

Expansionary govt. policies whichExpansionary govt. policies which

move out the demand curve canmove out the demand curve can

increase employment and output increase employment and output

but at the cost of inflation,but at the cost of inflation,sometimes private investment, andsometimes private investment, and

of higher external deficit (remember:of higher external deficit (remember:

when priv. sector saving =when priv. sector saving =investment, an increase in govt.investment, an increase in govt.

deficit creates an equal trade deficit).deficit creates an equal trade deficit).


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Technological advancementsTechnological advancements

However, technology improvementHowever, technology improvement

which shifts out the supply curvewhich shifts out the supply curve

(drawn sloping in the figure next(drawn sloping in the figure next

page) can increase output whilepage) can increase output whilereducing inflation. In fact, when thereducing inflation. In fact, when the

technological advance increasestechnological advance increases

labor productivity, this scenario islabor productivity, this scenario is

consistent also with an increase inconsistent also with an increase inreal wages of labor.real wages of labor.


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Technology improvement :Technology improvement :

diagramdiagram


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Consumption and InvestmentConsumption and Investment

DemandDemand

The specifications of consumption andThe specifications of consumption and

demand in the models discussed so fardemand in the models discussed so far

are rudimentary.are rudimentary.

Ch 11B indicates some more completeCh 11B indicates some more complete

specifications for consumption andspecifications for consumption and

investment demand.investment demand.GO TO CH 11B now!GO TO CH 11B now!

23831448 Monetary Fiscal Policy is LM Macro 2008

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