LECTURE 2 MONETARY AND FISCAL POLICIES IN ISLM MODEL Factors Causing the IS Curve to Shift • Changes in autonomous consumer expenditure • Changes in investment spending unrelated to interest rate • Changes in government expenditure • Changes in taxation • Changes in net exports unrelated to interest rate Factors Causing LM Curve to Shift • Changes in money supply • Autonomous changes in money demand Two Stylized Facts • An increase in money supply will cause an outward shift of the LM curve leading to an increase in output and a fall in the interest rate. A decline in money supply would do the opposite. Thus, aggregate output is positively related to the money supply. • An increase in government expenditure or a decrease in taxes will cause the IS curve to shift outward causing output and interest rate to rise. A decrease in government expenditure or an increase in taxes would do the opposite. Hence, aggregate output is positively related to government spending and negatively related to taxes. Notice the difference in the response of interest rate under both policies. The outward shift of LM curve and the attendant fall in interest rate under monetary policy are the logical consequences of the increase in money supply. Under fiscal policy however, the increase in government spending or decrease in taxes makes more income available for spending and thus raises aggregate demand and by extension, aggregate output. The rise in output increases the demand for money creating excess demand for money which can only be eliminated by a rise in the interest rate. Exercise: trace out graphically, the responses of output and interest rate to the changes in monetary policy and fiscal policy. Effectiveness of Monetary Versus Fiscal Policy • Under what condition would the authorities prefer one policy to another in eliminating unemployment? Let’s consider a special kind of situation in which the demand for money is insensitive to changes in interest rate. In that case, the LM curve would be vertical. Plane (a) of figure 5 depicts the case of response to expansionary fiscal policy while plane (b) describes the situation of expansionary monetary policy. Figure 5: Responses to Expansionary Policies Interest Rate, r LM r2 -----------------------2 r1 ----------------------- 1 IS2 IS1 Y1 Aggregate Output, Y (a) Expansionary Fiscal Policy Interest Rate, r LM1 LM2 r1 ------------------------ 1 r2 ---------------------------------- 2 IS Y1 Y2 Aggregate Output, Y (a) Expansionary Monetary Policy • In plane (a), the increase in government spending or reduction in taxes shifts the IS curve to the right (IS2) causing interest rate to rise from r1 to r2 but output remains unchanged. The difference with our earlier stylized fact which suggested that output would rise with expansionary fiscal policy is explained by the interest inelastic LM curve. Given that the LM curve is vertical, the rise in interest rate crowds out private investment and net exports, leaving output unchanged. This is a case of complete crowding out. • For contrast, in plane (b), the expansionary monetary policy cause the rightward shift of the LM curve to LM2 causing the rate of interest to fall from r1 to r2. Output rises to Y2 from Y1 because at every lower rate of interest, output must increase for the demand for money to rise to match the increase in the supply of money. Thus, monetary policy is effective at generating output growth while fiscal policy is not. The general maxim associated with this comparison is, the less interest sensitive the money demand is, the more effective is monetary policy relative to fiscal policy. • Application of ISLM in Policy Targeting • Disappointment with monetary targeting (a policy by which central bank targets a defined level of monetary aggregate using its instruments) in the 1970s and 1980s influenced a policy shift to interest rate targeting. ISLM could help us understand the reasons behind the policy choice. Given that monetary authority cannot use money supply and interest rate simultaneously, a choice between the two has to be made. The general maxim is, when the IS curve is more unstable than the LM curve, a money supply target will give a more credible result and vice versa for an interest rate targeting option. Note: unlike the textbook assumption of fixed price level, in the real world, the IS and LM curves could fluctuate pronouncedly due to uncertainty resulting from unanticipated changes in autonomous spending and money demand respectively. Figure 6: Relative Instability in IS and LM curves (a) When the Goods Market is Relatively Unstable Interest Rate, r Money Supply Target, LM* r* -------------------------------------------------- Interest Rate Target IS'' IS* IS' Y'I Y'M Y* Y''M Y'''I Aggregate Output, Y • With instability in the goods market, IS curve is uncertain and fluctuates from IS' to IS''. An interest rate target would cause output to fluctuate from YI' to YI'' in response to the authority’s efforts to control it using its open market operations. For contrast, a money supply target, labeled LM*, would cause the money supply to intersect the IS curve at the desired output level, Y*. Since this policy is not changing the money supply, keeping it at LM*, output fluctuates between YM' and YM''. Since smaller output fluctuations are desirable, when the IS curve is unstable, a money supply target is preferred. (b) When the Money Market is relatively Unstable Interest Rate, r LM' LM* LM'' r* ------------------------------------------------- Interest Rate Target– IS YM' Y* YM'' Aggregate Output, Y • Under interest rate targeting, the central bank simply sets the interest rate at r* and it corresponds to the intersection of IS and LM* curves, keeping output at the desired level, Y*. The interest rate is maintained at its desired position with central bank’s use of open market operations (OMO) to whip it into line. A rise in money base and money supply (not drawn to graph) are the only consequences of this policy action. If however, a money supply target is used, given the fluctuation of the LM curve between LM' and LM'', output could not be prevented from fluctuating between YM' and YM''. Because, smaller output fluctuations are desirable, when the LM curve is uncertain and unstable, an interest rate target is preferred. The breakdown of the relationship between money supply and economic activity observed in the 1970s and 1980s mostly in the developed economies should not warrant an automatic abandonment of monetary targeting in favour of interest rate targeting. The available evidence suggests that the IS curve is highly susceptible to fluctuations for the principal reason that the targeted interest rate is nominal in nature whereas, real interest rate (RIR) is the appropriate indicator of output growth. Because expected price level (used in computing RIR) lacks an accurate measure and could be unstable, RIR could fluctuate greatly causing significant fluctuation in output. • ISLM in the Long Run • In the long run, the price level is no longer assumed to be fixed so that nominal and real quantities are no longer the same. Also, there is the introduction of the natural rate level of output which is a vertical line denoting the rate of output at which the price level has no tendency to rise or fall. To the right of this line is the booming economy characterized by rising price level and to its left is the recession economy with falling price level. • The IS curve defines the physical quantity of goods and services that people want to hold and so is not affected by changing price level. Thus, the spending units constituting the IS (consumption expenditure, investment expenditure, government spending and net exports) are not affected by price level variations. However, unlike the IS, the LM curve is affected by price level changes since it reflects the purchasing power of money. Hence, increasing price level is tantamount to a decreasing real money balances and would cause a leftward shift of the LM curve and vice versa. Figure 7 illustrates the implications of these developments for monetary and fiscal policies. Figure 7: Long Run Responses to Policy Changes Interest Rate, r LM1 LM2 r0 ----------------------- 1 r1 --------------------------- 2 IS Y0 Y1 Aggregate Output, Y (a) Response to Expansionary Monetary Policy Interest Rate, r LM2 LM1 r2' ------------------------- 2' r2 ----------------------------- -- 2 r1 ------------------------- 1 IS2 IS1 Y0 Y1 Aggregate Output. Y (a) Response to Expansionary Fiscal Policy • In plane (a), the expansionary monetary policy shifted the LM curve to LM2 causing interest rate to fall to r1 and output to rise to Y1. However, output has risen above the natural rate level, hence, price level will rise causing the LM curve to shift back to LM1. The ultimate effect is an unchanged output and interest rate levels. This is what is referred to as long run neutrality. • In plane (b), the expansionary fiscal policy shifts the IS curve (IS1) to IS2 causing the interest rate to rise from r1 to r2. Output rises above the natural rate causing the price level to rise. The rise in the price level will cause the LM curve to shift from LM1 to LM2. At point 2' where the economy has settled, output has returned to the natural rate level and interest rate has risen significantly. This is a case of complete crowding out in the long run. • The conclusion from this comparative analysis is that, although, expansionary monetary and fiscal policies positively affect output in the short run, none affects output in the long run. • ISLM and the Aggregate Demand Curve • The aggregate demand curve reflects the combinations of output and the price level that are consistent with equilibrium in the goods and money markets. It can be derived from the ISLM curves as in figure 8. Figure 8: Deriving the Aggregate Demand Curve (a) ISLM Interest Rate, r LM(P3) LM(P2) r3 ----------- 3 LM(P1) r2 ---------------- 2 r1 -------------------- 1 IS Y3 Y2 Y1 Y Price Level, P P3 ----------- 3 P2 ---------------- 2 P1 --------------------- 1 AD Y3 Y2 Y1 Aggregate Output, Y (b) Aggregate Demand Curve • Plane (a) shows the IS and LM curves at different price levels. The LM curve shifts leftward as the price level rises with aggregate output following in tow. The line connecting the intersection of the IS and LM curves is projected to the plane (b) below and it is referred to as the aggregate demand curve. It is downward sloping reflecting the negative relation between price level and aggregate output. • Factors Causing the Aggregate Demand Curve to Shift • All the factors causing the IS curve to shift (changes in autonomous consumer expenditure, changes in investment spending unrelated to interest rate, changes in government spending, changes in taxes and changes in net exports unrelated to interest rate will cause the aggregate demand curve to shift in the same direction. In addition, ‘animal spirits’ that describe the wave of optimism or pessimism in the market will also shift the aggregate demand curve. Similarly, if the price level is held constant, any factor shifting the LM curve (increase in money supply or decline in money demand) will also shift the aggregate demand curve in the same direction.
