Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 20
Monetary and fiscal
policy
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Monetary policies
• A given monetary policy has two aspects.
• To what variable does it refer?
– the interest rate or the money supply?
– For the reasons given in the previous two
chapters, we prefer to focus on the interest
rate.
• A particular relationship defining how the interest
rate is chosen.
– This may reflect discretionary choices of the
central bank
– or a commitment to a particular rule.
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Monetary policies (2)
• In the heyday of monetarism, central banks
used to adjust interest rates to stop the
money supply deviating from a given
target path of monetary growth.
• Most central banks have abandoned this
policy, preferring to target the inflation rate
itself.
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The IS Schedule:
Goods market equilibrium
• The goods market is in equilibrium when
aggregate demand and actual income
are equal.
• The IS schedule shows the different
combinations of income and interest rates
at which the goods market is in equilibrium.
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The IS schedule
45o line
AD1
AD0
At a relatively high interest
rate r0, consumption and
investment are relatively
low – so AD is also low.
Equilibrium is at Y0.
r
Y0
Y1
Income
r0
At a lower interest rate r1
consumption, investment
and AD are higher.
Equilibrium is at Y1.
r1
IS
Y0
Y1
Income
The IS schedule shows all
the combinations of real
incomes and interest rates
at which the goods market
is in equilibrium.
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Shifts in the IS schedule
• Changes in aggregate demand shift the IS
schedule. For a given interest rate, more optimism
about future profits raises investment demand.
• Higher expected future incomes raise
consumption demand.
• Higher government spending adds directly to
aggregate demand.
• Any of these, by raising aggregate demand at a
given interest rate, raise equilibrium output at any
interest rate,
• And lead to an upward shift in the IS schedule.
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The slope of the IS schedule
• The IS schedule slopes down. Lower interest rates
boost aggregate demand and output.
• The slope of the IS schedule reflects the sensitivity
of aggregate demand to interest rates.
• If demand is sensitive to interest rates, the IS
schedule is flat.
• Conversely, if output demand is insensitive to
interest rates, the IS schedule is steep.
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The LM schedule:
Money market equilibrium
• The money market is in equilibrium when
money demand equals money supply.
• The LM schedule shows the different
combinations of income and interest rates
at which the money market is in
equilibrium.
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The LM schedule
r
r
r1
LM
r1
r0
LL1
r0
LL0
L0
Real money
balances
Y0
Y1
Income
At income Y0, money demand is at LL0 and equilibrium
in the money market requires an interest rate of r0.
At Y1, money demand is at LL1,and equilibrium is at r1.
The LM schedule traces out the combinations of real income
and interest rate in which the money market is in equilibrium.
©McGraw-Hill Companies, 2010
The slope of the schedule
• The LM schedule slopes up.
• Higher output induces a higher interest rate to
keep money demand in line with money supply.
• The more sensitive is money demand to income
and output, the more the interest rate must
change to maintain money market equilibrium,
and the steeper is the LM schedule.
• Similarly, if money demand is not responsive to
interest rates, it takes a big change in interest
rates to offset output effects on money demand,
and the LM schedule is steep.
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Shifts in the LM schedule
• Shifts in the schedule reflect a change in monetary
policy.
• A rise in the target money supply means that
money demand must also be increased to
maintain money market equilibrium.
• This implies a rightward shift in the LM schedule.
• Output is higher, or interest rates lower, raising
money demand in line with the rise in real money
supply.
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Equilibrium in goods & money
markets
r
LM
Bringing together the
IS schedule (showing
goods market equilibrium)
and the LM schedule
(showing money market
equilibrium)
r*
IS
Y*
Income
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We can identify the
unique combination of
real income and interest
rate (r*, Y*) which ensures
overall equilibrium.
Fiscal policy in the IS-LM model
Y0, r0 represents the
initial equilibrium.
r
LM
r1
r0



IS1
IS0
Y0 Y1 Y’
Income
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A bond-financed
increase in government
spending shifts the IS
schedule to IS1.
Equilibrium is now
at r1, Y1.
Some private spending
(Y1Y’) has been
crowded out by the
increase in the rate of
interest.
Monetary policy in the IS-LM model
Y0, r0 represents the
initial equilibrium.
r
LM0
r0
r1

LM1

IS0
Y0 Y1
Income
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An increase in money
supply shifts the LM
schedule to the right.
Equilibrium is now
at r1, Y1.
Combining policies in the IS-LM
model
Y0, r0 represents the
initial equilibrium.
r
r1
r0
LM
LM’



IS1
IS0
Y0 Y1 Y2
Income
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A bond-financed
increase in government
spending shifts the IS
schedule to IS1.
Equilibrium is now
at r1, Y1.
Loosening monetary
policy in order to keep
the rate of interest at r0
allows output to
expand to Y2.
The policy mix
Demand management is the use of monetary and fiscal policy
to stabilise the level of income around a high average level.
Income level Y* can
r
be attained by:
LM1
‘Tight’ fiscal policy (IS0)
LM0
with ‘easy’ monetary
policy (LM0)
r1

r0

IS1
IS0
Y*
Income
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OR with ‘easy’ fiscal
policy (IS1) with ‘tight’
monetary policy (LM1).
This affects the private:
public balance of
spending in the
economy.
The effect of future taxes:
Ricardian equivalence
• Individuals will react to a shock such as a
tax change in different ways, depending
on whether changes are seen to be
temporary or permanent.
• If the government cut taxes today, but
individuals realise this will have to be
balanced by higher taxes in the future,
then present consumption may not
adjust.
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But...
• The IS-LM model seems to offer
governments a range of options for
influencing equilibrium income.
• However…
– there are other issues to be
considered
•the price level and inflation
•the supply-side of the economy
•the exchange rate
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