Monetary and Fiscal Policy in the IS-LM Model
Chapter 4
Instructor: MELTEM INCE
1
The Definition of Money
Money is defined as any good or asset that serves the
following three functions:
 Medium of Exchange
 Store of Value
 Unit of Account
The Money Supply (MS) is equal to currency in
circulation plus checking accounts at banks and thrift
institutions.
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Money Demand
The demand for money is determined by people’s need for money to facilitate
transactions.
 If Income (Y)  Md
 If the Price Level (P)  Md
 Notice: Real money demand = is unaffected by P
The demand for money also depends negatively on the cost of holding money,
the interest rate (r).
 If r  Md as people switch out of money into interest-bearing savings
accounts or other financial assets
 Algebraically, the general linear form of Md is:
(M/P) = kY – hi
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What Shifts Money Demand?


The main shift factor for real Md is income (Y).
Additional shift factors include:
 Interest paid on money: If money pays more interest Md rises
 Wealth: If people become wealthier, some of the additional
wealth may be held as money, so Md rises.
 Expected future inflation: If people expect P to rise quickly
in the future, they will try to hold as little money as possible.
 Payment technologies: Any technological development that
alters how people pay for goods and services, or the ease of
switching between money and non-money assets can change Md
 Examples: Credit Cards and ATMs
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The IS Curve: Equilibrium in the Goods
Market
The goods market clears when desired investment
equals desired national saving. For any level of output
Y, the IS curve shows the real interest rate r for which
the goods market is in equilibrium
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The IS Curve
AE = C+Ip+G
C=C0+cDPI = C0+c(Y+TR-T)
I=I0-bi
G=G0 T=T0 +tY
AE=C0+c(Y+TR-T)+I0-bi+G0
AE= A0-bi+c(1-t)Y where A0= C0+cTR0-cT0+I0+G0
Y=AE
Y= A0-bi+c(1-t)Y
Y-c(1-t)Y=A0-bi
Y=ke(A0 –bi)
i = A0/ b – Y/keb
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The IS Curve: Equilibrium in the Goods
Market
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The IS Curve
 The
saving curve slopes upward because a higher
real interest rate increases saving
 An increase in output shifts the saving curve to the
right, because people save more when their income
is higher
 The investment curve slopes downward because a
higher real interest rate reduces the desired capital
stock, thus reducing investment
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Effect on the IS curve of a temporary increase in
government purchases
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The IS Curve
 The
IS curve shifts up and to the right because of
 an increase in expected future output
 an increase in wealth
 a temporary increase in government purchases
 a decline in taxes (if Ricardian equivalence doesn’t
hold)
 an increase in the expected future marginal product of
capital
 a decrease in the effective tax rate on capital
 The IS curve shifts down and to the left when the
opposite happens to the six factors above
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LM Curve


The LM Curve shows all the possible combinations of Y
and r such that the money market is in equilibrium.
Algebraic Derivation:
At equilibrium, real MS equals real Md:
(Ms/P) = kY – hi
Solving for r yields:
S
 1  M
r     
 h  P
 k
   Y

 h
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What shifts and rotates the LM Curve?


Anything that only affects the intercept term will shift the LM
curve:
 If MS  LM shifts →
 If P  LM shifts →
 Not captured by slope term: Md   LM shifts ←
Anything that affects the slope term will cause a rotation of the
LM curve:
 If h  LM becomes steeper
 If f  LM becomes flatter
i = (k/h)Y – (1/h)M/P
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LM Curve
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LM Curve
Factors that shift the LM curve
 Any change that reduces real money supply relative to real
money demand shifts the LM curve up
 For a given level of output, the reduction in real money
supply relative to real money demand causes the
equilibrium real interest rate to rise
 The rise in the real interest rate is shown as an upward
shift of the LM curve
 Similarly, a change that increases real money supply
relative to real money demand shifts the LM curve down
and to the right
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LM Curve

The LM curve shifts down and to the right because of
 an increase in the nominal money supply
 a decrease in the price level
 an increase in expected inflation
 a decrease in the nominal interest rate on money
 a decrease in wealth
 a decrease in the risk of alternative assets relative to the risk
of holding money
 an increase in the liquidity of alternative assets
 an increase in the efficiency of payment technologies
 The LM curve shifts up and to the left when the opposite
happens to the eight factors listed above
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An Increase In The Real Money Supply Shifts The LM Curve
Down And To The Right
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LM Curve
Changes in the real money supply
• A drop in real money supply shifts the LM curve up
and to the left
• An increase in real money demand shifts the LM
curve up and to the left
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An increase in the real money demand shifts the LM curve up
and to the left
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The General Equilibrium


A General Equilibrium is a situation of simultaneous
equilibrium in all of the markets of the economy.
How does the economy adjust to the general equilibrium?
 If the goods market is out of equilibrium  involuntary
inventory decumulation or accumulation occurs  firms
respond by increasing or decreasing production  Y
moves to equilibrium
 If the money market is out of equilibrium  pressure on
interest rates will bring back monetary equilibrium
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General equilibrium in the IS-LM model
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The FE Line: Equilibrium in the Labor
Market
If we plot output against the real interest rate, we get a
vertical line, since labor market equilibrium is
unaffected by changes in the real interest rate.
Labor market in showed how equilibrium in
the labor market leads to employment at its full
employment level and output at its full-employment
level
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Factors that shift the FE line
The full employment level of output is determined by the full
employment level of employment and the current levels of capital
and productivity; any change in these variables shifts the FE line
 The full-employment line shifts right because of
 a beneficial supply shock
 an increase in labor supply
 an increase in the capital stock
 The full-employment line shifts left when the opposite happens
to the three factors above
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Monetary Policy

An expansionary monetary policy is one that has the
effect of lowering interest rates and raising GDP.

A contractionary monetary policy is one that has the
effect of raising interest rates and lowering GDP.
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The Effect of Increase in the Money Supply
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Fiscal Policy and “Crowding Out”



An expansionary fiscal policy is one that has the
effect of raising GDP, but also raising interest rates
 Note: r  Private Autonomous Spending 
The reduction in the amount of consumption and/or
investment spending due to an increase in G (or fall
in T) is known as “Crowding Out”
Can crowding out be avoided?
 Yes! If the Fed simultaneously MS  r
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The Effect on Real Income and the Interest
Rate Increase in Government Spending
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Monetary and Fiscal Policy Effectiveness




Monetary policy is strong when:
 The IS curve is relatively flat and/or
 The LM curve is steep
Monetary policy is weak when:
 The IS curve is very steep and/or
 The LM curve is relatively flat
Fiscal policy is strong when:
 The IS curve is very steep and/or
 The LM curve is relatively flat
Fiscal policy is weak when:
 The IS curve is relatively flat and/or
 The LM curve is steep
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The Effect on Real Income of a Fiscal
Stimulus
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The Liquidity Trap


A Liquidity Trap occurs when investors are indifferent
between holding money and short-term assets.
 Why might investors be indifferent?
 Because the nominal interest rate on short-term assets is
close to zero!
 Why is a liquidity trap a problem?
 Because the interest rate is close to zero, the Fed can no
longer use monetary policy to lower the interest rate to
boost output.
How is a liquidity trap represented?
 The LM curve starts off horizontal at very low interest rates
before having its normal upward slope.
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Aggregate Demand and Aggregate Supply
Use the IS-LM model to develop the AD-AS model
 The two models are equivalent
 Depending on the issue, one model or the other may
prove more useful
 IS-LM relates the real interest rate to output
 AD-AS relates the price level to output
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Aggregate Demand and Aggregate Supply
The aggregate demand curve
 The AD curve shows the relationship between the
quantity of goods demanded and the price level
when the goods market and asset market are in
equilibrium
 So the AD curve represents the price level and
output level at which the IS and LM curves
intersect
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Aggregate Demand and Aggregate Supply
The aggregate demand curve
 The AD curve is unlike other demand curves, which relate
the quantity demanded of a good to its relative price; the
AD curve relates the total quantity of goods demanded to
the general price level, not a relative price
 The AD curve slopes downward because a higher price
level is associated with lower real money supply, shifting
the LM curve up, raising the real interest rate, and
decreasing output demanded
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The effect of an increase in government purchases on the
aggregate demand curve
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Aggregate Demand and Aggregate Supply
Factors that shift the IS curve up and to the right and thus the
AD curve up and to the right as well
 Increases in future output, wealth, government purchases, or
the expected future marginal productivity of capital
 Decreases in taxes if Ricardian equivalence doesn’t hold, or
the effective tax rate on capital
Factors that shift the LM curve down and to the right and thus
the AD curve up and to the right as well
 Increases in the nominal money supply or in expected
inflation
 Decreases in the nominal interest rate on money or the real
demand for money
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Aggregate Demand and Aggregate Supply
The aggregate supply curve
 The aggregate supply curve shows the relationship
between the price level and the aggregate amount of
output that firms supply
 In the short run, prices remain fixed, so firms supply
whatever output is demanded
 The short-run aggregate supply curve is horizontal
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Full-employment output isn’t affected by the price
level, so the long-run aggregate supply curve (LRAS) is
a vertical line
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Aggregate Demand and Aggregate Supply
Factors that shift the aggregate supply curves
 The SRAS curve shifts whenever firms change their
prices in the short run
 Factors like increased costs of producing goods lead
firms to increase prices, shifting SRAS up
 Factors leading to reduced prices shift SRAS down
 Anything that increases full-employment output shifts
the LRAS curve right; anything that decreases fullemployment output shifts LRAS left
 Examples include changes in the labor force or
productivity changes that affect labor demand
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Short-run equilibrium: AD intersects SRAS
Long-run equilibrium: AD intersects LRAS
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Adverse Supply Shock
Price,P
LRAS
B
SRAS2
A
SRAS1
AD
Y
Income, Y
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Adverse Supply Shock
If aggregate demand is held constant, the economy moves
from A to B. The price level rises and the amount of output
falls below the natural level. This is called Stagflation,
because it combines falling output with rising price level.
As a summary, the real wage, employment, and output
decline, while the real interest rate and price level are
higher. Since the real interest rate is higher and output is
lower, consumption and investment must be lower
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Accommodating an Adverse Supply Shock
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Accommodating an Adverse Supply Shock
If the increase in aggregate demand coincides with
the shock to aggregate supply, the economy goes
immediately from E to H. The price level is
permanently higher. There is no way to maintain
full employment and keep the price level stable.
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