Chapter 7
Effectiveness of
Monetary Policy and
Fiscal Policy
© Pilot Publishing Company Ltd. 2005
Contents:
• More about the IS-LM model
• Effectiveness of monetary policy & fiscal policy
• Advanced Material 7.1: Interest rate vs. money
supply as an instrument of monetary policy
• Advanced Material 7.2: Comparison between
the IS-LM model and the Y-E model
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More about the IS-LM Model
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Determinants of the slope of the IS curve
 The slope of the IS curve:
1  c  i  ct  cq  m
b
<0
 The slope is negative.
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>0
Interest elasticity of investment (rEI or b )
r
 The larger the interest elasticity
when r changes, the larger the change
in I  the larger the required change
in Y (& W) to restore equilibrium, i.e.,
the gentler the IS curve.
IS* (I is more interest elastic)
0
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IS (I is less interest elastic)
Y
Income elasticity of saving (YES or s or MPS)
r
 The larger the income elasticity
when Y changes, the larger
the change in S  the larger
the required change in r (& J)
to restore equilibrium,
i.e., the steeper the IS curve.
IS* (S is less income elastic)
0
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IS (S is more income elastic)
Y
Determinants of the extent of shift of the IS curve
Reason of the shift: (an autonomous ∆ in J or W)
 e.g., an autonomous  in J  J > W
1. If r remains unchanged, Y has to  to raise W until J=W,
 IS curve shifts rightward.
2. If Y remains unchanged, r has to  to lower J until J=W,
 IS curve shifts upward.
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Interest elasticity of investment
r
Consider two IS curves with different rEI but equal YES





auton.
 in
 An
As they
have
theJ same
income
elasticity,
theya
 The IS
curve with
require
the same
 in Y
larger interest
elasticity
to restoreaequilibrium.
requires
smaller  in r
to restore equilibrium
IS* (I is more interest elastic)
IS (I is less interest elastic)
0
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Y
Income elasticity of saving
r
Consider two IS curves with different YES but equal rEI




 As
An they
auton.
 in

have
theJ same
interest
elasticity,
theya
 The IS
curve with
require
the same
 in r to
larger income
elasticity
restore
thea equilibrium.
requires
smaller  in Y
to restore equilibrium
IS (S is less income elastic)
IS* (S is more income elastic)
0
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Y
Extreme Shape of
case
IS curve
Extent of shift of the IS curve
(e.g., an autonomous J or
W that J > W)
Es = 0
Horizontal
Upward shift: normal
(∵ Y
Rightward shift:  in Y
 r = 0) cannot restore equilibrium
Es = 
Vertical (∵ Upward shift: normal
Y  r
Rightward shift: a negligible 
= )
in r is enough to restore equil.
Y
Y
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Extreme cases of the IS curve
Extreme Shape of
case
IS curve
rEI =
0
rEI =

Extent of shift of the IS curve
(when autonomous J
or W that J > W)
Vertical
Upward shift:  in r cannot
(∵Δr
restore equilibrium
Rightward shift: normal
 ΔY = 0)
Horizontal
Upward shift: a negligible 
(∵Δr
in r is enough to restore equil.
Rightward shift: normal
ΔY = )
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Determinants of the slope of the LM curve
The slope of the LM curve:
<0
d

e
 The slope is positive.
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>0
Q7.2:
Given a two-sector economy,
with S = 0.2Y – 100 and I = 10 – 20r.
(a) Derive the IS equation.
(b) Suppose there is an autonomous rise in I by 40.
(i) What is the extent of rightward shift of the IS
curve?
(ii) What is the extent of upward shift of the IS
curve?
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Interest elasticity of asset demand for money
 The larger the interest elasticity,
r
LM (Ma is less
interest elastic)
when r changes, the larger the change in
Ma  the larger the required change in Y
(& Mt) to restore equilibrium,
i.e.,
the gentler the LM curve.
LM* (Ma is more
interest elastic)
0
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Y
Income elasticity of transactions demand for money
 The larger the income elasticity,
r LM* (Mt is more
income elastic)
when Y changes, the larger the
change in Mt  the larger the
required change in r (& Ma) to
restore equilibrium,
i.e., the steeper the LM curve.
LM (Mt is less
income elastic)
0
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Y
Determinants of the extent of shift in the LM curve
Reason of the shift: (an autonomous Δ in Md or Ms)
 e.g., an autonomous  in money supply  Md < Ms
1. If r remains unchanged, Y has to  to raise Mt until Md = Ms,
 LM curve shifts rightward.
2. If Y remains unchanged, r has to  to raise Ma until Md = Ms,
 LM curve shifts downward.
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Interest elasticity of asset demand for money
Consider two LM curves with different rEMa but equal YEMt
r
LM0 (Ma is less
interest elastic)




LM0* (Ma is more
interest elastic)
LM1
0
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As they
have
theMsame
An
auton.
 in
s
elasticity, they
LM1*income
The LM curve with a
require the same  in Y
larger interest elasticity
to restore the equilibrium
requires a smaller Δ in r
to restore equilibrium
Y
Income elasticity of transactions demand for money
Consider two LM curves with different YEMt but equal rEMa
r
LM0 (Mt is less
income elastic)
LM0*(Mt is
more income
elastic)

LM1*


0
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
LM1
As
have
Anthey
auton.
 the
in Msame
s
interest elasticity, they
The LM curve with a
require the same  in r
larger income elasticity
to restore the equilibrium
requires a smaller  in
Y to restore equilibrium
Y
Extreme cases of the LM curve
Extreme Shape of Extent of shift of the LM curve
case
LM curve (when autonomous Md  or
autonomous Ms)
rEMa =
0
Vertical
Downward shift:  in r cannot
(∵Δr
restore the equil.
Rightward shift: normal
ΔY = 0)
rEMa =

Horizontal
Downward shift: a negligible 
(∵Δr
in r is enough to restore the equil.
ΔY= )
Rightward shift: normal
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Extreme Shape of Extent of shift of the LM curve
case
LM curve (when autonomous Md  or
autonomous Ms )
EMt = 0
Horizontal
Downward shift: normal
(∵ΔY
Rightward shift:  in Y cannot
Δr = 0) restore equilibrium
EMt = 
Vertical
(∵ΔY
Δr = )
Y
Y
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Downward shift: normal
Rightward shift: a negligible 
in Y is enough to restore equil.
Monetary policy (MP) is the government measure
which achieves economic objectives through
manipulating the money supply or interest rate.
Fiscal policy (FP) is the government measure
which achieves economic objectives through
manipulating the government revenue or
expenditure.
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Effectiveness of
Monetary Policy and
Fiscal Policy
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Effectiveness of monetary policy
Effect of monetary policy
e.g., an expansionary monetary policy (Ms)
Mechanism:
Md<Ms
r
Ma
I
J>W
 until J=W & Md=Ma+Mt=Ms
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Y
W
Mt
Determinants of the effectiveness of MP
1. Multiplier
2. Interest elasticity of investment
3. Income elasticity of saving
4. Interest elasticity of asset demand for
money
5. Income elasticity of transactions
demand for money
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Multiplier
ΔY = ΔI X
Multiplier
The larger the multiplier

The larger the change in Y

The more effective the monetary policy
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Interest elasticity of investment (rEI )
r
IS
LM0
LM1
 The larger the rEI ,
the larger the  in I &
the larger the  in Y.

The more effective the MP
IS* (I is more
interest elastic)
0
Y0 Y1 Y*1
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Y
Income elasticity of saving (YES)
r
 The smaller the YES ,
the larger the required
LM0
 in Y to raise enough
LM1 W to restore equil.
IS

The more effective the MP
IS* (S is less
income elastic)
0
Y0 Y1 Y*1
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Y
Interest elasticity of asset demand for money (rEMa)
r
LM*0 (Ma is less
interest elastic)
IS
LM0 LM*1
LM1

 The smaller the
rEMa , the larger the
required  in r to
raise enough Ma to
restore the equil.
 Then the larger
the  in I & Y

The more effective the MP
0
Y0 Y1Y*1
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Y
Income elasticity of transaction demand for money (YEMt)
r
IS
LM0
LM0*(Mt is less
income elastic)
LM1

0
Y0 Y1Y*1
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LM1*
 The smaller the
YEMt , the larger
the required  in Y
to raise enough Mt
to restore the equil.

The more effective the MP
Y
Effectiveness of Fiscal Policy
Effect of fiscal policy
e.g., an expansionary fiscal policy (G)
Mechanism:
J>W
Y
W
Mt
Md>Ms
 until J=W and Md=Ma+Mt=Ms
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r
I
Ma
Determinants of the effectiveness of FP
1. Multiplier
2. Interest elasticity of asset demand for
money
3. Income elasticity of transactions
demand for money
4. Interest elasticity of investment
5. Income elasticity of saving
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Multiplier
ΔY = ΔG X
G-Multiplier
ΔY = ΔT X
T-Multiplier
The larger the multipliers

The larger the change in Y

Fiscal Policy is more effective
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Interest elasticity of asset demand for money (rEMa)
r
IS1
IS0
 The larger the rEMa ,
the smaller the required
LM
 in r to restore the
equil. and the smaller
LM* (Ma is more the crowding out effect.
interest elastic)
0
Y0
Y1Y*1
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
The more effective the FP
Y
Income elasticity of transactions demand for money (YEMt)
r
IS1
IS0
LM
LM* (Mt is less
income elastic)
0
Y0
Y1Y*1
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 The smaller the YEMt ,
the smaller the  in Mt
and the smaller the
required  in r to restore
the equil. and the smaller
the crowding out effect.

The more effective the FP
Y
Interest elasticity of investment (rEI )
r IS*0 (I is less
income elastic)
IS*1
IS1
IS0

0
Y0
Y1 Y*1
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LM
 The smaller the rEI ,
the smaller the drop in I
and the smaller the
crowding out effect.

The more effective the FP
Y
Income elasticity of saving (YES)
r

LM
IS*1
IS1
IS0
0
Y0
Y1Y*1
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 The smaller the YES ,
the larger the required
 in Y to raise enough
W to restore the equil.

The more effective the FP
IS*0 (S is less income elastic)
Y
Effectiveness of the policies in extreme cases
Extreme
case
Effectiveness of MP
Horizontal
IS
Most effective
Vertical
IS
Totally ineffective
Horizontal rEMa=   totally
ineffective
LM
YEMt = 0  most effective
Vertical rEMa = 0  most effective
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LM
YEMt=  totally
Effectiveness of FP
=   totally
ineffective
YES = 0  most effective
rEI = 0  most effective
YES=   totally
ineffective
Most effective
rEI
Totally ineffective
Effectiveness of MP
Horizontal IS
r
LM0
Cause of horizontal IS:
rEI =  or YEs = 0
LM1
IS0
Y0
Y1
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E.g., an expansionary MP
Y

MP is most effective
 Effectiveness of FP
Horizontal IS
r
Cause of horizontal IS:
rEI = 
LM0
IS0
= IS1
E.g., an expansionary FP

FP is completely ineffective
Y0 = Y1
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Y
 Effectiveness of FP
Horizontal IS
r
Cause of horizontal IS:
YEs = 0
LM0
IS1
IS0
Y0 Y1
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E.g., an expansionary FP
Y

FP is most effective
Vertical IS
r
IS0
Effectiveness of MP
Cause of vertical IS:
rEI =0 or YEs =
LM0 LM1
E.g., an expansionary MP

MP is completely ineffective
Y0 = Y1
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Y
 Effectiveness of FP
Vertical IS
r
IS0 IS1
Cause of vertical IS:
rEI = 0
LM0
E.g., an expansionary FP

FP is most effective
Y0 Y1
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Y
 Effectiveness of FP
Vertical IS
r
IS0 = IS1
Cause of vertical IS:
Es = 
LM0
Y
E.g., an expansionary FP

FP is completely ineffective
Y0= Y1
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Y
Effectiveness of MP
Horizontal LM
Cause of horizontal LM:
rEMa = 
r
LM0
= LM1
IS0
Y0 = Y1
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E.g., an expansionary MP

MP is completely ineffective
Y
 Effectiveness of MP
Horizontal LM
Cause of horizontal LM:
YEMt = 0
r
LM0
E.g., an expansionary MP
LM1
IS0
Y0 Y1
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
MP is most effective
Y
 Effectiveness of FP
Horizontal LM
Cause of horizontal LM:
YEMt = 0 or rEMa =
r
E.g., an expansionary FP
LM0
IS0 IS1
Y0
Y1
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Y

FP is most effective
 Effectiveness of MP
Vertical LM
r
Cause of vertical LM:
rEMa = 0
LM0 LM1
E.g., an expansionary MP
IS0
Y0
Y1
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
MP is most effective
Y
 Effectiveness of MP
Vertical LM
r
LM0= LM1
Cause of vertical LM:
YEMt = 
E.g., an expansionary MP
IS0
Y0= Y1
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
MP is completely ineffective
Y
 Effectiveness of FP
Vertical LM
r
Cause of vertical LM:
YEMt =  or rEMa = 0
LM0
E.g., an expansionary FP
IS1
IS0
Y0= Y1
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
FP is completely ineffective
Y
Advanced Material 7.1
Interest rate versus money supply as an
instrument of monetary policy
 Money supply as an instrument of MP
Money supply is fixed & is adjusted deliberately.
The LM curve is upward sloping.
 An expansionary MP shifts the LM curve
rightward or downward.
 Ms is exogenous but interest rate is endogenous.
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Advanced Material 7.1
Interest rate versus money supply as an
instrument of monetary policy
 Interest rate as an instrument of MP
 Interest rate is fixed & is adjusted deliberately.
The LM curve is horizontal at that fixed rate.
 An expansionary MP lowers the interest rate &
shifts the LM curve downward to the new rate.
 Interest rate is exogenous but Ms is endogenous.
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Advanced Material 7.2
Comparison between the IS-LM model and
the Y-E Model
 Differences between the two models
 The Y-E model considers the goods market only,
while the IS-LM model considers both the goods
market & the money market.
 In the Y-E model, I is a constant independent of r,
while in the IS-LM model, I is a variable negatively
related to r.
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Advanced Material 7.2
Comparison between the IS-LM model and
the Y-E Model
 Superiority of the IS-LM model
 can investigate the effects of monetary forces
(changes in Md & Ms)
 can predict the value of the equil. interest rate
 can give a more accurate prediction on the value of
the equil. Y
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 The Y-E model is a special case of the IS-LM model
 When rEMa =  (horizontal LM),
YEMt = 0 (horizontal LM) or
rEI = 0 (vertical IS)
 No crowding-out effect
 The Y-E model gives the same (& accurate)
prediction as the IS-LM model on how real forces (in
the goods market) affect the equil. Y.
 Notice that when rEI = 0 and rEMa, monetary forces are
neutral, having no effect on Y. In other words, the goods
market & the money market are separated.
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Correcting Misconceptions:
1. For the same amount of autonomous change in
J or W causing J > W, the IS curve will shift
rightward (upward) by the same amount.
2. For the same amount of autonomous change in
Md or Ms causing Md < Ms, the LM curve will shift
rightward (downward) by the same amount.
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Correcting Misconceptions:
3. The flatter the IS curve, the more effective
the monetary policy but the less effective the
fiscal policy.
4. The steeper the LM curve, the less effective
the fiscal policy but the more effective the
monetary policy.
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