A
Closer Look at Policy
• Fiscal Policy and Crowding Out
• Monetary Policy and the Liquidity Trap
 Real World
Monetary and Fiscal Policy
 Problems of Using IS-LM in the Real
World
• Interpretation Problems
• Implementation Problems
 Fiscal
Policy
• Expansionary fiscal policy shifts the IS
curve to the right
• Contractionary fiscal policy shifts the IS
curve to the left
 Monetary
Policy
• Expansionary monetary policy shifts the
LM curve to the right
• Contractionary monetary policy shifts the
LM curve to the left
1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000.
2. The increase in income
increases money demand
which increases interest
rates from 4% to 5%.
LM
3. The increase in the interest
rate causes a decrease in
investment so that the increase
in income is only $600, less that
the full multiplier effect.
$1000
5%
4%
IS1
IS0
$6000
$6600
$7000
Aggregate Output
 When
government expenditures increase,
output and income begin to increase.
 The increase in income increases the
demand for money.
 The increase in money demand increases
the interest rate.
 Higher interest rates cause a decrease in
investment, offsetting some of the
expansionary effect of the increase in
government spending.
1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000.
LM
9%
$1000
2. If the demand for money
is totally insensitive to the
interest rate, the interest rate
increases from 4% to 9%.
3. The increase in the interest
rate causes a decrease in
investment that completely offsets
the increase in government spending.
4%
IS1
IS0
$6000
$7000
Aggregate Output
 When
complete crowding out
occurs, fiscal policy is ineffective,
changing only interest rates, not
output.
 Crowding out is greater if:
• Money demand is very sensitive to income
changes
• Money demand is not very sensitive to
interest rate changes
The Fed increases the
money supply which
decreases interest rates
and increases investment
and output.
In a liquidity trap, increases
in the money supply do not
decrease interest rates, so
investment and output do
not increase.
LM0
LM0
LM1
LM1
r0
r0
r1
IS
Y0
Y1
Aggregate Output
IS
Y0
Aggregate Output
 Investment
is not sensitive to the
interest rate
• If investment does not respond to interest
rate changes (the IS curve is steep),
monetary policy in ineffective in changing
output.
 Liquidity trap
• If increases in the money supply fail to
lower interest rates, monetary policy is
ineffective in increasing output.
 Interpretation
happening?)
Problems (what is
• Problems in knowing how to interpret
real-world events within the IS-LM
framework
 Implementation
deal with it?)
Problems (how to
• Problems encountered in undertaking
policy
 Interest
Rate Problem
 Credit Conditions Problems
 Budget Problems
• Cyclical and Structural Problems
• Accounting Methods
 Which
interest rate, nominal or real,
is relevant?
 Which of many interest rates in the
economy is relevant?
• The Federal funds rate?
• The interest rate households and
businesses pay to borrow money?
 Default
risk
• Interest rates differ according to the
likelihood that the borrower will repay the
loan.
 Term
to Maturity
• The longer the term to maturity, the higher the
interest rate that is paid because
 Bonds with longer maturities are less liquid
 Differences in expected inflation
 More uncertainty
6
6
5.5
5.5
5
5
4.5
4.5
4
4
3.5
3.5
3 6
mos.
1 2
yr.
5 10 30
Maturities
3 6
mos.
1 2
yr.
5 10 30
Maturities
 The
IS-LM model assumes that interest
rates are the only determinant of
investment.
 Investment may also depends on credit
conditions, the willingness of banks to
lend independent of interest rates.
 If banks raise their lending standards,
investment may not respond to
expansionary monetary policy.
 Mexico after 1994, Japan in the 90s.
 The
structural budget surplus or deficit is
the fiscal budget balance that would exist
when the economy is at potential output.
 The cyclical budget surplus or deficit is
that portion of the fiscal budget balance
that exists because output is above or
below potential output.
Uncertainty
about Potential
Output
Information Lag
Policy Implementation Lag
 One
macroeconomic policy goal is to
keep output as close to potential as
possible. But, what is potential output?
 If policymakers use contractionary
policy when the economy is actually
below potential, they create
‘unnecessary’ unemployment.
 Using expansionary policy above
potential output will cause inflation.
 The
IS-LM model assumes that
policymakers see what is happening in
the economy and can instantly alter
policies to fix any problem.
 In the real world there is an information
lag, a delay between a change in the
economy and knowledge of that change.
• Example: are we in a recession or a boom
right now?
 The
policy implementation lag: the delay
between the time policymakers recognize the
need for a policy action and when the policy is
actually instituted.
 U.S. fiscal policy has a large implementation
lag because policy must be formulated and
legislation passed by Congress and signed by
the President.
 Monetary policy has a much shorter
implementation lag because the Federal Open
Market Committee decides monetary policy
and implements it immediately.