Chapter 25
Money and
Economic
Stability in
the ISLM
World
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Learning Objectives
• Explain the circumstances under which fiscal or
monetary policy is a more effective method of
stabilizing GDP
• Understand the importance of crowding out and
possible liquidity traps
• Define the role of prices and their impact on
economic stability
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Monetary Policy, Fiscal Policy,
and Crowding Out
• Controversy within the ISLM framework relates to the
relative effectiveness of monetary and fiscal policy
• Monetarists “special case” (Figure 25.1)
– Demand for money is unresponsive to interest rates, depends
on income only
– Produces a vertical LM function
– Since velocity is constant and a fixed money supply, GDP
cannot change
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FIGURE 25.1 When the LM curve is vertical,
an increase in the money supply increases
income by ∆M times velocity.
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Monetarists “special case”
(Figure 25.1) (Cont.)
– Increase in the money supply shifts the LM curve to
the right along a fixed IS curve
– Income increases until all the increased money
supply is absorbed into increased transactions
demand
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Figure 25.2
– LM curve is not vertical, but is positively sloped
– Demand for money is somewhat responsive to rate of interest
– Increase in money supply will result in an increase in income,
but less than in the monetarist’s case
– Smaller increase in income is due to lowering of interest rates
inducing holding of money in “idle” balances rather than for
transactions purposes
– Therefore velocity of the total money supply falls
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FIGURE 25.2 When the LM curve is not vertical, an
increase in the money supply is less powerful in
increasing income.
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Keynesian reservations about monetary policy
– Liquidity trap (Figures 25.3 and 25.4)
• Money demand is non-responsive to lowering of interest
• Therefore, the LM curve is perfectly horizontal and does not shift
down following an increase in the money supply
• Increase in money supply does not lower the interest rate
• All the additional money is held as idle balances (hoarding) and
equilibrium is unchanged
• Therefore, the velocity of the money supply has decreased
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FIGURE 25.3 With a liquidity trap, an increase in
the money supply from M to M does not shift the LM
curve (see Figure 25.4).
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FIGURE 25.4 With a liquidity trap, an increase in the
money supply, because it does not shift the LM curve,
does not change income.
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Keynesian reservations about monetary
policy (Cont.)
– Perfectly vertical IS curve (Figure 25.5)
• Investment spending is completely unresponsive to the
rate of interest
• Therefore, changes in the money supply do not affect
income even though it may change the rate of interest
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FIGURE 25.5 When the IS curve is
vertical, monetary policy is ineffective.
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Summary of monetary policy
– Monetary stimulus works when both the IS and LM
curve are “normal”
– Extreme cases of a horizontal LM curve and vertical
IS curve render monetary policy ineffective
– However, the impact of monetary policy with
“normal” curve may be reduced if increased money
supply causes a decline in the velocity
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Critique on Fiscal Policy (Figure 25.6)
– Fiscal policy has zero impact with a vertical LM
curve and is completely effective with a horizontal
LM curve
• Vertical LM curve
– Increased money supply will be absorbed by a higher interest rate
with an increase in GDP
– This case represents total crowding-out due to higher interest
rates
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FIGURE 25.6 When the LM curve is vertical, fiscal
policy is completely ineffective; when it is horizontal,
it is totally effective.
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Critique on Fiscal Policy (Figure 25.6) (Cont.)
• Horizontal LM curve
– Increased money supply would not increase interest rates and the
impact would be entirely on GDP
– This case completely eliminates the crowding-out effect caused
by higher interest rates
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Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• In the general case of a positively sloped LM curve
– The results lie between the two extremes described above
– While increased government spending will increase GDP, it
will be less than the “full multiplier” of the simple Keynesian
system
– The reduction in the ultimate impact in the increase of GDP is
a result of some increase in interest rates (partial crowdingout)
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Is the Private Sector Inherently Stable?
• Most economists agree that the LM curve is
positively sloped, although there is disagreement
as to magnitude of the slope
• These differences in the slope of the LM curve
are sufficient to demonstrate the stability or
instability of economic activity resulting from
exogenous shifts in private investment
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Is the Private Sector Inherently Stable?
(Cont.)
• Figure 25.7
– There are two alternative LM curves: LMsteep and LMflat with
two IS curves representing shifts in autonomous investment
– Shift of the IS curve will result in much greater variations in
economic activity with a flat LM curve
– This is a result of greater variations in the rate of interest with
the steep LM curve inducing a large change of endogenous
investment to offset a large part of the change in exogenous
investment
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FIGURE 25.7 A flatter LM curve means wider
fluctuations in GDP associated with exogenous
shifts in investment.
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Is the Private Sector Inherently Stable?
(Cont.)
• Figure 25.8
– When the economy operates near full employment capacity,
fluctuations in the price level help provide self-correcting
stability
– Starting at the intersection of IS and LM(P0)—E, the economy
is operating at YFE which represents full employment
– An increase in autonomous spending shifts IS to IS and raises
demand to Y, which is above full employment
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FIGURE 25.8 At full employment,
fluctuations in the price level help stabilize
economic activity.
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Is the Private Sector Inherently Stable?
(Cont.)
• Figure 25.8 (Cont.)
– With the economy operating above capacity, there
will be an upward pressure on prices to P1
– If the supply of money is fixed, increased prices will
reduce the real supply of money which pushes the
LM curve back to LM(P1) reducing income to the
full employment level
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Is the Private Sector Inherently Stable?
(Cont.)
• Figure 25.8 (Cont.)
– At the new equilibrium, E1, prices and interest rates
are higher, but output and employment revert to the
original level
– Therefore, a condition with a fixed supply of money
and flexibility of prices and interest rates indicates
the economy will be insulated from changes in
exogenous investment spending
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Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out
• When economy is at or near full employment,
the Keynesian interest rate mechanism supports
the classical argument of automatic adjustments
• At full employment, the rate of interest is
independent of movements in the money supply
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Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Figure 25.9
– Initial equilibrium at YFE and rFE
– The interest rate is the real rate since there is
an assumption of no inflationary pressure in the
economy
– An increase in the money supply will initially
push the LM curve rightward to LM, which
reduces interest rates to r
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FIGURE 25.9 An increase in money
supply at full employment doesn’t lower
the interest rate.
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Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Figure 25.9 (Cont.)
– However, since the economy is operating above
full employment (Y), prices will rise which
reduces the real supply of money
– As a result, the LM curve shifts leftward back
to the original position, increasing the rate of
interest back to rFE
– Therefore, at full employment, increases in
the money supply cannot reduce the interest
rate below rFE
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25-28
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Natural rate of interest (rFE)
– That rate which equates savings and investment
at full employment
– At full employment, only saving and
investment (including government spending)
determine the interest rate and money supply
plays no role
– Since real rate is fixed at rFE, nominal rate will
rise if inflationary expectations are generated
by the increased money stock
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Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Fiscal policy under flexible prices
– Refer back to Figure 25.8
– Assume initial equilibrium of E and a positively
sloped LM curve
– Additional government spending shifts the IS
curve to IS
– Initial movement along LM(P0) will increase
interest rates which partially crowds investment
spending
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25-30
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Fiscal policy under flexible prices (Cont.)
– Since the economy is now above YFE, there will
be an increase in prices pushing the LM curve
left to LM(P1), where P1 > P0.
– The economy will move to equilibrium
condition E, with even higher interest rates
which reduces investment spending to a level
equal to the increased government spending
(complete crowding-out)
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Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Fiscal policy under flexible prices (Cont.)
– Two important observations in the case of
increased government spending
• Real Interest rates at full employment are affected
by shifts in the real sector of the economy—pushed
upward by increased government spending
• Although real output returns to the full employment
level, increased government spending will increase
nominal output because of higher prices
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Appendix
INTEREST RATES
VERSUS THE
MONEYSUPPLY
UNDER
UNCERTAINTY
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APPENDIX—INTEREST RATES
VERSUS THE MONEY SUPPLY
UNDER UNCERTAINTY
• Chapter 21 discussed the advantages and disadvantages
of using the money supply versus interest rates as a
target of monetary policy
– Monetarists generally prefer money supply target
– Keynesians prefer an interest rate objective
• The basic question is it always better for the Fed to
specify a target for the money supply rather than the
interest rate
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APPENDIX—INTEREST RATES
VERSUS THE MONEY SUPPLY
UNDER UNCERTAINTY (Cont.)
• Figure 25A.1
– The IS curve is shifting back and forth
– In this case, the money supply target is superior—smaller variation in
GDP when the major source of instability is in the IS curve
• Figure 25A.2
– The demand for money is highly unstable which results in a shift of the
LM curve
– In this case, the interest rate target is superior—there is no instability in
GDP
• Therefore, the choice between interest rate or money supply targets depends
on where the instability comes from—the IS or the LM curve
• The authors suggest the demand for money is unstable (LM curve) which
indicates that an interest rate target is best
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FIGURE 25A.1 With an interest rate target, an unstable IS
curve leads to wider variation in GDP than if the Fed had a
money supply target.
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FIGURE 25A.2 With a money supply target, an unstable
LM curve leads to wider variation in GDP than if the Fed
had an interest rate target.
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