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IS-LM Model

- Fiscal Policy
- Monetary Policy

Outline

- Introduction
- Revision
- Slope Shift of IS curve
- Slope Shift of LM curve
- Fiscal Policy
- Expansionary Contrationary Fiscal Policy
- Crowding-Out Effect
- Effectiveness of Fiscal Policy

Outline

- Monetary Policy
- Expansionary Contractionary Monetary Policy
- Effectiveness of Monetary Policy
- Deflationary Inflationary Income Gap
- IS-LM model versus Simple Keynesian Model

Introduction

- Unemployment (when Y lt Yf) is one of the major

economic problems - The government always tries to attain full

employment Yf - In the simple Keynesian model, the government can

adopt expansionary fiscal policy (?G ?T) when

there is a deflationary / recessionary gap (Yf -

Y)

Introduction

- Y will then increase by the amount of k E?G OR

k T?T - Since in a three-sector Keynesian model
- Y
- ?Y OR ?Y

Introduction

- Will income increase by the same amount as in the

elementary Keynesian model when the government

adopt a discretionary (fiscal / monetary) policy,

when both interest rate and income are endogenous

variables in the IS-LM model?

Revision - IS Curve

C C cYd C - cT cY T T I I - br G

G

r slope ??r/?Y Y x-intercept when r

0

Revision - IS Curve

When b is smaller, the IS curve will be When s

is larger, the IS curve will be But k E will be

r

Construct IS2

IS1

Y

Revision - IS Curve

b s k E

b s k E

r

r

Y

Y

Revision - IS Curve

r

Y ?Y/?G ?Y/?T x-intercept when r 0

Y

Revision - LM Curve

Ms Ms Mt dY Ma Ma - er

r slope ??r/?Y Y x-intercept when r

0

Revision - LM Curve

When e is larger, the LM curve will be When d is

smaller, the LM curve will be But 1/d will be

r

Construct LM2

LM1

Y

Revision - LM Curve

e d 1/d

e d 1/d

r

r

Y

Y

Revision - LM Curve

r

Y ?Y/?Ms x-intercept when r 0

Y

Expansionary Fiscal Policyve ?G OR -ve ?T

LM

IS

r

Y

Contractionary Fiscal Policy-ve ?G OR ve ?T

LM

IS

r

Y

Crowding-Out EffectExpansionary Fiscal Policy ?G

When r r1, there is excess money _____ as Y

rises and _____ rises _____ has to decrease in

order to restore equilibrium in the money market

Ms Mt Ma

IS1

LM

IS2

r

r1

Y

Y1

Y2

Crowding-Out EffectExpansionary Fiscal Policy ?G

- When government expenditure increases, G?, IS

curve will shift outward by k E?G. - If interest rate remains constant, when Y ? ,

there will be excess money demand, as

transactions demand for money has increased - Mt ? dY ?
- In order to restore equilibrium in the money

market Ms Mt ? Ma ? - Interest rate has to increase r ? in order to

reduce the asset demand for money - Ma ? Ma - er ?

Crowding-Out EffectExpansionary Fiscal Policy ?G

- But when r ? investment will decrease I ?
- I ? I - br ?
- Income will decrease Y ? through the multiplier

effect ?Y k E ?I - As a result, ?Y is less than that as in the

simple Keynesian model

Crowding-Out EffectExpansionary Fiscal Policy ?G

- If interest rate will increase (How about e??)

and investment will decrease (How about b0?),

the effectiveness of an expansionary fiscal

policy on income is reduced. - Crowding-out effect refers to the situation in

which a rise in government expenditure raises

interest rate, causing interest sensitive

investment to fall.

Zero Crowding OutExpansionary Fiscal Policy ?G

Horizontal LM slope ??r/?Y d/e e ??Ma/?r

r

IS1

IS2

LM

When Y? by k E ?G Mt ? Ma ? to restore

equilibrium Since e ?, ?r 0 and ?I 0. Thus,

NO Crowding-out Effect

Y

Zero Crowding OutExpansionary Fiscal Policy ?G

Horizontal LM slope ??r/?Y d/e d ??Mt/?Y

r

IS1

IS2

When Y? by k E ?G Since d0, ?Mt0 and ?Ma0,

in order to maintain equilibrium Thus, ?r 0

and ?I 0. Thus, NO Crowding-out Effect

LM

Y

Zero Crowding Out ???Expansionary Fiscal Policy

?G

IS

r

Vertical IS slope ??r/?Y -s/b s ? 1/k

E ? k E ?Y k E ?G

LM

Y

Zero Crowding OutExpansionary Fiscal Policy ?G

Vertical IS slope ??r/?Y -s/b b ??I/?r

IS1

IS2

r

LM

When Y? by k E ?G Mt ? Ma?, in order to

maintain money mkt equilibrium r ? but ?I 0

since b 0 Thus, NO Crowding-out Effect

Y

Full Crowding OutExpansionary Fiscal Policy ?G

Vertical LM slope ??r/?Y d/e e ?Ma/?r

0 ? Mt? but as ? Ma 0 ? r ? I ? ? Y ? in

order to reduce Mt to the original level

r

IS1

IS2

LM

Y

Full Crowding OutExpansionary Fiscal Policy ?G

Vertical LM slope ??r/?Y d/e d ?Mt/?Y

? ? Mt ? ? Ma ? ? r ? I ? ? Y ? in order to

reduce Mt to the original level

r

IS1

IS2

LM

Y

Full Crowding OutExpansionary Fiscal Policy ?G

Horizontal IS slope ??r/?Y -s/b s 0 1/k

E ? k E b ?

r

LM

IS

Y

Crowding-Out Effect

- Zero crowding-out effect occurs when
- IS curve is vertical with b 0
- LM curve is horizontal with e ? or d 0
- How about the case when IS curve is vertical with

s?? - Full crowding-out effect occurs when
- IS curve is horizontal with b ?
- LM curve is vertical with e 0 or d ?
- How about the case when IS curve is vertical with

s0?

1999 A7

- If consumption expenditure does not only depend

positively on income but also negatively on

interest rate, the IS curve will become ___ and

the crowding out effect of fiscal policy will be

___ (assuming that the LM curve is upward

sloping) - A. flatter smaller
- B. flatter bigger
- C. steeper smaller
- D. steeper bigger

1997 C6

- Use the IS-LM model to explain the meaning of the

crowding-out effect and how it affects the impact

of government expenditure on national income.

Illustrate your answer with a diagram. (5 marks) - Explain whether the crowding-out effect will

definitely occur when an increase in government

expenditure leads to an increase in the interest

rate. Illustrate your answer with a diagram. (5

marks)

1997 C6 (a)

Crowding-out effect means that as government

increases its expenditure, interest rate will be

bid up, which in turn will reduce investment. The

reduction in investment will reduce the impact of

government expenditure on income

r

IS1

IS2

LM

Y

?Yk E?G

1997 C6 (b)

Suppose investment is independent of interest

rate b 0. IS curve will be vertical. Increase

in government expenditure will shift the IS

curve to the right. The increase in interest

rate will not lead to any reduction in I. There

will be no crowding out effect.

LM

IS1

r

Y

Many candidates argued that when the LM curve was

horizontal, there would be no crowding out

effect. But the question specified that the

interest rate will rise.

Effectiveness of Fiscal Policy

- G? ? k E ? Y? ? d ? Mt? ?
- Excess Money Demand ? e ? r? ? b ?
- I? ? k E ? Y?
- The effectiveness of fiscal policy depends on
- k E
- d
- e
- b

Effectiveness of Fiscal Policy

- The greater the simple Keynesian multiplier k E

( ?Y/?G), the larger the multiplying effect

the more effective/ potent will be the fiscal

policy - k E is larger when MPS is smaller / MPC is

larger, proportional tax rate t is smaller, MPM

is smaller

Effectiveness of Fiscal Policy

- The smaller income elasticity of money demand d

( ?Mt/?Y), the more effective will be the fiscal

policy. - Given any increase in Y, the increase in Mt will

be smaller. - Smaller excess money demand means smaller

increase in interest rate, which cuts back Ma, is

enough - Smaller increase in interest rate means smaller

decrease in investment, i.e., smaller

crowding-out effect.

Effectiveness of Fiscal Policy

- The greater interest elasticity of money demand e

( ?Ma/?r), the more effective will be the fiscal

policy. - Given any excess money demand, smaller increase

in interest rate is enough to cut back Ma to

restore equilibrium in the money market. - Smaller increase in interest rate means smaller

decrease in investment and smaller crowding out

effect.

Effectiveness of Fiscal Policy

- The smaller the interest elasticity of investment

b ( ?I/?r), the more effective will be the

fiscal policy. - Given any increase in interest rate, the

reduction in investment is smaller, and hence a

smaller crowding out effect.

Effectiveness of Fiscal Policymore effective

fiscal policy means less crowding-out effect, so

compare with the cases of zero crowding-out

- Fiscal policy will be more effective when
- simple Keynesian income multiplier rises k E ?
- income elasticity of money demand falls d ?
- interest elasticity of money demand rises e ?
- interest elasticity of investment falls b ?
- Fiscal policy will be more effective when
- IS curve is steeper when b ? not because of s ?
- s will affect the shift of the IS curve
- LM curve is flatter when e ? or d ?

Effectiveness of Fiscal Policy

r

The increase in Y is greater when the IS curve is

steeper, i.e., smaller interest elasticity of

investment b

LM

Y

Effectiveness of Fiscal Policy

The increase in Y is greater when the LM curve is

flatter, i.e, interest elasticity of money demand

e greater income elasticity of money demand d

smaller

Expansionary Monetary Policyve ?Ms

r

IS

LM

Y

Contractionary Monetary Policy-ve ?Ms

LM

IS

r

Y

Expansionary Monetary Policyve ?Ms

- Ms? ? ESM ? r ? ? e ? Ma?
- ?
- ? b ? I ? ? k E ? Y ?
- ?
- ? d ? Mt?

Expansionary Monetary Policyve ?Ms

- A rise in money supply (Ms?) will lead to excess

supply of money (ESM) initially. - Interest rate will fall (r ?), the asset demand

for money will increase (Ma?) to absorb part of

the excess money supply - Ma ? Ma - er ?

Expansionary Monetary Policyve ?Ms

- When interest rate falls (r ?), investment will

increase (I ?) - I ? I - br ?
- Here, the adjustment in the money market has

already been transmitted to the goods market.

Expansionary Monetary Policyve ?Ms

- The rise in investment (I ?)will cause income to

increase (Y ?) in a multiplying way. - ?Y k E ?I
- When income increases, transaction demand for

money will also increase (Mt ?). - Mt ? dY ?
- This will then help to absorb the excess money

supply

Effectiveness of Monetary Policy

- The effectiveness of monetary policy depends on
- e
- b
- k E
- d

Effectiveness of Monetary Policy

- The smaller the interest elasticity of money

demand e ( ?Ma/?r), the more effective is the

monetary policy - Given an increase in money supply, interest rate

has to fall by a greater extent to stimulate

sufficient Ma ? to absorb the excess money

supply. - The greater the fall in interest rate, the

greater the rise in investment and the greater

the increase in income.

Effectiveness of Monetary Policy

- The greater the interest elasticity of investment

b ( ?I/?r), the more effective is the monetary

policy. - Given the excess money supply, interest rate will

fall. - If investment is more elastic to interest rate,

investment will then increase by a greater extent

and so will the income

Effectiveness of Monetary Policy

- The greater the income multiplier k E (?Y/?E),

the more effective is the monetary policy. - Given any increase in money supply, interest rate

will fall and investment will increase. - If the income multiplier is larger, income will

increase by a greater extent. - k E is larger if the marginal leakage rate w

(i.e. s, t, m) is smaller

Effectiveness of Monetary Policy

- The smaller the income elasticity of money demand

d (?Mt/?Y), the more effective is the monetary

policy. - Given any increase in money supply, interest rate

will fall, investment and income will increase. - If the money demand is less income elastic, the

rise in transaction demand will be smaller.

Effectiveness of Monetary Policycontd

- Thus, interest rate has to fall by a greater

extent in order to generate sufficient Ma to

absorb the excess money supply. - With a greater fall in interest rate, the rise in

investment and income will be larger. - The shift of the LM curve will be affected by d .

Effectiveness of Monetary Policy

- Monetary policy will be more effective when
- interest elasticity of money demand rises e ?
- interest elasticity of investment falls b ?
- simple Keynesian income multiplier rises k E ?
- income elasticity of money demand falls d ?
- Monetary policy will be more effective when
- IS curve is flatter when b ? or w ?
- LM curve is steeper when e ? not because of d ?
- d will affect the shift of the LM curve

Effectiveness of Monetary Policy

The increase in Y is greater when the IS curve is

flatter, i.e., larger interest elasticity of

investment b smaller marginal leakage rate w

r

Flatter IS

Y

Effectiveness of Monetary Policy

The increase in Y is greater when LM is steeper,

i.e., smaller interest elasticity of money demand

e BUT d has also to be small, otherwise the shift

will be smaller

r

Y

Monetary Policy will be most effective with

horizontal IS

r

Horizontal IS w/b 0 when b ? OR when w 0

Y

Monetary Policy will be most effective with

vertical LM

r

Vertical LM d/e ? when e 0 !!! BUT when d ?

Y

Monetary Policy will be totally ineffective with

vertical IS

Vertical IS w/b ? when b 0 OR when w ?

r

Y

Monetary Policy will be totally ineffective with

horizontal LM

Horizontal LM d/e 0 when e ?

r

Y

Monetary Policy will be totally ineffective with

horizontal LM

- If money demand is perfectly interest elastic,

people are willing to hold whatever amount of

money as asset demand Ma at the prevailing

interest rate - Accordingly, any excess money supply caused by an

expansionary monetary policy will then

immediately be absorbed as asset demand without

leading to a fall in interest rate. - With interest rate constant, no change in

investment and income can then be conceived.

If money demand is perfectly elastic to interest

rate e ?

r

Y

Ma

Mt

Expansionary Fiscal PolicyFull Employment

- When government expenditure rises, aggregate

expenditure increases. - Given flexible prices and full employment, the

excess demand in the goods market will raise the

price level, rather than output.

Expansionary Fiscal PolicyFull Employment

- The increase in the price level will lead to a

fall in real money supply refer IS-LM.model 2

12 - Ms / P ms
- Real interest rate will rise which leads to a

reduction in investment. - The excess demand in the goods market will be

eliminated.

Expansionary Fiscal PolicyFull Employment

- Full crowding-out will occur.
- Since the subsequent fall in investment must

equal the initial rise in government spending for

aggregate demand to fall back to the full

employment level. - Hence, an expansionary fiscal policy will only

cause the price level and real interest rate to

rise but have no effect on income.

Expansionary Monetary PolicyFull Employment

- If an expansionary monetary policy is applied,

interest rate will fall to stimulate investment,

causing aggregate demand to rise. - Given flexible prices and full employment, the

rise in aggregate demand will raise prices. - This will cause the real money supply to fall

Expansionary Monetary PolicyFull Employment

- Interest rate will then increase and cut back the

aggregate demand for goods. - As a whole, real money supply, real interest rate

and aggregate demand will return to the original

level and income will remain unchanged. Only

price level has risen.

Deflationary Income Gap

Expansionary Monetary Policy

Expansionary Fiscal Policy

r

r

Y

Y

Yf

Yf

Inflationary Income Gap

Contractionary Monetary Policy

Contractionary Fiscal Policy

r

r

Y

Y

Yf

Yf

Numerical Example

- C 150 0.5Yd
- I 100 - 400r
- G 150
- T 100

Numerical Example

- Mt 0.25 Y
- Ma 50 - 100r
- Ms 180

Numerical Example

- Yf 1000
- Ye
- Inflationary / Deflationary Gap

More on fiscal policy

- Refer Three-sector.model61-68
- Location of Effects
- Reversibility of Policy
- Time Lags
- Recognition, Decision, Action/Executive, Outside
- Efficiency of Taxation
- Total tax burden Tax payment Excess burden

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