CHAPTER 9

Policy Analysis with

the IS/LM Model

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 1

 Thread
• What is the condition of the economy and what, if
anything, should be done about it?
• Steps to deal with that fundamental question:
– Measurement and policy objectives
– Conceptual and theoretical frameworks
– Monetary and fiscal policies
• It’s this last step we explore more thoroughly here

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 2

 Objectives: you should be able to …

• Explain the [conventional] limits of

monetary and fiscal policies – crowing out
and the liquidity trap
• Explain how these policies can achieve
policy targets in principle

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 Policy Analysis with the IS/LM
Model
• A Closer Look at Monetary and Fiscal
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
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 Effects of Monetary and Fiscal
Policy in the IS/LM Model
• 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
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 Fiscal Policy and Crowding Out
• 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.
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 1. The multiplier is 2 and
Partial Crowding Out
government spending increases by 2. The increase in income
$500, so the IS increases by $1000. increases money demand
which increases interest
LM
Real Interest Rate (%)

rates from 4% to 5%.

$1000 3. The increase in the interest

rate causes a decrease in
investment so that the increase
5%
in income is only $600, less that
the full multiplier effect.

4% IS1

IS0

$6000 $6600 $7000

Aggregate Output
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 1. The multiplier is 2 and
Full Crowding Out
government spending increases by
$500, so the IS increases by $1000. 2. If the demand for money
is totally insensitive to the
interest rate, the interest rate
Real Interest Rate (%)

LM increases from 4% to 9%.

9% 3. The increase in the interest

rate causes a decrease in
investment that completely offsets
the increase in government spending.
$1000
4%
IS1

IS0

$6000 $7000
Aggregate Output
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 Ineffective Fiscal Policy
• 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

2002 Prentice Hall Business Publishing Macroeconomics, 1/e Colander/Gamber 9

 Monetary Policy in the IS/LM Model
The Fed increases the In a liquidity trap, increases
money supply which in the money supply do not
decreases interest rates decrease interest rates, so
and increases investment investment and output do
Real Interest Rate (%)

Real Interest Rate (%)

and output. not increase.

LM0 LM0
LM1
LM1

r0 r0
r1
IS IS

Y0 Y1 Y0
Aggregate Output Aggregate Output
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 Ineffective Monetary Policy
• 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.
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 Short-Run Outcomes of Policy

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 Examples of Monetary and
Fiscal Policies

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 Policy when the Economy is Above Potential
Contractionary monetary Contractionary fiscal policy
policy raises interest rates decreases interest rates and
and reduces output. decreases output.
Real Interest Rate (%)

Real Interest Rate (%)

LM1
LM0 LM

r1

r0 r0
IS0
r2
IS IS1

Y1 Y0 Aggregate Output Y1 Y0 Aggregate Output

potential potential
output output
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 Accomodative Monetary Policy
2. Accomodative monetary policy
increases output even further and
Real Interest Rate (%)

offsets the rise in interest rates.

LM0
LM1
B
r1

C
IS1
r0
 
A 1. Expansionary fiscal
IS0 policy increases output
and interest rates.
Y0 Y1 Y2
Aggregate Output

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 Accomodative Fiscal Policy
1. Contractionary monetary policy
lowers output and increases
interest rates.
Real Interest Rate (%)

LM1
B LM0

r1
 2. Contractionary
fiscal policy further
C A reduces output and
IS0
r0
  offsets the increase
in interest rates.

IS1
Y2 Y1 Y0 Aggregate Output
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 Offsetting Policies
2. Expansionary monetary policy
further reduces the interest rate
and offsets the decline in output.
Real Interest Rate (%)

LM0
LM1
A
r0

B IS0

C 1. Contractionary fiscal
r1
 policy lowers the interest
rate and output.
IS1
Y1 Aggregate Output
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 U.S. Economic Policy in the 1940s
2. The Fed accomodated the
expansionary fiscal policy to keep
Real Interest Rate (%)

interest rates constant.

LM0 LM1

r1

IS1
r0
1. Government increased
defense expenditures
during World War II.
IS0
Y0= Y1 Y2
Aggregate Output
potential

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 U.S. Economic Policy in the 1950s
The Fed uses
Real Interest Rate (%)

contractionary
LM1 monetary
LMo policy to fight
inflation.
r1

IS0
r0

Y 1= Y0
potential Aggregate Output

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 U.S. Economic Policy in the 1980s
1. The Fed fought inflation by
Real Interest Rate (%)

reducing the money supply.

LM1
LM0

r2
r1
IS1

r0 2. And
government
spending rose.
IS0
Y 1 Y2 Y0 Aggregate Output

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 Group Exercises
• P.269 – 1+

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 Problems Using IS/LM in Real
World Policy Analysis
• Interpretation Problems
– Problems in knowing how to interpret
real-world events within the IS/LM
framework
• Implementation Problems
– Problems encounter in undertaking
policy
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 Interpretation Problems
• Interest Rate Problem
• Anticipation of Policy Problems
• Monetary Tools and Credit Condition
Problems
• Interest Rate Target Problem
• Budget Problems
– Cyclical and Structural Problems
– Accounting Methods
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 The Interest Rate Problem
• Which interest rate, nominal or real, is
relevant?
– When there is inflation, the nominal rate is
greater than the real rate.
• Which of many interest rates in the
economy is relevant?
– The Fed can control the Federal funds rate,
but it is not the interest rate households and
businesses pay to borrow money.
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 Why Interest Rates Differ
• 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
• http://www.federalreserve.gov/releases/h15/update/
• Differences in expected inflation

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 Typical Yield Curve Inverted Yield Curve
6 6

5.5 5.5

5 5
Yield(%)

Yield(%)
4.5 4.5

4 4

3.5 3.5
3 6 1 2 5 10 30 3 6 1 2 5 10 30
mos. yr. Maturities mos. yr. Maturities
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 Anticipation of Policy Problems
• The IS/LM model does not take into
account the effect of people’s expectations
of policy actions.
• If investors expect the Fed to increase the
money supply and decrease interest rates,
they will buy bonds now.
• The increase in demand for bonds
increases their price and decreases interest
rates before the money supply is actually
increased.
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 Monetary Policy Tools and
Credit Condition Problems
• The IS/LM model assumes that interest
rates are the only determinant of
investment.
• Investment 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.
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 The Interest Rate Target
Problem
Real Interest Rate (%)

To keep the interest rate at

its target of 2%, the Fed
offsets shifts in the IS curve
with accomodating
monetary policy. The Fed
is maintaining an effective
Effective LM Curve LM curve that is
horizontal
at the targeted interest rate
IS1 of 2%.

IS0
IS2
Y2 Y0 Y1
Aggregate Output
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 Budget Problem: Cyclical and
Structural Budgets
• 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.

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 Structural and Cyclical Deficits
and Surpluses

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 Implementation Problems of
Monetary and Fiscal Policy

• Uncertainty about Potential

Output
• Information Lag
• Policy Implementation Lag

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 Uncertainty About Potential Output
• One macroeconomic policy goal is to
keep output as close to potential as
possible.
• In the real world, economists aren’t sure
what potential output is.
• If policymakers use contractionary policy
when the economy is actually below
potential, they create unemployment.
• Using expansionary policy above
potential output will cause inflation.
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 Information Lag
• 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.

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 Policy Implementation Lag
• The policy implementation lag is the delay
between the time policymakers recognize the
need for a policy action and when the policy is
instituted.
• Fiscal policy has a large implementation lag
because policy must be formulated and
legislation passed by Congress and the
President.
• Monetary policy has a shorter implementation
lag because the Federal Open Market
Committee decides monetary policy.

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 Automatic Stabilizers
Countercyclical Built-in Programs

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