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Agenda

• Policy Analysis with the IS – LM Model

The IS – LM Model, Part 4

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Policy Analysis with the IS – LM Model
• Monetary policy:
Changes in the nominal money supply.

Policy Analysis with the IS – LM Model
• Expansionary policies:
Increases in the nominal money supply. Increases in government purchases. Decreases in taxes (no Ricardian equivalence).

• Fiscal policy:
Changes in government purchases. Changes in taxes.

• Contractionary policies:
Decreases in the nominal money supply. Decreases in government purchases. Increases in taxes (no Ricardian equivalence).
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Expansionary monetary policy r FE LM0 r0 IS0 Y0 15-5 Y 15-6 Expansionary monetary policy • An expansionary monetary policy shifts the LM curve to the right. and Md/P. Cd. and r begins to fall. • Investment is higher. At the initial real interest rate (r0). 15-7 Expansionary monetary policy • Net result: An increase in Y and a decrease in r. This increases Ms/P directly. which increases Y. 15-8 2 . This process continues until general equilibrium is re-established. M > L.Policy Analysis with the IS – LM Model • Expansionary monetary policy: Increases in the nominal money supply. Composition of spending has changed: • Consumption is higher. • Government spending is the same. A falling r decreases Sd and increases Cd and Id.

targeting. 15-9 15-10 Ms targeting. • With a demand for money shock. Ms. • A stabilizing central bank. • With a goods market shock. Interest rate. targeting. targeting. Y. targeting. MS. Md shock r FE LM0 r0 r0 IS0 Y0 Y 15-11 IS0 Y0 Y 15-12 3 .Policy Analysis with the IS – LM Model • Monetary policy objectives: Money supply. Economic activity. r. Policy Analysis with the IS – LM Model • Monetary policy objectives: Money supply. Goods market shock r FE LM0 Ms targeting.

Goods market shock r FE LM0 r0 IS0 Y0 15-13 Y 15-14 Interest rate targeting. targeting. Md shock r FE LM0 Policy Analysis with the IS – LM Model • Monetary policy objectives: Economic activity. IS0 Y0 Y 15-15 15-16 4 . r0 • With a demand for money shock.Policy Analysis with the IS – LM Model • Monetary policy objectives: Interest rate. Interest rate targeting. • With a goods market shock. r. targeting. • With a goods market shock. Y. • With a demand for money shock.

Expansionary fiscal policy (gov’t purchases) r FE LM0 r0 IS0 Y0 15-19 Y 15-20 5 .Y targeting. Goods market shock r FE LM0 Y targeting. Md shock r FE LM0 r0 r0 IS0 Y0 Y 15-17 IS0 Y0 Y 15-18 Policy Analysis with the IS – LM Model • Expansionary fiscal policy: Increases in government purchases.

A rising r increases Sd and decreases Cd and Id. L > M. which reduces Y and Md/P. This increases Y directly and increases Cd by the marginal propensity to consume. • Government spending is higher. Composition of spending has changed: • Consumption is higher. • Investment is lower.Expansionary fiscal policy (gov’t purchases) • An expansionary fiscal policy shifts the IS curve to the right. This process continues until general equilibrium is reestablished. Expansionary fiscal policy (taxes) r FE LM0 r0 IS0 Y0 15-23 Y 15-24 6 . 15-22 Policy Analysis with the IS – LM Model • Expansionary fiscal policy: Decreases in taxes (no Ricardian equivalence). At the initial interest rate (r0). and r begins to rise. which also increases Md/P. 15-21 Expansionary fiscal policy (gov’t purchases) • Net result: An increase in both Y and r.

• Investment is lower. A rising r increases Sd and decreases Cd and Id. 15-25 Expansionary fiscal policy (taxes) • Net result: An increase in both Y and r. which reduces Y and Md/P. Expansionary fiscal policy.Expansionary fiscal policy (taxes) • An expansionary fiscal policy shifts the IS curve to the right. and r begins to rise. At the initial interest rate (r0). This increases YD directly and increases Cd by the marginal propensity to consume. Composition of spending has changed: • Consumption is higher. • Government spending is constant. which also increases Md/P. • Government spending is constant. Composition of spending has changed: • Consumption is higher. 15-26 Expansionary fiscal policy. • Investment is lower. Crowding out • Expansionary fiscal policies lead to: An increase in both Y and r. Crowding out r FE LM0 r0 Higher interest rates have “crowded out” investment. L > M. This process continues until general equilibrium is reestablished. Y0 15-27 IS0 Y 15-28 7 .

Crowding out • Can “crowding out” of investment be avoided when using an expansionary fiscal policy? Avoiding Crowding Out r FE LM0 r0 IS0 Y0 15-29 Y 15-30 Expansionary fiscal policy. This is called “accommodating monetary policy. Depending on the policy combination used. 15-31 15-32 8 .Expansionary fiscal policy. different interest rates will result. Crowding out • “Crowding out” of investment can be avoided when using an expansionary fiscal policy by combining it with an expansionary monetary policy.” Policy Analysis with the IS – LM Model • By using monetary and fiscal policy in conjunction. any desired level of economic output can be achieved. This also implies a different composition of output.

Fiscal Contraction • A monetary expansion and fiscal contraction can maintain the same level of economic activity but with a lower real interest rate. Fiscal Expansion • A monetary contraction and fiscal expansion can maintain the same level of economic activity but with a higher real interest rate. What happens to the composition of output? r0 IS0 Y0 Y 15-35 15-36 9 . What happens to the composition of output? r0 IS0 Y0 Y 15-33 15-34 Monetary Contraction. Fiscal Expansion r FE LM0 Monetary Contraction. Fiscal Contraction r FE LM0 Monetary Expansion.Monetary Expansion.

Policy Analysis with the IS – LM Model • Which composition of output is better? Higher or lower investment? What kind of investment? What kind of government purchases? What kind of taxes? 15-37 10 .