CHAPTER 11

MONETARY AND FISCAL POLICY

Chapter Outline:

• The effects of fiscal and monetary policy on output

• Monetary policy and the transmission mechanism
• The liquidity trap
• The classical case
• The quantity theory of money
• Fiscal policy and crowding out
• Monetary accommodation
• The effects of alternative policies on the composition of output
• The U.S. economy in the 1980s and 1990s
• Anticipatory monetary policy
• The policy mix during the German re-unification

Changes from the Previous Edition:

The material in this chapter has been updated, but its format is essentially the same. More
emphasis is given to the economic expansion in the U.S. in the 1990s.

Introduction to the Material:

Chapter 11 uses the IS-LM model derived in Chapter 10 to show how monetary and fiscal
policies can be used to dampen economic disturbances. The economic effects of various policy mixes are
highlighted in discussions of actual events: the recession and recovery in the United States in the 1980s,
the U.S. recession in 1990-91, the long economic expansion thereafter, and the policies enacted by
Germany during the re-unification process in 1990-92.
First, the Fed's conduct of monetary policy is discussed, with an explanation of how open market
operations can be used to change nominal money supply. The effectiveness of monetary policy in
changing the amount of output demanded depends on the steepness of the LM-curve. The transmission
mechanism, that is, the process by which monetary policy changes affect the economy, occurs in several
steps. First, a change in money supply leads portfolio holders to make adjustments in their asset holdings.
As a result, asset prices and interest rates change. The change in interest rates subsequently affects
intended spending and thus national income. Table 11-1 provides a summary of this process.
Two extreme cases in the operation of monetary policy are given special attention. Monetary
policy is powerless to affect interest rates (and thus the economy) in the liquidity trap (represented by a
horizontal LM-curve). The polar opposite is the classical case (represented by a vertical LM-curve), in
which a given change in money supply has the greatest effect on the level of income.
The effectiveness of expansionary fiscal policy depends on the amount of crowding out that takes
place, that is, on the reduction in private spending (most notably investment) caused by rising interest
rates following fiscal expansion. It is important to state that crowding out is always a matter of degree.

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When output is close to the full-employment level, any increase in aggregate demand due to fiscal
expansion will be reflected mainly in an increase in interest rates and the price level, with little effect on
the level of output. But when the economy experiences high unemployment, fiscal expansion can
stimulate the economy successfully, without much upward pressure on interest rates or prices.
Since Chapter 11 deals only with the IS-LM model, the extent of the crowding-out effect depends
on the slopes of the IS- and LM-curves. The flatter the IS-curve and the steeper the LM-curve, the larger
the crowding-out effect. (Special attention is again given to the two extremes of the liquidity trap and the
classical case). The factors that determine the slopes of the IS- and LM-curves have already been
discussed in the previous chapter. Here, some additional examples are given to emphasize the effects of
fiscal policy changes on the composition of output, including the effects of investment subsidies.
While monetary and fiscal policy can both raise the level of output, their impacts on the
composition of GDP can differ significantly. Monetary policy operates by affecting interest rates, which
will first be felt by the most interest-sensitive sectors of the economy. In contrast, the effects of fiscal
policy depend on which category of government expenditures and/or taxes are changed. Intended
spending is affected first, but the impact on interest rates will modify the overall size of the multiplier
effect.
Since different monetary and fiscal policy mixes vary in their effects on the different sectors of
the economy, actual policy choices are often determined by political preferences. Liberals often favor
increases in government spending on education, job training, or the environment, while conservatives
tend to favor tax cuts. Those advocating rapid economic growth favor investment subsidies and lower
interest rates.
The economic policies implemented in the early 1980s differed greatly from those implemented
in previous decades and serve as an excellent example of the effects of a tight monetary/expansionary
fiscal policy mix. Monetary restriction in combination with fiscal expansion sharply increased interest
rates. The Fed's tight monetary policy caused the 1981/82 recession but successfully reduced the high
inflation rate, whereas the administration's expansionary fiscal policy drove the recovery after 1982.
For the rest of the 1980s, the Fed's monetary policy succeeded in keeping the recovery going, but
the fear of renewed inflation kept the Fed from lowering interest rates more rapidly in 1990 when early
warning signs showed that the economy was headed for a recession. With Congress and the
administration deadlocked over which fiscal policy measures to implement, it was up to the Fed to fight
the recession. In an effort to stimulate the economy, the Fed repeatedly cut interest rates but, considering
the long monetary policy lags, probably should have moved earlier and more aggressively.
After the 1990-91 recession, the U.S. economy experienced its longest peacetime expansion ever.
The Fed and its chair Alan Greenspan deserve considerable credit for manipulating interest rates to allow
continued economic expansion. The enormous growth rates of the late 1990s were attributed primarily to
rapid technological growth, particularly due to investment in computer technology. Throughout this
period, the Fed used prudent demand side management, always alert to the inflationary pressure that can
build up as the economy grows too much. This anticipatory monetary policy became particularly evident
in 2000, when the Fed raised interest rates several times after reports of very strong growth in late 1999.
While the political climate surrounding the re-unification of Germany was quite different from
that in the U.S. in the early 1980s, the consequences of Germany's policy mix in the early 1990s closely
resembled those of the early Reagan policies. Chancellor Kohl had promised that the German
re-unification would not be financed by a tax increase. However, the German Bundesbank (one of the
most anti-inflationary and independent central banks in the world), was unwilling to accommodate a
massive increase in public spending with expansionary monetary policy. It is not surprising that, as a
result of this restrictive monetary and expansionary fiscal policy mix, Germany experienced high real
interest rates and a deficit in the current account of the balance of payments.

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Suggestions for Lecturing:

Discussing actual events with which students should be at least somewhat familiar always makes
the theoretical material come to life and gets students to participate more actively in class. The material
presented in Chapter 11 about the economic policies implemented in the 1980s and early 1990s provides
an excellent opportunity to show how various policy mixes affect income and the interest rate via the
IS-LM framework. On the one hand, the discussion of real life events serves to show how well even a
fairly simple model such as the IS-LM diagram can be used to predict the outcomes of various policy
mixes. On the other hand, it also points out the limitations of the static, short-run nature of the model.
References to aspects not incorporated in the model, such as international linkages and inflation should be
included in classroom discussions.
While most instructors probably vividly remember the supply-side experiment under Reagan, they
should realize that most of today’s students were borne after 1980 and know little, if anything, about
economic events of that period. The same may be true for the recession of 1990-91 and the German
re-unification. Thus it is extremely important to supplement the material in this chapter with examples of
some more recent policy actions.
When discussing monetary accommodation of expansionary fiscal policy, the following point
should be made: Within an IS-LM framework, that is, as long as prices are assumed to be fixed, the Fed
can prevent crowding out fairly easily by expanding money supply. However, as soon as prices are
allowed to vary, such policy may lead to a higher price level. In this case, crowding out cannot be avoided
since a higher price level implies lower real money balances, which provide upward pressure on interest
rates.
It is also important that students understand why fiscal policy has a much smaller multiplier effect
in the IS-LM model than in the simple Keynesian model of income determination that was presented in
Chapter 9. In the IS-LM framework, the extent of crowding out clearly depends on the slopes of the IS-
and LM-curves. Even though the factors determining these slopes are covered in Chapter 9, it may be
beneficial to mention them here again. Instructors also may want to assign both Chapter 9 and Chapter 10,
simultaneously, since Chapter 9 lays the theoretical framework for the IS-LM model, while Chapter 10
provides its practical application.
Since the IS- and LM-curves represent equilibrium conditions in the expenditure and money
sectors, respectively, any change in slope must be the result of a structural change in one of the basic
relationships used in formulating the models for these sectors. The classical case (the case of a vertical
LM-curve, in which total crowding out occurs) and the liquidity trap (the case of a horizontal LM-curve,
in which no crowding out occurs) are two extreme cases. Although it is unlikely that either case will ever
occur, it is nonetheless useful to discuss them as they show students when fiscal or monetary policy either
has a maximum effect or no effect at all on national income and interest rates. In the discussion of the
liquidity trap, instructors should mention that some economist believe that Japan may have been in (or
close to) a liquidity trap in 1999.
Students should be asked to work out several examples of either fiscal or monetary policy
changes, both graphically and with a written explanation of the adjustment processes that take place. In
doing these exercises, students should ask themselves the following three questions:

• Which sector is involved, the expenditure sector or the money sector? This will tell them which
curve will shift, the IS-curve or the LM-curve.
• Will the policy change lead to an increase or decrease in national income? This will tell them
whether the respective curve will shift to the right or left.
• Is it a parallel shift (caused by a change in autonomous spending or nominal money supply) or is
it a change in the slope? The only policy change discussed here that could cause a change in slope

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 is a change in the marginal income tax rate (t), which would change the size of the expenditure
multiplier (α) and therefore the slope of the IS-curve.

The following simplified description of the adjustment process in response to an increase in

government purchases (G) may be used:

G up ==> Y up ==> the IS-curve shifts right ==> md up ==> i up ==> I down ==> Y down.

Effect: Y goes up, i goes up.

IS2
i IS1 LM

i2

i1

0
Y1 Y2 Y

The following simplified description of the adjustment process following an increase in real
money supply may be used:

ms up ==> i down ==> I up ==> Y up ==> the LM-curve shifts right ==> md up ==> i up.

Effect: Y goes up, i goes down.

i IS LM1

LM2

i1

i2

0
Y1 Y2 Y

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 When these simplified adjustment processes above are presented to students, they are often
confused that income goes up, even though the adjustment process ends with "Y down," or that interest
rates go down, even though the adjustment process ends with "i up." Instructors need to point out that the
initial effects of a policy are almost always stronger than the offsetting effects. The exceptions are the
extreme cases, such as the liquidity trap or the classical case. Students should also always remember the
following:

• Whenever there is a shift in the IS-curve, income is affected first and the resulting change in the
interest rate will offset some of the initial change in income by changing the level of investment.
The total income change will be less than what would be predicted by the expenditure multiplier
that was originally derived in Chapter 9.
• Whenever there is a shift in the LM-curve, interest rates are affected first and the resulting change
in income will offset some of the change in the interest rate by changing money demand.

It should also always be pointed out that all other variables that are dependent on either income or
the interest rate (such as consumption, income taxes, the budget surplus, etc.) are also affected by such
changes. Students should recognize that actual responses to a policy change are much more complex in
the real world than is shown in the simplified IS-LM model, which is static and short-run in nature and
shows only a basic adjustment process to a new macroeconomic equilibrium.
In discussing the material in Chapter 11, it should be made clear that the success of fiscal policy
in raising income (rather than interest rates or prices) depends largely on its timing, that is, at the stage in
an economic cycle at which the policy is applied. In other words, crowding out is always a matter of
degree; in a recession there is little upward pressure on interest rates and therefore little crowding out. But
in a boom income will not be stimulated much further while interest rates will rise much more easily.
Since some students have the notion that an increase in government purchases (G) always
requires an increase in taxes (TA), instructors should point out that an increase in government purchases
can be financed in three ways. The first two options involve only fiscal policy, while the third option is a
fiscal/monetary policy mix. Drawing the flows of money and government securities between the Treasury,
the public, and the Fed shows that only the third option involves an increase in the supply of money. The
three options of financing an increase in government spending are:

• by increasing taxes (an application of the so-called balanced budget theorem). This involves a
shift in the IS-curve by ∆IS = α(1-c)(∆G) to the right (assuming a lump sum tax increase and a
model without income taxes).
• by borrowing from the public (debt financing). This shifts the IS-curve by ∆IS = α(∆G) to the
right.
• by borrowing (indirectly) from the central bank. This case occurs if the central bank is concerned
about high interest rates caused by increased government borrowing and conducts open market
purchases to inject money into the economy to bring interest rates down. This is called money
financing, and involves not only a shift in the IS-curve by ∆IS = α(∆G) to the right but also a
shift in the LM-curve by ∆LM = (1/k)(∆M/P) to the right.

Concerns about the ill effects of a budget deficit often create the impression that budget deficits
are always bad and that a deficit reduction would be unequivocally good for the economy. It should be
stressed that an increase in deficit spending will stimulate the economy through the multiplier effect. On
the other hand, policies geared towards deficit reduction may contract the economy, since a spending cut
or tax increase will lead to a decline in aggregate demand. However, as the 1990s have shown, deficit

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reduction causes interest rates to decline, which may result in increased spending in private domestic
investment, leading to an economic growth spurt.
Since budgetary issues are always hotly debated, it is important to remind students that any
change in the budget deficit (or surplus) need not necessarily be caused by fiscal policy. Changes in the
actual budget surplus can also be the result of changing economic conditions (which may have been
caused by monetary policy changes or a supply shock). Therefore, the difference between the actual
budget surplus and its structural and cyclical components should again be stressed.
It should also be made clear to students that political preferences always come into play when
choosing a particular policy mix in any given situation. Who will benefit most from an increase in output?
Should it take the form of an increase in the size of the government? Should it take the form of lower
taxes so personal spending will increase? Should interest rates be lowered so more construction will take
place? Similarly, the discussion on what to do with the current and future predicted U.S. budget surpluses
is strongly influenced by political considerations.
The events of 1991 serve as an example to show that monetary policy may not always have the
desired effect on the economy--at least not initially. In the recession of 1991, the Fed pursued a policy of
easy money. However, banks were very reluctant to increase their lending since they were still recovering
from bad loans made to finance risky real estate deals. Since firms rely on banks to finance a large part of
their investment spending, the transmission process was interrupted. Critics of the Fed argued that, given
the length of monetary policy lags, the Fed should have lowered interest rates earlier and more
aggressively. It is unclear, however, whether expansionary policy can actually be successful if banks
practice credit rationing.
It cannot be stressed enough that anticipatory monetary policy can be very successful but also is
somewhat risky, since future economic conditions cannot be forecast with precision. Several times during
the long expansion of the 1990s, some suggested that interest rates should be raised to prevent a possible
increase in the inflation rate. However, others suggested that strong global competition would keep prices
low despite wage increases and that there was therefore no need to raise interest rates prematurely.
Even though international linkages won't be discussed until Chapter 12, it is important to note
here that not only the level of investment but also the level of net exports may be negatively affected by
expansionary fiscal policy. This becomes evident in a discussion of the economic events in the U.S. in the
early 1980s and the events in Germany in the early 1990s. In both countries, a policy mix of fiscal
expansion and monetary restriction caused high interest rates, resulting in an influx of foreign funds. This
led to an appreciation of the domestic currency that resulted in a trade imbalance. In Germany, the
situation became even more complicated since the countries of the European Community were supposed
to keep exchange rates virtually fixed, which became untenable. This led to the European currency crisis
in 1992. Discussing these two situations is a good starting point for the material that is presented in
Chapter 12.

Additional Readings:

Bernanke, B. and Lown C., “The Credit Crunch,” Brookings Papers on Economic Activity, 1991.
Bullard, James B., “The FOMC in 1991: An Elusive Recovery,” Review, FRB of St. Louis,
March/April, 1992.
Business Week, “The Boom,” Special Report, February 14, 2000.
Carlson, Keith M., “Federal Budget Trends and the 1981 Reagan Economic Plan,” Review, FRB of St.
Louis, January, 1989.
Carlson, K. and Spencer R., “Crowding Out and Its Critics,” Review, FRB of St. Louis, December, 1975.
The Economist, “Productivity on Stilts,” June 10, 2000.

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The Economist, “The New Economy,” July 24, 1999.
Gali, Jordi, “How Well Does the IS-LM Model Fit Postwar U.S. Data?” Quarterly Journal of Economics,
May, 1992.
Kretzmer, Peter E., “Monetary vs. Fiscal Policy: New Evidence on Old Debate,” Economic Review, FRB
of Kansas City, Second Quarter, 1992.
Krugman, Paul, “How Fast Can the U.S. Economy Grow,” Harvard Business Review, July/August, 1997.
Morgan, Donald P., “Are Bank Loans a Force in Monetary Policy?” Economic Review, FRB of Kansas
City, Second Quarter, 1992.
McNees, Stephen, “The 1990-91 Recession in Historical Perspective,” New England Economic Review,
FRB of Boston, January/February, 1992.
Tobin, James, “Voodoo Curse: Exorcising the Legacy of Reaganomics,” Harvard International Review,
Summer, 1992.
Uchitelle, Louis, “Productivity Gains Help Keep Economy on a Roll,” The New York Times,
March 22, 1999.

Learning Objectives:

• Students should understand the dynamics of adjustment in the IS-LM model following a fiscal or
monetary policy change.
• Students should understand the concept of crowding out.
• Students should be aware that crowding out is a matter of degree. In the IS-LM model, that degree
depends on the slopes of the IS- and LM-curves.
• Students should be able to identify the factors that determine the slopes of the IS- and LM-curves.
• Students should be aware of the limitations of the static, short-run nature of the IS-LM model.
• Students should know that different ways of financing an increase in government spending will affect
the economy differently.
• Students should understand that budget deficits are not always bad and that deficit reduction may
involve economic contraction.
• Students should know that different policy mixes differ in their impact on the components of
aggregate demand and that the choice of policy mixes is often determined by political considerations.
• Students should be aware of the motivations for the policy choices made in the 1980s and 1990s and
understand their effects on the U.S. economy.

Solutions to the Problems in the Textbook:

Conceptual Problems:

1.a. An open market operation is an exchange of bonds for money or vice versa by the Fed. In an open
market purchase, the Fed buys bonds from the public (generally via government bond dealers) in
exchange for money. This action increases the monetary base and therefore the supply of money. In
an open market sale, the Fed sells bonds in exchange for money, decreasing the monetary base and
therefore the supply of money.

1.b. When the Fed undertakes open market sales, it exchanges bonds for money. This decreases the
monetary base and the resulting decrease in money supply creates a portfolio disequilibrium. The

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 public adjusts by selling other assets, so asset prices decrease and yields (interest rates) increase. This
increase in interest rates has a negative effect on aggregate demand (investment spending) and output
contracts. A lower level of national income reduces money demand and therefore interest rates decline
again. But if the price level is assumed to be fixed (as in the IS-LM model), then interest rates still
settle at a level higher than the original one. Overall, in an IS-LM diagram, the LM-curve shifts to the
left, leading to a higher level of interest rates and a lower level of income.

2. The IS-curve is vertical, if investment spending is totally interest insensitive. This is called
investment insufficiency; in this case the monetary multiplier is zero. Since the parameter b in the
investment equation equals zero, the equation changes from

I = Io - bi to I = Io.

A horizontal LM-curve will also render monetary policy ineffective. This is called the liquidity
trap. In this case, money demand is totally interest elastic, and the parameter h in the money demand
equation is assumed to be infinitely large.
The fiscal policy multiplier is zero if the LM-curve is vertical. This case is called the classical
case, and money demand (and money supply) is assumed to be totally interest insensitive. Since the
parameter h in the money demand equation equals zero, the equation changes from

L = kY - hi to L = kY.

None of these three cases is very likely to occur. However, some economists assert that Japan in
the late 1990’s and the U.S. in the Great Depression were in, or close to, the liquidity trap.

3. A liquidity trap is a situation in which the public is willing to hold, at a given interest rate, however
much money the Fed is willing to supply. In this case, the LM-curve is horizontal and monetary
policy is totally ineffective. Fiscal policy (which will shift the IS-curve) is clearly the better choice to
stimulate the economy in such a situation, since no crowding out will occur. This means that fiscal
policy will have its maximum effect.

4. Crowding out occurs when an increase in government spending raises interest rates, which reduces
private spending (especially investment). For example, an increase in government purchases (G) will
increase income (Y) and therefore consumption (C); but because the interest rate (i) will increase, the
level of investment spending (I), and most likely also net exports (NX), will decrease, changing the
composition of GDP. Some degree of crowding out will always occur as long as the LM-curve is
upward sloping, that is, in all cases except the liquidity trap. The steeper the LM-curve is, the greater
the degree of crowding out. This implies that if the LM-curve is steep monetary policy will be more
effective than fiscal policy in stimulating national income.

5. In the classical case, the LM-curve is vertical at the full-employment level of output. In this case,
money demand (and money supply) would be completely interest inelastic. After any type of
disturbance, a return to an equilibrium in the money sector could only be accomplished through

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 changes in the level of output. In this situation, fiscal policy would be completely ineffective, since it
would be totally crowded out. On the other hand, monetary policy would achieve its maximum effect.

6. Assume the government finances an increase in government spending by borrowing from the public
(the Treasury sells government bonds to finance the increase in the budget deficit). The increase in
the demand for credit by the government will lead to an increase in interest rates. If the Fed is worried
about high interest rates, it may monetize the budget deficit, that is, buy the government bonds that
the public now holds. This will inject money into the economy, and interest rates will drop again, so
no crowding out of private spending may occur, at least in the short run.
In an IS-LM model, the expansionary fiscal policy will shift the IS-curve to the right, while the
Fed’s action will shift the LM-curve to the right. This means that the AD-curve will shift further to
the right than would have been the case if the Fed had not accommodated the expansionary fiscal
policy. But this causes more upward pressure on the price level. In a recession, when there is little
inflationary pressure, such a fiscal/monetary policy mix may be beneficial and cause only a small
increase in the price level. However, if the economy is close to full employment, then we can expect a
significant increase in the price level. In the long run, when the AS-curve is vertical, there will be
total crowding out, whether the Fed monetizes the increase in the budget deficit or not.

7. A combination of restrictive fiscal policy and expansionary monetary policy will not significantly
affect aggregate demand or income, and neither will expansionary fiscal policy combined with
restrictive monetary policy. However, the first policy mix will decrease interest rates, while the latter
will increase interest rates. Therefore the composition of output will be different in each case.
The first combination will shift the IS-curve to the left and the LM-curve to the right, in which
case income will remain roughly the same while interest rates will be reduced. A tax increase will
lower consumption while increasing investment spending due to lower interest rates. The second
combination will shift the IS-curve to the right and the LM-curve to the left, leaving income roughly
the same, while increasing interest rates. This will decrease the level of investment spending, while
either government spending or consumption (through a tax cut) will increase.
Other considerations may involve the effect of a given policy mix on the budget surplus and the
value of the dollar (and therefore net exports). The first policy mix will increase the budget surplus.
Lower interest rates may also lead to an outflow of funds, which will lower the value of the dollar,
leading to an increase in net exports. The second policy mix will decrease the budget surplus. Higher
interest rates may lead to an inflow of funds, which will increase the value of the dollar, leading to a
decrease in net exports.

Technical Problems:

1. If the government wants to change the composition of GDP towards investment and away from
consumption without changing the level of aggregate demand, it needs to implement a combination of
restrictive fiscal policy and expansionary monetary policy. An increase in personal income taxes or a
decrease in transfer payments will reduce consumption and thus aggregate demand. The IS-curve will
shift to the left, leading to a decrease in the level of output and the interest rate. To increase output to
its original level, the Fed can undertake expansionary monetary policy. This will shift the LM-curve
to the right, leading to a further decrease in the interest rate, thus stimulating investment, and, in turn,
aggregate demand. If the intersection of the new IS- and LM-curves is at the same income level as

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previously, then the decrease in the interest rate will have stimulated investment spending sufficiently
to exactly offset the decrease in consumption. (Note: The tax increase can be combined with an
investment subsidy. In this case, the IS-curve will not shift as far to the left as before.)
The following diagram shows the effect of a decrease in transfer payments (TR) that is
combined with an increase in money supply (M/P). The adjustment process is as follows:

1-->2: TR↓ ==> C ↓ ==> Y↓ == md ↓ ==> i ↓ ==> I ↑ ==> Y ↑. Effect: Y ↓ and i ↓.

2-->3: (M/P) up ==> i ↓ ==> I ↑ ==> Y ↑ ==> md ↑ ==> i ↑ Effect: Y ↑ and i ↓.

Combined effect: Y about the same and i ↓.

i IS1 LM1

IS2 LM2
1
i1
2
i2
3
i3

0
Y2 Y1 Y

2. A cut in the income tax rate will flatten the IS-curve and shift it to the right. Both the level of
income and the interest rate will increase. If the Fed increases money supply to keep the interest
rate constant, then the LM-curve will also shift to the right, maximizing the multiplier effect,
since no crowding out will take place. However, if money supply is held constant, then the
LM-curve will not shift and the overall effect of this fiscal expansion on income will be
weakened, since the increase in the interest rate will crowd out investment.

i IS2
IS1 LM1
LM2
2
i2
1 3
i1

0
Y1 Y2 Y3 Y

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 The adjustment process is as follows:

1-->2: t ↓ ==> C ↑ ==> Y ↑ == md ↑ ==> i up ==> I ↓ ==> Y down. Effect: Y ↑ and i ↑.

2-->3: (M/P) ↑ ==> i ↓ ==> I ↑ ==> Y ↑ ==> md ↑ ==> i ↑ Effect: Y ↑ and i ↓.

Combined effect: Y ↑ and i about the same.

3. Either a removal of an investment subsidy or an increase in the income tax rate will shift the IS-curve
to the left. This will lead to a decrease in the level of income and the interest rate. A rise in the income
tax rate will reduce consumption, but investment will increase due to the decrease in the interest rate.
Removing an investment subsidy will reduce investment, but the effect will be partially offset by the
decrease in the interest rate. The decrease in income will lead to a decrease in consumption.

i IS1 i I1

IS2 LM I2

i1 i1

i2 i2

0 0
Y2 Y1 Y I2 I1 I

Note: An increase in the income tax rate will decrease the multiplier. The IS-curve will not only shift
to the left but will also become steeper. The removal of an investment subsidy, as shown in the
textbook, will lead to a parallel shift of the IS-curve to the left. Here, only a parallel shift is shown.

4. Monetary expansion will lead to lower interest rates, which will stimulate investment and thus
output. The LM-curve will shift to the right, and a new equilibrium will be reached at point E2 in
Figure 11-8.
Fiscal expansion will lead to a higher level of output and higher interest rates. The IS-curve will
shift to the right and a new equilibrium can be reached at point E1 in Figure 11-8.
Fiscal expansion through an increase in government purchases will allow public spending as a
share of GDP to increase, while private spending (especially investment) as a share of GDP will
decline. A reduction in income taxes will increase the level of consumption, while decreasing the
level of investment because of higher interest rates. Monetary expansion will increase the level of
investment spending (due to lower interest rates) and consumption (due to higher income).
A more balanced growth can be achieved through an investment subsidy. This will shift the
IS-curve to the right and a new equilibrium will be reached at E1. But even though interest rates will
rise, the impact of the investment subsidy will not be totally lost. Here we have an example in which
both consumption, induced by higher income, and investment, induced by the subsidy, will rise.

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 Full employment can also be achieved through a combination of expansionary monetary and
expansionary fiscal policy. This will shift both the LM- and IS-curves to the right and we will end up
somewhere between points E1 and E2 in Figure 11-8.

Additional Problems:

1. True or false? Why?

"Fiscal policy is more effective when the interest sensitivity of money demand is lower."

False. If money demand is totally independent of interest rates, the LM-curve is vertical. This is the
classical case. A change in government spending has no effect on output, since there is complete crowding
out. Clearly, in the case of a normal (upward-sloping) LM-curve, less crowding out will occur and income
will go up as government spending increases. But the more interest insensitive money demand is, that is,
the steeper the LM-curve is, the smaller the increase in income will be, due to a larger crowding out
effect.

2. Comment on the following statement:

"Crowding out is complete when money demand is perfectly interest inelastic."

Crowding out refers to the fact that an increase in public spending may lead to a decrease in private
spending, thus dampening the output expansion. An increase in government spending raises interest rates,
which leads to a reduction in investment spending. When money demand is perfectly interest inelastic, the
LM-curve is vertical at the level of real output that clears the money market. An increase in government
spending will stimulate income and encourage people to hold more money balances. The excess demand
for money will cause interest rates to rise to the level at which equilibrium in the money market is
restored. If money demand is perfectly interest inelastic, the rise in interest rates will not lower the
quantity of money demanded. Instead, income will have to go back to its original level before the money
market is back in equilibrium. This means that interest rates will have to increase until the level of
investment spending has been reduced by the same amount as government spending has been increased.
Therefore the level of output demanded is unchanged and crowding out is complete.

3. True or false? Why?

"Expansionary monetary policies reduce bond prices in the liquidity trap."

False. Expansionary monetary policies generally reduce interest rates and thus increase bond prices. In the
liquidity trap, however, interest rates do not change, since the LM-curve is horizontal. If the Fed increases
the money supply through an open market purchase, the public is willing to hold all the money the Fed
supplies at the prevailing interest rate. Nobody wants to shift into bonds and thus bond prices do not
change.

4. True or false? Explain your answer.

"Expansionary fiscal policy is more effective when it is financed by borrowing from the public
than when it is monetized."

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False. If the government finances an increase in its spending by selling bonds to the public, no change in
the supply of money will occur, and the IS-curve will shift without a corresponding shift in the LM-curve.
On the other hand, if an increase in the budget deficit is monetized, then money supply will increase, as
the central bank buys government bonds from the public. Therefore, the LM-curve will also shift to the
right, leading to lower interest rates than in the first case. Less crowding out will occur and the overall
effect on income will be greater--at least in the IS-LM model, that is, the short run. In the long run, when
prices are allowed to be flexible, then crowding out cannot be avoided by monetizing the debt, since an
increase in the price level will lead to lower real money balances and therefore higher interest rates.

5. True or false? Why?

"Crowding out is complete in the liquidity trap."

False. In the liquidity trap the public is prepared to hold whatever money is supplied at any given interest
rate. This implies that the LM-curve is horizontal. If government spending rises, the IS-curve will shift to
the right. Income will rise but interest rates will not increase. This means that there will be no crowding
out.

i IS1 IS2

i1 LM

0
Y1 Y2 Y

6. Assume the government wants to increase output without changing interest rates. What kind
of policy mix would you recommend and how would your policy mix affect the composition of
GDP? Explain your answer and the adjustment processes that take place with the help of an
IS-LM diagram.

A combination of expansionary fiscal and monetary policy will increase output without affecting interest
rates. Expansionary fiscal policy will shift the IS-curve to the right and income and interest rates will both
increase. Expansionary monetary policy will shift the LM-curve to the right and interest rates will
decrease while income increases. Thus we will have an increase in income without a change in interest
rates.
Since income will increase, consumption will also increase, but since interest rates will not change,
induced investment will not be affected (Note: In a more advanced model, an increase in sales
expectations may actually increase the overall investment level. See Chapter 14). Therefore the level of
investment as a fraction of GDP will decrease, while consumption and government purchases will have a
greater share. (A more balanced growth can be achieved if investment subsidies are given.)

1-->2: G up ==> Y up ==> money demand up ==> i up ==> I down ==> Y up

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Effect: Y up and i up

2-->3: (M/P) up ==> i down ==> I up ==> Y up ==> money demand up ==> i up.

Effect: i down and Y up Overall effect: Y up and i constant.

i IS2 LM1
IS1 LM2
2
i2

i1 1 3

0
Y1 Y2 Y3 Y

7. Discuss the effect of an investment subsidy on consumption. In your answer, indicate whether
the effect on consumption would differ if money demand were more interest sensitive.

An investment subsidy will stimulate investment spending and therefore income, which will lead to an
increase in consumption. If money demand were more interest sensitive, then the LM-curve would be
flatter and the shift of the IS-curve to the right would have a larger effect on income (and thus
consumption). As income increases, so does money demand, but if money demand were more interest
sensitive, then a smaller increase in the interest rate would be required to bring the money sector back to
equilibrium. Thus, less crowding out would occur and the overall increase in income or consumption
would be greater.

i IS1 IS2 LM1

i3 LM2
i2

i1

0
Y1 Y3 Y2 Y

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8. "Monetary policy cannot change real output as long as investment is independent of interest
rates." Comment on this statement.

When investment spending is not affected by changes in the interest rate but is determined solely by
changes in business expectations, then monetary policy is ineffective. In this case, the transmission
mechanism breaks down and monetary policy will not bring about changes in real output. Expansionary
monetary policy may reduce interest rates, but this will not increase the level of investment spending and
the economy will not be stimulated. In the IS-LM framework, we would have a vertical IS-curve. Thus,
when the LM-curve shifts, we simply see a change in the interest rate, while the output level remains
constant.

9. Assume investment is very interest inelastic and money demand is very interest elastic. With the
help of an IS-LM diagram, explain the effect of a cut in the income tax rate (t) on investment (I),
money demand (md), and the budget surplus (BuS) and briefly explain the adjustment process.

Investment is interest inelastic so the IS-curve is steep; money demand is interest elastic so the LM-curve
is flat. An income tax cut will shift the IS-curve to the right and make it flatter. Income and the interest
rate will increase. Since the LM-curve is flat, the interest rate will not increase by much, so investment
will decrease only a little. The budget deficit will increase due to the tax cut. Higher income will lead to
more money demand but a higher interest rate will lead to lower money demand. Overall, money demand
will remain constant, since money supply hasn't changed. The adjustment process can be described a
follows:

t↓ C↑ Y↑ md↑ i↑ I↓ Y↓ ↑ and
effect: Y↑ ↑
i↑

LM

i2
i1

IS1
IS2
0
Y1 Y2
Y

10. Assume money demand is very interest inelastic and investment is very interest elastic. Explain
how the level of savings (S), money demand (md) and investment (I) would be affected if the
government increased welfare spending.

If money demand is very interest inelastic, the LM-curve is very steep, and if investment is very interest
elastic, the IS-curve is very flat. With a steep LM-curve and a flat IS-curve, fiscal policy is not very
effective, since most of it is crowded out. An increase in government transfer payments (TR) shifts the
IS-curve to the right and income and the interest rate increase. Since income has increased, saving has

176
increased and since the interest rate has increased, investment has decreased. In the end, money demand
cannot be affected since money supply has not changed. The increase in income increases money demand,
but the increase in the interest rate brings it back to its original level, that is, in equilibrium with money
supply. The adjustment process that takes place is as follows:

TR ↑ Y ↑ md ↑ i ↑ I ↓ Y ↓ Effect: Y ↑
i↑

Since i increases a lot a lot, the effect on I is large, as is the offsetting effect (the crowding out effect) on
output (Y). This means that the overall effect on Y is small.

i LM

i1

io

IS1

ISo
0
Yo Y1
Y

11. Use the formal IS-LM model derived in Chapter 10 to show algebraically how the degree of
crowding out that is associated with an increase in government spending (G) is determined by
the different parameters in the fiscal policy multiplier (b, k, h and α).

The equilibrium interest rate for the IS-LM model was derived in Equation (9) of Chapter 10 as

i = (k/h)γAo - [1/(h + kbα)](M/P).

If we substitute this equation into the equation for investment, we get

I = Io - bi = Io - b{(k/h)γAo - [1/(h + kbα)](M/P)},

and therefore we get

∆I = - (bk/h)γ(∆Ao) = - (bk/h){α/[1 + kα(b/h)]}(∆Ao) = - [(bkα)/(h + kαb)](∆Go).

From this we can see the following:

• If the interest sensitivity of investment (b) goes up, then we have more crowding out.
• If the interest sensitivity of money demand (h) goes up, then we have less crowding out.
• If the income elasticity of money demand (k) goes up, then we have more crowding out.

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• If the multiplier (α) goes up, then we have more crowding out.
Note: Since b, k, and α are in both the numerator and the denominator of the factor preceding (∆G) in the
equation above, some students may have difficulty deciding whether this factor goes up or down as these
parameters increase. An easy way to find out is to calculate the inverse of this factor, which is

(h + kαb)/(kαb) = h/(kαb) + 1.

As either k, α, or b increases, then this inverse decreases and the factor will increase.

12. If the government increased the income tax rate (t) and the Fed responded by increasing the
money supply, how would investment (I), savings (S) and money demand (md) be affected?

1.->2. A higher income tax rate decreases the expenditure multiplier. The IS-curve becomes steeper and
shift to the left, so both income and the interest rate increase.
2.->3. An increase in money supply shifts the LM-curve to the right. The interest rate decreases, leading
to an increase in investment and thus income.
Overall, the interest rate will decrease, but it is unclear what will happen to income. A lower interest
rate means an increase in investment. Since income has not changed much, savings hasn't been affected
much, although it will change in the same direction as income. Since the tax rate is lower, most likely
savings will increase. Money demand has increased, since money supply has been increased (the money
sector has to be in equilibrium).
The adjustment processes that take place can be described as follows:

1.->2. t ↑ C ↓ Y ↓ md ↓ i ↓ I ↑ Y ↑
effect: Y ↓ i ↓

2.->3. ms ↑ i ↓ I ↑ Y ↑ md ↑ i ↑
effect: Y ↑ i↓

Overall effect: Y ? i ↑

i IS1 LM1
LM2
IS2

1
i1
2
i2

i3 3

0
Y1 Yo
Y

13. "Combining income tax cuts with restrictive monetary policy is counterproductive, since it will

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 lead to a higher budget deficit and higher interest rates. What we need instead is a tax increase
in combination with expansionary monetary policy, since the tax increase will lower the budget
deficit while the money expansion stimulates the economy." Comment on this statement.

Neither policy mix described above is likely to significantly affect the level of output. A combination of
expansionary fiscal policy and restrictive monetary policy will lead to an increase in interest rates but it
will not significantly affect output. The IS-curve will become flatter and shift to the right, and the
LM-curve will shift to the left. The budget deficit will increase due to the tax cut.
Restrictive fiscal policy that is combined with expansionary monetary policy will also not
significantly affect output, but it will reduce interest rates. (The IS-curve will become steeper and shift to
the left, and the LM-curve will shift to the right.) The tax increase will lead to a decrease in consumption,
but the decrease in interest rates will lead to an increase in investment and a higher potential for future
economic growth. The budget deficit will decrease due to the higher tax rates. Lower interest rates will
also help to finance the existing national debt and may stimulate net exports, since a capital outflow may
occur that will reduce the value of the dollar.

14. “If investment is very interest inelastic, then most of an income tax rate cut will be crowded out;
therefore the Fed should always supplement a tax cut with an increase in money supply.”
Comment on this statement with the help of an IS-LM diagram and explain the adjustment
process.

If investment is very interest inelastic, then the IS-curve is very steep. An income tax cut will shift the
IS-curve to the right and make it flatter. Therefore income and the interest rate increase. The increase in
the interest rate will crowd out only a small part of investment, since investment is very inelastic. If the
Fed increases money supply, the LM-curve will shift to the right and income will increase, while interest
rates will go down. Overall, we have an increase in income, but interest rates will be largely unaffected.
Therefore, we do not have to worry about the crowding out of investment. The adjustment processes that
take place can be described as follows:

1.->2. t ↓ C↑ Y↑ md↑ i↑ I↓ Y↓ ↑ and

effect: Y↑ ↑
i↑

2.->3. ms↑ i↓ I↑ Y↑ md↑ i↑ ↑ and

effect: Y↑ ↓
i↓

↑ and i
Overall Effect: Y↑ unchanged
i

LM1

i2 2
LM2
1
i1 3

IS1
IS2
0

179
 Y1 Y2 Y3 Y

15. "A cut in the income tax rate is not an effective way to stimulate the economy if money demand
is very interest elastic, since most of the tax cut will be crowded out." Comment on this
statement.

A situation in which money demand is extremely interest elastic comes very close to the so-called
liquidity trap (the LM-curve will be almost horizontal). A decrease in the income tax rate (t) will stimulate
consumption and increase national income. The size of the expenditure multiplier (α) will increase and
the IS-curve will become flatter and shift to the right. The increase in income will initially induce people
to hold more money balances and thus provide upward pressure on interest rates. But since money
demand is extremely interest sensitive, it will take only a very small increase in interest rates to bring the
money sector back to equilibrium. Therefore, the crowding out effect on investment will be minimal and
the tax cut will prove to be very effective in stimulating national income.

16. "Expansionary monetary policy becomes more effective as the interest sensitivity of investment
increases." Comment on this statement.

One of the ways monetary policy affects the level of output demanded is by changing interest rates and
thereby the level of investment spending. The adjustment can be described as follows: An increase in
money supply lowers the interest rate. If investment is very interest elastic, a large increase in investment
spending will follow. This means that, given a certain size of the expenditure multiplier, income will
change by more than in the case when investment does not respond much to a change in interest rates. In
other words, if investment is very interest sensitive, then we have a flat IS-curve. For the same change in
money supply, the flatter the IS-curve is, the larger the change in real output will be.
The formal analysis of Chapter 10 shows that, if investment becomes more interest sensitive, then the
value of b increases. This leads to an increase in the monetary policy multiplier, which is defined as

(∆Y)/(∆M/P) = (b/h)γ.

Note: b is also in the denominator of the equation for γ, and therefore an increase in b will lower the value
of γ. But the change in γ is proportionally less than the change in b and thus the value of the monetary
policy multiplier will actually increase as b gets larger.

17. Assume that the marginal propensity to save increases. If the Fed wants to keep the level of
output from fluctuating, should it undertake open market purchases or sales? In your answer
discuss the combined effect of these changes on the composition of GDP.

An increase in the marginal propensity to save (s = 1 - c) will decrease the size of the expenditure
multiplier (α) and therefore the IS-curve will shift to the left and become steeper. If people save more and
spend less, then firms will experience an increase in unintended inventories. Firms will respond to this by
decreasing production and national income will decrease. Therefore, the Fed will have to stimulate the
economy by increasing the supply of money via open market purchases (which will shift the LM-curve to
the right). As a result of these two shifts we will have lower interest rates. This means that investment as a
fraction of GDP will increase, while consumption's share of GDP will decrease. (Lower interest rates may

180
also cause an outflow of capital, which will lower the value of the domestic currency, leading to an
increase in net exports.)

18. "In 1991, the transmission mechanism broke down, since banks were still suffering from having
made bad real estate loans and were unwilling to increase their lending in response to the Fed's
expansionary monetary policy." Comment on this statement.

It is true that many banks had made bad loans in the late 1980s and were therefore extremely cautious in
their lending in 1991. They preferred to buy virtually risk-free government bonds. Thus, even though the
Fed's money expansion led to lower interest rates, private firms had little access to bank loans and the
economy was not significantly stimulated. But it would be an exaggeration to say that the transmission
mechanism had broken down, since bank lending finally picked up in 1992 after the Fed increased its
expansionary monetary policy effort. One can argue that, given the economic situation at the time, the
Fed's initial policy measure simply was not sufficient to achieve the desired result.

19. "If investment is very interest elastic and money demand is very interest inelastic, then fiscal
policy is less effective than monetary policy." Comment on this statement.

The more interest elastic investment is, the flatter the IS-curve will be. Expansionary fiscal policy (a shift
of the IS-curve to the right) becomes less effective, since the crowding-out effect becomes larger.
Expansionary monetary policy (a shift of the LM-curve to the right) becomes more effective, since the
decrease in the interest rate will now stimulate investment to a larger degree.
The more interest inelastic money demand is, the steeper the LM-curve will be, since any increase in
money demand due to an increase in income now has to be offset by a larger increase in the interest rate.
Expansionary fiscal policy becomes less effective, since any increase in income will increase money
demand and this will have to be offset by a larger increase in the interest rate, leading to a larger
crowding-out effect. Expansionary monetary policy becomes more effective, since the increase in money
demand needed to bring the money sector back into equilibrium must be achieved primarily through an
increase in income.
The formal analysis in Chapter 10 introduces the fiscal and monetary policy multipliers as

(∆Y)/(∆G) = γ = α/[1 + kα(b/h)] and (∆Y)/(∆M/P) = (b/h)γ

respectively. Therefore, if investment becomes more interest elastic, the value of b increases and the value
of the fiscal policy multiplier decreases, while the value of the monetary policy multiplier increases. But
if money demand becomes less interest elastic, then the value of h and the fiscal policy multiplier become
smaller, while the monetary policy multiplier becomes larger.

181