Prof.

Gustavo Indart
Department of Economics
University of Toronto

ECO209
MACROECONOMIC THEORY

Chapter 12
MONETARY AND FISCAL POLICY
IN THE VERY SHORT RUN

Discussion Questions:
1. Technically, although it is difficult to show this at this level, the optimal policy will depend on
the relative slopes of the IS and LM curves. However, the general results could be applied
here: if the shocks to the goods market are relatively bigger, then a money supply rule is
superior; if the shocks to the money supply are larger then an interest rate rule is superior.
You could also point out that if you really do not know, then a policy where there is minimal
intervention (money supply rule) is probably the safest policy.

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 Canada 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, as
much money as the Bank of Canada is willing to supply. In this case, the LM-curve is
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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 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 Bank of Canada 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 Bank of Canada’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 Bank of
Canada 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 Bank of Canada 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,
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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.

Application Questions:
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 Bank of Canada 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
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.)

i IS1 LM1

IS2 LM2

i1 E1

i2 E2

i3 E3

0
Y2 Y1 Y

The diagram above 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 ↓.
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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 Bank of Canada 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
E2
i2
E1
i1 E3

0
Y1 Y2 Y3 Y

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.