The Keynesian System III:

Policy Effects in the

IS-LM Model
Introduction
⚫ The main objectives of a government policy is to cure
certain macroeconomic problems, such as recession,
unemployment, and inflation in order to stabilize the
economy.
⚫ This can be done by influencing real output, using
fiscal and monetary policy.
⚫ To cure recession and unemployment, real output
should be raised using expansionary policy
⚫ To cure inflation, real output should be reduced using
contractionary policy
Policy Effectiveness
⚫ To determine whether a policy is effective or not,
we look at the size of the change in real output
associated with the policy change.
⚫ If the size of the change in real output is big, the
policy is effective, vice-versa.
⚫ The relative effectiveness of monetary and fiscal
policy depends upon the shape (slope) of the IS
and LM curves
o The slope of these curves depends on the
interest elasticities of money demand and
investment
MP effectiveness & the slope of the IS curve
r
LM0
LM1
ΔMxm
r0
r1
r2 IS1

IS0
Y
Y0 Y2 Y1
• IS0 is steep (low interest elasticity of investment), equilibrium at r0 ,Y0
• An increase in M shifts the LM curve by ΔMxm, from LM0 to LM1
r falls a lot to r2, but Y increases a little bit to Y2
• IS1 is flat (high interest elasticity of investment)
• The same increase in MS shifts the LM curve from LM0 to LM1
r falls a bit to r1, but Y increases a lot to Y1
• Conclusion: MP is more effective when IS curve is flat (elastic)
FP effectiveness & the slope of the IS curve
r r
LM LM

r1
r1
r0 r0 IS1
ΔGxk IS0
ΔGxk

IS0 IS1

Y0 Y1 Y Y0 Y1 Y
▪ Steep IS curve - low interest elasticity of investment
▪ An increase in G shifts the IS curve by ΔGxk, from IS0 to IS1
r and Y increase a lot to r1 and Y1, respectively
▪ Flat IS curve - high interest elasticity of investment
▪ The same increase in G shifts the IS curve by ΔGxk, from IS0 to IS1
- r and Y increase a little to r1 and Y1, respectively
Conclusion: FP is more effective when IS curve is steep (inelastic)
MP effectiveness & the slope of the LM curve
▪ Steep LM curve - low interest elasticity of money demand
▪ Flat LM curve - high interest elasticity of money demand
r LM0 LM1 r
LM0
ΔMxm ΔMxm LM1
r0
r0
r1 r2

IS IS
Y Y
Y0 Y1 Y 0 Y2

▪ An increase in M shifts the LM curve from LM0 to LM1

Steep LM curve, r and Y changes a lot to r1 and Y1, respectively
Flat LM curve, r and Y changes a little to r2 and Y2, respectively
Conclusion: MP is more effective when LM curve is steep (inelastic)
FP effectiveness & the slope of the LM curve
r LM0

r2 LM1
r1
r0
ΔGxk
IS0 IS
Y
Y0 Y2 Y1 1

▪ LM0 is steep (low interest elasticity of money demand)

▪ LM1 is flat curve (high interest elasticity of money demand)
▪ An increase in G shifts the IS curve from IS0 to IS1
Steep LM curve: r increases a lot to r2, but Y increases a bit to Y2,
Flat LM curve, r increases a bit to r, but Y increases a lot to Y1,
Conclusion: FP is more effective when LM curve is flat (elastic)
Policy Effectiveness-Vertical IS Curve
r r
IS0 IS1 LM IS0 LM0 LM1

r1
r0
ΔMxm
r0
r1
ΔGxk

Y0 Y1 Y Y0 Y
▪ Vertical IS curve - interest elasticity of investment is zero
▪ An increase in G shifts the IS curve from IS0 to IS1 by ΔG x k
r increases, real output rises to Y1, that is by the full size of ΔG x k
▪ An increase in M shifts the LM curve from LM0 to LM1
r increases to r1, but real output remains the same
Conclusion: FP is fully effective, but MP is completely ineffective
when IS curve is vertical
Policy Effectiveness-Vertical LM Curve
r r
LM0 LM0 LM1

r1
ΔMxm
ΔGxk r0
r0

IS1 r1
IS0 IS0
Y0 Y Y0 Y1 Y
▪ Vertical LM curve - interest elasticity of money demand is zero
▪ An increase in G shifts the IS curve from IS0 to IS1 by ΔG x k
r increases, but real output remains at Y0
▪ An increase in M shifts the LM curve from LM0 to LM1
r falls to r1, but real output rises from Y0 to Y1
Conclusion: FP is completely ineffective, but MP is fully effective
when LM curve is vertical
The Liquidity Trap (LT)
⚫ A liquidity trap is a situation, in which, after the rate of interest
has fallen to a certain level, liquidity preference may become
virtually absolute
⚫ Almost everyone prefers holding cash rather than holding
bonds which yields so low a rate of interest
⚫ The interest rate becomes very low, relative to what is
considered normal, so a consensus develops that future
interest rate will increase
⚫ Because bonds have an inverse relationship to interest rates,
consumers do not want to hold bonds whose price is
expected to decline (when interest rate is low)
⚫ Consumers keep their funds in cash because of the belief that
interest rates could soon rise (which would push bond prices
down).
 Money and the Early Keynesians
⚫ The early Keynesians (circa 1945-50), relying on what
they believed to be the experience of the 1930s,
thought that:
o the demand for money was highly interest elastic
- This because interest rate was so low during those
times
- So the LM curve was flat
o investment was highly interest inelastic
- because under depression there was low utilization of
existing plant and machinery and excess capacity)
- So the IS curve was steep
Money and the Early Keynesians (Cont.)
⚫ Economists believe that LT happened during the GD in
1930s
⚫ In this case, increases in the quantity of money have little
effect on the level of income
⚫ Interest rates have fallen to such a low level that individuals
do not care to hold bonds at all.
⚫ Thus, an increase in the money supply is held by the public
and does not stimulate spending.
⚫ Injections of money into the banking system by a central
bank fail to lower the interest rate and hence to stimulate
economic growth.
⚫ In this case, increases in the quantity of money have little
effect on the level of income.
LM Curve in a Liquidity Trap
LM
 MP and The Liquidity Trap
⚫ An increase in nominal money supply shifts the LM curve to
the right (LM1) that is by the size of ΔM x m
⚫ There is a very small increase in real output (Y0 to Y1).
⚫ So, MP is ineffective in a liquidity trap

ΔMxm
MP and The Liquidity Trap
(Cont.)
• In the case of horizontal
LM curve, the increase in
money supply will have no
effect on real output,
• Output remains the same
at Y*
• So MP is completely
ineffective
FP and The Liquidity Trap
r • An increase in G shifts the IS
curve from IS0 to IS1, that is
by the size of ΔG x k
LM0
• Output increases by almost
equal to the size of ΔG x k
from Y0 to Y1
ΔG x k • There is a very big increase
IS0 IS1 in real output that it is
Y • So FP is highly effective in
Y0 Y1
a liquidity trap
Practice Quiz
1. In the Keynesian view,
a. both monetary and fiscal policy can affect income.
b. monetary policy can be effective when money demand is less
interest rate elastic.
c. fiscal policy is a more reliable way to stimulate output during
a recession.
d. all of the above

2. The effect on the level of income of a given increase in the

money stock is
a. irrelevant to the interest elasticity of money demand.
b. greater the lower the interest elasticity of money demand.
c. greater the higher the interest elasticity of money demand.
d. None of the above
Practice Quiz (Cont.)
3. In the liquidity trap case where the LM schedule is nearly horizontal,
a. both monetary and fiscal policy are highly effective.
b. monetary and fiscal policy are ineffective.
c. monetary policy is ineffective and fiscal policy is effective.
d. fiscal policy is ineffective and monetary policy is effective.

4. The Early Keynesians tend to favor

e. monetary policy over fiscal policy because of the effectiveness of
central banks.
f. monetary policy over fiscal policy because it reduces interest
rates.
g. fiscal policy over monetary policy because it doesn’t impact
interest rates.
h. fiscal policy over monetary policy because of the liquidity trap.
Practice Quiz (Cont.)
5. An increase in the money stock has no effect on equilibrium
income whenever the
a. IS curve is horizontal.
b. IS curve is vertical.
c. LM curve is vertical.
d. LM curve is horizontal.

6. In the case where the LM schedule is relatively steep and the

IS schedule is relatively flat, the most effective policy would be
a change in
e. money supply.
f. government expenditures.
g. government spending financed by a change in taxes.
h. taxes.
Sample Exam Questions
1.The government unveiled a package of fiscal stimulus measures worth
RM7 billion in early November 2008 to combat recession. Use IS-LM
diagrams to explain your answer in the following situations:
i) Would the policy action be effective if the interest elasticity of
investment is low?
ii) Would the policy action be effective if the interest elasticity of money
demand is low?

2. Bank Negara Malaysia has announced that the Government intends to

implement an expansionary policy to offset the recent drop in real
output. Use an IS-LM diagram to help explain your concerns regarding
the possibility that the suggested policy is ineffective.

3. Explain what is meant by a liquidity trap. Is the central bank able to

raise real GDP in a liquidity trap? Support your answer by using IS-LM
diagram.