You are on page 1of 33

# Chapter 7

IS-LM Model
7.1 Introduction

Now that we have reviewed the basic fundamentals of the goods and money markets we will construct the IS-LM model. The IS-LM model shows the relationship between interest rates and income in the economy. In the goods market we assumed both interest rates and price level were exogenous. In the money market we looked at how the interest rate was determined and saw one of the key factors for determining the interest rate was income. Combining the money market with the goods market will allow us to analyze how the interest is determined (i.e. the interest rate will now be endogenous). The price level will remain exogenous, which is in line with the Keynesian view of sticky prices and wages. The IS (or investment-savings) schedule is derived from the goods market while the LM (or liquidity preference and money supply equilibrium) is derived from the money market.

7.2

## Money Market - LM Curve

The LM curve will show a positive relationship between income and the interest rate. The LM curve represents all equilibrium values in the money market. Since money supply is exogenously determined by the central bank we will primarily focus on money demand. We are interested in knowing how much does the interest rate need to increase for a given increase in income to restore equilibrium in the money market (holding money supply constant). One important clarication needs to be made: money demand refers to the demand for real money balances (for simplicity we are going to assuming P=1). This simply means

95

money demand and money supply are both real variables. Recall our equation for money demand is:

M d = L(Y, r + e ).

## More specically we can write money demand in linear form: Md = l0 l1 e + l2 Y l3 r. P

(7.1)

Money demand is positively related with income and negatively related to the interest rate. The LM curve will trace out a line connecting dierent levels of income with the interest rate. To do this we will increase income to Y1 , Y2 , and Y3 and observe how the interest rate changes to r1 , r2 , and r3 . These points will make up the LM schedule. As income increases, money demand shifts up, and the interest rate will increase. For successively higher levels of income, the interest rate increases. Graphically, this is depicted in gures 7.1. r r

## M Figure 7.1: Deriving the LM Curve

Mathematically we can solve for our LM curve by equating money demand with money supply and solving for Y (or r):

## M s = M d = l 0 l 1 e + l 2 Y l3 r Solving for r we have: r= Solving for Y we have: Y = M l 0 l1 e l3 + r l2 l2 96 l1 l2 1 l0 e + Y M l3 l3 l3 l3

(7.2)

(7.3)

(7.4)

The mathematical representation will help when we look at the slope and shift factors of the LM schedule. Both are important to understand for policy eectiveness.

7.2.1

l2 l3 .

## The LM curve will become steeper (atter) as l2

increases (decreases) relative to l3 . The rst parameter we will focus on is l2 , the income sensitivity (elasticity) of money demand. If l2 is larger than it takes a larger change in the interest rate to oset the increase in money demand caused by the increase in income. The money demand curve will shift up by a larger amount as l2 increases, causing the LM curve to be steeper. A small change in income will result in a large change in the interest rate. The reverse is true for small values of l2 . Interest rates will increase by a small amount for a large change in income (money demand shifts up by a small amount for a change in income). Graphically we can see this in gure 7.2. r r

M Figure 7.2: Determining the Slope of the LM Schedule For the most part we take l2 as being a relatively stable parameter. Most of the debate among

macroeconomists concerns the value of l3 which we interpret as the interest sensitivity (elasticity) to money demand. Recall the equation for money demand:

Md = l0 + l1 e l2 Y l3 r,

, where 1/l3 is the slope of the money demand line (see equation 7.3. Which means l3 tells us how much the interest rate will change for a given change in the quantity of money. We already know from the mathematical representation a higher value of l3 will make the LM curve atter. As l3 increases, the slope

97

(l2 /l3 ) will become smaller. A large l3 means money demand is interest elastic; small changes in the interest rate cause large changes in money demand, the money demand schedule is at. When l3 is low, the elasticity between money demand and the interest rate is relatively inelastic, the money demand curve is steep. This means larger changes in the interest rate will not signicant change the quantity of money demand. Figure 7.3 will depict the case for a low value of l3 . r r

## M Figure 7.3: Money Demand - Low Interest Rate Elasticity (inelastic)

From gure 7.3 the LM curve is relatively steeper (inelastic) for lower values of l3 . This should make sense, because money demand does not respond signicantly to changes in the interest rate (remember inelastic) the interest rate must increase a lot to oset the increase in money demand. The interest rate needs to increase in order to reduce the quantity of money demand back to the level of money supply (which is vertical, xed by the central bank). Now the opposite will hold for large values of l3 . Figure 7.4 depicts a high elasticity between money demand and the interest rate. Now the relationship between money demand and the interest rate is highly sensitive. For the same increase in income (the same horizontal shift in money demand) the interest rate does not need to increase as much (relative to before) to bring the quantity of money demand back to money supply. The result is a at LM curve. For now it is important to understand what factors determine the slope of the LM curve, later on we will see the slope of the LM curve plays an important role for policy eectiveness (particularly with scal policy).

7.2.2

98

## M Figure 7.4: Money Demand - High Interest Rate Elasticity (elastic)

Case 1: L3 = 0 - Classical View When the interest elasticity of money demand is zero changes in the interest rate will have no aect on money demand. This means only income will aect money demand, in the money market this implies the money demand line will be vertical. The equation for the LM curve becomes Y = r
M l0 l1 e . l2

The LM schedule is now vertical. This ts with the classical view of money. r

## M Figure 7.5: Money Demand - l3 = 0 - Classical View

Case 2: L3 - Liquidity Trap The alternative extreme occurs when the interest elasticity of money demand becomes extremely large. In the money market this occurs at a relatively at portion of our money demand schedule. As l3 , a small change in the interest rate will cause a large change in the quantity of money demanded. In terms of income, the interest rate only needs to increase by a small amount it restore equilibrium in the money market due to the highly sensitive relationship between interest rates and money demand. It will help to graph the money market with a nonlinear money demand function:

99

## M Figure 7.6: Money Demand - l3 - Liquidity Trap

From the above graphs we can see that when the money demand schedule is at (steep) the LM curve will also be at (steep). When interest rates are highly (weakly) sensitive to changes in money demand it takes small (large) changes to restore equilibrium given an exogenous shift. Keynes coined this situation the liquidity trap. Recall the three motives for a holding money. The speculative motive emphasized at low interest rates agents will choose to hold great quantities of money. Low interest rates signal future increases which will cause bond prices to decrease. Shortly we will look into key policy implications of a high elasticity between interest rates and money demand, but it is easily to see as the interest elasticity to money demand increases equal increases in the money supply will have smaller aects on the interest rate.

7.2.3

Shift Factors

As we have discussed, the LM curve models equilibrium in the money market. The relationship between interest rates and income is positive. Recall our linear money demand line was:

M d = l0 l1 e + l2 Y l3 r

(7.5)

l2 l3

r=
l0 l1 e M , l3

(7.6)

## the slope. We have already

discussed the factors that aect the slope of the LM curve. Now we will focus on the shift factors which are seen in the intercept.

100

The LM curve will shift when any variable (other than interest rates or income) cause money demand or money supply to shift. The most obvious variable we need to consider is M . When the central bank increases the money supply the interest rate will decrease for a given level of income. This will correspond with a downward shift of the LM curve. We can see a graph an increase in the money supply in gure 7.7. r r

## M Figure 7.7: An Increase in LM - Increase in M

s

The second factor that will shift the LM curve will be autonomous changes in money demand (l0 ). The term l0 corresponds with changes in precautionary demand (Y2K, stock market concerns, nancial crises). When the money demand line increases at a given level of income then interest rates will also increase. Income has remained unchanged, but interest rates have increased. This will cause the LM curve to shift leftward (a higher interest rate for all levels of income). We can see this in gure 7.8. r r

## M Figure 7.8: A decrease in LM - Increase in Autonomous M

d

The third factor we need to consider is a change in expected ination ( 3 ). The term l1 measures the 101

impact a change in expected ination will have on the interest rate. An increase in expected ination will cause the demand for money to decline. Households will shift assets into interest bearing securities. The return on holding money will decline. The decline in money demand will lower interest rates for all levels of income. This will result in the LM curve shifting to the right. We can see the eect of higher expected ination in gure 7.9. r r

## M Figure 7.9: An Increase in LM - Increase in Expected Ination

e

An increase in expected ination will lower the real interest rate at all levels of income.

7.2.4

LM Curve Summary

1. The LM schedule is the schedule giving the combinations of values of income and the interest rate that produce equilibrium in the money market 2. The LM schedule slopes upward to the right 3. The LM schedule will be relatively at (steep) if the interest elasticity of money demand is relatively high (low). 4. The LM schedule will shift downward (upward) to the right (left) with an increase (decrease) in the quantity of money 5. The LM schedule will shift upward (downward) to the left (right) with a shift in the money demand function that increase (decreases) the amount of money demanded at given levels of income and the interest rate.

102

7.3

## Goods Market - IS Curve

I hate to tell you this, but we nished the easy part (well at least on paper). I believe the IS schedule is easier to interpret but more complicated to derive. The IS schedule stems from the relationship between investment and savings. From the goods market recall equilibrium was represented as:

Y =C +I +G

(7.7)

## Using the GDP equation and Y = C + S + T we can write equilibrium as:

S+T =I +G

(7.8)

Our objective is to map the relationship between the interest rate and income through equilibrium in the goods market. Essentially we are asking the following question: when interest rates increase how does income change. For now changes in the interest rate will only aect investment (for simplicity we are going to assume the consumption function is independent of interest rates), I = I i1 r. So an increase in the interest rate will decrease investment by an amount of i1 . Through our equilibrium condition, Y = C + I + G a decrease in investment will cause income to fall. The IS curve has a negative relationship between interest rates and investment. We can graph this approach using the Keynesian Cross, see gure 7.10. E r

## Y Figure 7.10: Deriving the IS Curve with the Keynesian Cross

A second approach is to derive the IS curve through the relationship between saving and investment. At rst this approach will be slightly more complicated but will allow us to easily extend the model to the

103

## I Figure 7.11: IS Curve - Saving and Investment Schedules

open economy. The IS curve represents the relationship between investment and savings (S + T = I + G). Investment takes the same form as before, I = I i1 r or r =
I i1

1 i1 I

## and personal savings is derived from

the consumption function, S = a + (1 b)YD . Since we are assuming the consumption function is independent of the interest rate, it follows that saving is also independent of the interest rate. Studies have shown the relationship between changes in the real interest rate and personal saving rates is extremely week. This assumption is not that extreme. The slope of the investment function depends on i1 , the investment sensitivity to the interest rate. When i1 is small (large), investment is interest inelastic (elastic), and the investment function is steep (at). For now we are going to assume T = G = 0 which gives us S = I. The investment and savings functions are shown in gure 7.11. For a given interest rate, r0 , we nd the quantity of investment. In equilibrium I = S which allows us to use the savings function to determine the equilibrium level of income. To construct the IS curve we must change the interest rate and observe what happens to income. As the interest rate decreases, the quantity of investment increases, which will increase saving and output. Graphically this can be seen in the gure 7.12. Again to construct the IS curve we start at an initial interest rate and observe the level of investment. Because investment equals saving this allows us to determine the level of income. In order to graph the IS schedule we repeat this process for successively higher levels of the interest rate.

7.3.1

## Slope of the IS curve

From the above graphs we can see the slope of the IS curve will depend on the slope of the investment schedule (1/i1 ) and the slope of the savings function (1 b). We will start by looking at i1 , the interest sensitivity of investment. In the above graphs we have interest rates on the vertical axis so it might help to

104

I r

Y Figure 7.12: Deriving the IS Schedule - Saving and Investment dene the investment function in terms of the interest rate: r = I
1 i1 I.

## If the investment schedule is

steep, i1 small (inelastic), then investment is not very sensitive to changes in the interest rate which implies for given decrease (increase) in the interest rate, investment will not increase (decrease) by a large quantity. If investment only responds by a small amount, then income will only change by a small amount. The IS curve will be steep. A change in the interest rate will have little aect on investment and income. We can see this eect in gure 7.13. Using the same analysis but with a at investment schedule, i1 large, then investment will be very sensitive to changes in the interest rate (elastic). Now that same change in the interest rate will have a large aect on investment and conversely income will increase by a large amount. We can show the eect of a large value of i1 in gure 7.14. An extreme case does emerge when the interest sensitivity to investment is zero. The slope of the

105

I r

Y Figure 7.13: IS Schedule - Small i1 (inelastic) investment function approaches innity (becomes vertical) and changes in the interest rate will not change the quantity of investment, and consequently income will not change. The IS curve will also be vertical. The second factor that will aect the slope of the IS curve is the marginal propensity to consume. Normally the MPC is relatively constant which means the savings function is fairly stable. One factor worth exploring in the future will be how to incorporate taxes when they are a function of income. This will change both the slope of the consumption and savings function. For now we will restrict our discussion to the MPC. If the MPC increases then the slope of the savings function (1 b) will decrease. This implies for a given increase in investment a higher MPC (a atter savings function) will cause output to increase by a larger amount. The IS curve will be atter. We can graph this outcome in gure 7.15.

106

I r

## Y Figure 7.14: IS Schedule - Large i1 (elastic)

7.3.2

Shift Factors

Now that we understand the determinants of the IS function we are going to analyze variables that shift the IS schedule. Remember we used the equation, S + T = I + G, to begin our analysis. One way to view this equation is through leakages and injections. The left hand side (S + T ) are leakages from GDP. When we add taxes to the model the savings function will increase. There are more leakages in the system for a given level of income. The right hand side of the equation has what we call injections (G + I). Saving and taxes remove income from the system and are injected through investment and government spending. Adding government spending to the model will shift the investment function to the right. Now it is easy to see how a change in government spending and taxes will aect the IS curve. If government spending increases, the investment function will shift to the right. At a given interest rate, I + G and S + T will increase causing the IS curve to shift rightward. The size of the rightward shift will

107

I r

Y Figure 7.15: IS - MPC large be equal to the autonomous expenditure multiplier (we will explore this below). Figure 7.16 shows the eects of an increase in government spending. Instead of increasing government spending, suppose the government decides to increase taxes. The increase in taxes will cause the saving function to shift left. There are now more leakages from the system. The IS curve will also shift left. The IS curve will decrease by the size of the tax multiplier (b/(1 b)). The increase in taxes is modeled in gure 7.17.

7.3.3

IS Curve Summary

1. The IS schedule slopes downward to the right 2. The IS schedule will be relatively at (steep) if the interest elasticity of investment is relatively high (low). 108

Y Figure 7.16: IS Curve - An Increase in Government Spending 3. The IS schedule will shift to the right (left) when there is an increase (decrease) in government expenditures. 4. The IS schedule will shift to the left (right) when taxes increase (decrease). 5. An autonomous increase (decrease) in investment expenditures will shift the IS schedule to the right (left).

7.4

Mathematical Derivation

In the previous sections we primarily focused on the graphical representations of the IS/LM curves. Now we are going to explain both gures through math. We are going to start with the LM curve. Recall our

109

I r

Y Figure 7.17: IS Curve - An Increase in Taxes key equation for the LM curve: M s = M d = l0 l 1 e + l2 Y l 3 r and the equilibrium interest rate is: r= The equilibrium level of income is: Y = Ms l0 + l1 e l3 + r l2 l2 (7.11) l0 l1 e Ms l2 + Y l3 l3 (7.10) (7.9)

The slope of the LM curve is the change in r per unit change in Y, holding constant the factors that x the position of the schedule. In equation 8.20 our slope is: l2 Y l3

r =

110

l2 r = Y l3 As we discussed above, the LM schedule will be steep (at) for higher (lower) values of l2 and lower (higher) values of l3 . A high l2 can be interpreted as a greater increase in money demand for a given change in income. The money demand line will have a larger shift for a given change in income. A small value of l3 can be interpreted as a low interest elasticity to money demand. The money demand line is steep, small changes in the quantity of money demand will have large aects on interest rates. The shift factors of the LM curve can be seen through the intercept terms of equation 8.20. These terms represent money supply and autonomous demand for money. Both variables will have the same aect on the LM schedule. Taking the change in these variables yields the following: 1 Ms l3

r =

(7.12)

r 1 = Ms l3

(7.13)

The negative sign implies the intercept for the LM curve will be smaller, an increase in money supply will cause the LM curve to shift downward. We can nd the slope and the size of the shift factors in a similar fashion for the IS curve. We are going to maintain the assumptions that consumption and saving are independent of the interest rate, taxes are lump sum, and N X = 0. The starting point for our IS schedule is:

S+T =I +G

Recall our savings function was S = a + (1 b)(Y T ) and investment was I = I i1 r. Using these equations we have: a + (1 b)(Y T ) + T = I i1 r + G Solving for income we have: Y = 1 i1 r (a + I + G bT ) 1b 1b (7.14)

Equation 8.17 looks very similar to the equilibrium condition found in the simple Keynesian model. We can also nd the equilibrium interest rate as: 1 1b (a + I + G bT ) Y i1 i1

r=

(7.15)

111

The slope of the IS curve can be found by taken the change in the relationship between interest rates and income. This is easily seen in equation 8.18. The slope of the IS curve is 1b . The IS schedule is i1 downward sloping and depends on the marginal propensity to consume and interest rates sensitivity to investment. The IS schedule will be steep (at) for small (large) values of the MPC and i1 the interest rates sensitivity to investment. Shift factors of the IS curve can be easily seen through equation 8.17. The change in income (the horizontal shift in the IS) for a given change in the exogenous variables can be seen in the rst term of equation 8.17. Y = 1 (a + I + G bT ) 1b

For a change in autonomous consumption, autonomous investment, or government spending, the horizontal shift of the IS curve is: 1 Y = 1b a, I, G For a change in lump sum taxes we have: Y b = T 1b

7.4.1

Equilibrium

Now that we understand the slopes and shift factors for the IS and LM schedules we need to solve for equilibrium income and interest rates. Using the equations that dene the IS and LM curves will can solve for equilibrium level of interest rates by plugging in equation 8.21 into equation 8.18. Doing so yields: 1 (1 b) + l2 (1 b) (l0 l1 e M ) + (a + I + G bT ) l3 l3

r=

i1 l 2 l3

(7.16)

To nd equilibrium income we can plug equation 8.20 into equation 8.17. Doing so yields: 1 (1 b) + i1 (Ms l0 ) l3

Y =

i1 l2 l3

(a + I + G bT +

(7.17)

Previously we had solved for the IS curve multiplier (the goods market) now that we have incorporated the LM curve the multiplier has changed. We can see the new multiplier in both equations. It will be
1 i l (1b)+ 1 2 l
3

. This multiplier is smaller than previously. When we focused solely on the goods market

we did not account for how changes in income aect other variables besides consumption. Suppose government spending increases. Income will increase following by a change in consumption. Now we are incorporating the money market into our analysis. An increase in income will cause an increase in money

112

demand (the money demand curve increases by l2 . The increase in money demand will cause interest rates to increase (which depends on the size of l3 . An increase in the interest rate will decrease investment (which depends on i1 ). Intuitively, an increase in government spending will cause income to increase, but by a much smaller amount than previously discussed in the goods market. The following chain diagram will be useful in our analysis:

As we can see through the chain diagram, the multiplier will be larger when the MPC is big (people spend their extra income), the income sensitivity to money demand, l2 , is small (money demand does not respond to changes in income), the interest sensitivity to money demand, l3 , is large (at the initial interest rate, it only takes a small increase in rates to restore equilibrium in the money market) and nally the interest sensitivity to investment, i1 , is small (interest rates will increase in the money market for the multiplier to be large investment cannot respond to the increase). We can also do a similar diagram for an increase in the money supply.

113

In the above chain diagram an increase in the money supply will lower interest rates (depending on the size of l3 ), increase investment (depending on the size of i1 ), increase income, and then the standard aects on consumption. Also the increase in income will cause money demand to increase (depending on the size of l2 ), the interest rate will increase (depending on the size of l3 ), investment will decrease (depending on the size of i1 ), and income will fall. We can see the role each parameter has through our multipliers.

7.4.2

Multipliers

Our focus will be on the eects of scal policy (changing government spending and taxes) and monetary policy. The government spending multiplier is: 1 Y = G (1 b) +

i1 l2 l3

(7.18)

As we can see in equation 7.19, scal policy is more eective for larger value of b and l3 and smaller values of i1 and l2 . The tax multiplier has the same intuition as the government spending multiplier: b Y = T (1 b) +

i1 l2 l3

(7.19)

Notice that if i1 or l2 approach zero, the multiplier reduces down to the standard Keynesian multiplier. In other words the money market become irrelevant. The investment schedule becomes nearly vertical, changes in the interest rate have no aect on investment, and money demand line no longer responds to change in income. Essentially there will be no crowding out eect. The LM curve would be horizontal for l2 = 0. When l3 becomes extremely small, the second term in the multiplier becomes very large. This will make the LM curve vertical and scal policy ineective. The multiplier for monetary policy will be slightly dierent: 1 Y = Ms (1 b) + rewriting: Y i1 . = Ms (1 b)l3 + i1 l2 (7.20) i1 l3

i1 l2 l3

As we can see from our multiplier equation, monetary policy is more eective if l3 is relatively small, the LM curve is steeper. As l3 becomes smaller, the denominator of the money multiplier becomes smaller, making monetary policy more eective. A small l3 also corresponds with a steep money demand curve (slope of Md = 1/l3 ), meaning small changes in the money supply lead to large changes in the interest rate.

114

It is dicult to isolate the eects of i1 on the money multiplier. The smaller i1 becomes then investment becomes less sensitive to changes in the interest rate (the investment and IS schedules become steep), which makes monetary policy ineective. This is seen in our multiplier through the nominator becoming small.

7.5
r

## Y Figure 7.18: Adjustment to Equilibrium in the IS/LM Model

7.6

Policy Eectiveness

As we learned in the last section, the slope of the IS curve depends on the interest sensitivity to investment and the marginal propensity to consume. The size of IS curve shifts depend on changes to the exogenous variables (notably government spending and taxes). The slope of the LM curve depends on the interest sensitivity to money demand and the income sensitivity to money demand. The LM curve shifts depend on changes in the money supply. We can graph an increase in government spending in gure 7.19 The IS curve will shift horizontally by the size of our simple multiplier 1/(1 b). The increase in income will cause money demand to increase, interest rates to increase, investment to decrease, and income to decrease. This reduces the overall eectiveness of our spending program. In the above graph will can see the secondary eects as we move up our new IS curve to equilibrium. The government spending program will increase output and interest rates. The same reasoning holds for a decrease in taxes, expect the initial shift in the IS curve will be smaller. The horizontal shift will be b/(1 b). Autonomous changes in investment will act in a similar manner with government spending. As you can probably tell the eectiveness of scal and monetary policy will depend on the slopes of both LM and IS curves. 115

7.6.1

## Fiscal Policy Eectiveness

To start our analysis we will begin by looking graphically as the eects of an expansionary scal policy when the IS schedules are at and steep. For starters, scal policy will be most eective for large values of the MPC. We want our multiplier to be as large as possible. Referring to the chain diagram above, the rst and primary eect is through the MPC. When government spending increases, income increase, followed by changes in consumption. Given we want the MPC to be large, what else will increase scal policy eectiveness. Graphically we can see for a given increase in government spending, the change in income is largest as the IS curve becomes steeper (see gure 7.20). r r

## Y Figure 7.20: Fiscal Policy Eectiveness - Steep IS

What makes the IS curve steep. Recall the slope of the IS curve is 1b , for a given MPC, the IS i1 curve will be steeper as i1 , the interest sensitivity to investment, becomes small. This implies investment is 116

relatively interest-inelastic. This parameter captures the crowding out eect of government spending. Looking back to our chair diagram. An increase in income will cause money demand and interest rates to increase. In order for scal policy to be eective investment needs to be relative insensitive to the increase in the interest rate (i1 small). The IS curve will be steep. Fiscal policy will be most eective when the IS curve is vertical, investment does not respond to an increase in the interest rate. Next we turn to the LM curve. Looking back to our chain diagram, an increase in government spending will increase income which in turn will cause money demand to increase. The increase in money demand will cause the interest rate to increase. Fiscal policy is most eective when money demand does not respond to changes in income (the upward shift in money demand is minimal), and interest rates are highly sensitive to money demand (for a given shift of money demand, interest rates are highly elastic and therefore need to increase a small amount to restore equilibrium in the money market). Both of these eects can be seen in the slope of the LM curve,
l2 l3 .

## The relationship between income and money demand

is represented by l2 . If we dont want money demand to increase in response to an increase in income then we need l2 to be small. Next, when money demand does increase following a change in income we want the interest rate to be highly sensitive. This implies that we only need a small change in the interest rate to restore equilibrium, in other words we need l3 to be large. A small l2 combined with a large l3 will give us a at LM curve. We can compare these results in gure 7.21. r r

## Y Figure 7.21: Fiscal Policy Eectiveness - Flat LM Curve

As we can see above, scal policy is most eective when money demand does not respond to change in income and the interest rate is highly sensitive to changes in money demand. At the extreme scal policy will be completely ineective when the LM curve is vertical. This can occur as l3

117

approaches zero, the interest elasticity to money demand becomes extremely small. The interest rate no longer responds to movements in money demand (this was the classical case we presented earlier.

7.6.2

## Monetary Policy Eectiveness

An increase in the money supply will cause the LM curve to shift right. It will help to start our analysis by looking at a detailed chain diagram reecting the change in the money supply. An increase in the money supply, which causes the interest rate to decrease. A decrease in the interest rate will cause investment to increase and income to increase. An increase in income will cause consumption to increase in the goods market but at the same time money demand will increase. The increase in money demand will cause interest rates to increase and investment to decline. How does all of this relate to the parameters of our model. Graphically we can see that monetary policy is more eective for a relatively at IS curve (see gure 7.22). Remember the horizontal shift in the LM curve is held constant. r r

## Y Figure 7.22: Monetary Policy Eectiveness - Flat IS Curve

Recall the slope of the IS curve was: 1b which means the IS curve will be at for large values of b i1 and i1 . This makes perfect sense, a large MPC is needed to ensure households spend their added income. This is seen in the above chain diagram after the initial increase in income. Secondly we also need i1 to be large. Since the Federal Reserve is increasing the money supply, the interest rate decreases and investment will increase. The more sensitive investment is to changes in the interest rate the more eective monetary policy becomes. Monetary policy is most eective when the MPC is large, and investment is highly sensitive to changes in the interest rate, the IS curve is at. At the extreme case, if i1 approaches zero the IS curve become vertical and monetary policy is completely ineective.

118

## Y Figure 7.23: Monetary Policy Eectiveness - Steep LM Curve

Now for a given IS curve is monetary policy most eective for a steep or at LM curve? We can start our analysis by looking at the graphs for the same change in the LM curve (see gure 7.23). In the above gures we can see monetary policy is most eective when the LM curve is steep. Recall the slope of the LM curve is
l2 l3

and the LM curve will be steep for large values of l2 and small values of l3 .

In other words we want a money demand to be highly sensitive to changes in income, but more importantly we want money demand to be interest inelastic. To understand this logic it will help to look at our money market. A small measure of interest elasticity is reected in a relatively steep money demand line. For a given change in the money supply, interest rates will decrease by a larger amount when interest rates are highly inelastic. The larger decrease in the interest rate will cause investment and income to increase by larger amounts. Monetary policy is most eective when the LM curve is steep, which occurs when money demand is interest-inelastic. Ironically, the condition that makes monetary policy most eective (money demand being interest inelastic, a small l3 ) corresponds with scal policy being least eective. The monetary authority wants interest rates to be highly inelastic, they want small changes in the money supply to create large changes in the interest rate. Conversely, the scal authority wants to be able to increase income without having to worry about large increases in the interest rate. An expansionary scal policy will cause interest rates to increase, but an expansionary monetary policy will cause interest rates to decrease. The following table will sum up monetary and scal policy eectiveness. As we can see in table 7.1 the conditions for monetary policy and/or scal policy to be eective are very dierent.

119

Table 7.1: Monetary and Fiscal Policy Eectiveness Monetary Policy IS Schedule LM Schedule Steep Ineective Eective Flat Eective Ineective Fiscal Policy IS Schedule LM Schedule Eective Ineective Ineective Eective

Steep Flat

7.7

## Limitations of the IS-LM Model

The IS-LM model was the workhorse model in macroeconomics starting in 1937 (with Hicks) through 1980. Even today, most economists picture the IS-LM when thinking about the eects of policy. Compared to new models, it is relatively simple to understand and can explain a number of relationship in the economy. Further is has proven to do a good job at depicting business cycle movements. Even with all the successes of the IS-LM model, there are limitations. Three primarily limitations fall along the lines of expectations, microfoundations, and prices. Starting with the idea of rational expectations. Keynes assumed agents formed expectations adaptively (essentially projecting the past into the future). In the 1970s a group of Chicago School economists (Robert Lucas) developed the idea of rational expectations. Agents use all relevant information when making future projections. Agents are foreword looking. Another limitation of the IS-LM model stems from the failure to account for supply side eects and microfoundations in supply and demand. In the classical model we saw the important of real variables. Stemming from the assumption of sticky wages, Keynes ignored the eects of the supply side on determining equilibrium output. Additionally, the IS-LM model does not account for individual optimizing behavior. Current macroeconomic models start at the household level and model labor, consumption, and investment through household and rm behavior. The macroeconomy is simply an aggregate of all households and rms. To correctly understand movements in the macroeconomy we need to understand how households and rms make decisions. Macro models shifted focus in the 1990s and looked closely at the households decision process between working and consumption and the rms capital decisions. These models include what economists call microfoundations. The next limitation of the IS-LM model deals with the eects of nominal shocks, ination, and policy responses. Since the IS-LM model does not incorporate supply side eects, policy makers had a dicult time conducting policy following the oil shocks in the 1970s. As oil prices spiked, the demand for money increased. To oset the higher demand for money the Federal Reserve increased the money supply. They 120

were able to maintain their interest rate target. Unfortunately the model was unable to gauge the impact their actions would have on ination. The result was extreme ination throughout the 1970s and 1980s. Today we know the policy response was incorrect, the Federal Reserve has shifted policy into more ination targeting opposed to interest rate targeting. Had this been the norm in the 1970s then we would probably see the IS-LM at the forefront of macroeconomics.

7.8

## Monetarists Rebuttal to Keynes

A monetarists is someone who thinks it more important to regulate the supply of money in an economy than to inuence other economic instruments. This is thought very wicked by those who cant be bothered by what it means. The monetarist counterrevolution began shortly after Keynes death in 1946 and can be characterized by four propositions: 1. The supply of money is dominant inuence on national income. 2. In the long run, the inuence of money is primarily on the price level and other nominal magnitudes. In the long run, real variables, such as output and employment are determined by real, not monetary, factors. 3. In the short run, the supply of money does inuence real variables. Money is the dominant factor causing cyclical movements in output and employment. 4. The private sector is inherently stables. Instability in the economy is primarily the result of government policies. The take away is the stability in the growth of the money supply is crucial for a stable economy. Milton Friedman, the primary intellectual force behind monetarism, is known for always advocating the central bank should follow a monetary policy rule. Monetary policy governed by discretion would result in excess volatility. By looking at the four propositions we can see where monetarists borrowed and expanded on the ideals of classical economists. The rst and third propositions stem from the Keynesian view of the IS-LM where money could inuence output. The second proposition follows directly from the classical view of the economy. As we discussed earlier, the Great Depression primarily brought an end to the Classical school and quantity theory of money. Friedman argued the events of the Great Depression were not properly analyzed.

121

That instead of a failure in the quantity theory of money, the instability was a result of government policy (proposition 4).

7.8.1

## Keynesian View of Monetary Policy During the Great Depression

In the IS-LM model weve already seen the role money plays. An increase in the money supply will result in lower interest rates and higher levels of income. However, many early Keynesians believed money was of little importance. Most early Keynesians were inuenced by the Great Depression. During the Great Depression the LM schedule of very at (high interest rate elasticity of money demand), while the IS schedule was very steep. This ts with the characterization of low output and low interest rates during the Depression. The money market feel into a liquidity trap, but early Keynesians believed the interest rate elasticity of investment was very high. In other words, small changes in the interest rate would stimulate investment. Combining these two features with a very low rate of resource utilization causing excess capacity early Keynesians thought investment would be unlikely to respond to changes in the interest rate. We can see gure 7.24 r

Y Figure 7.24: Early Keynesians on the Great Depression As we can see in gure 7.24 the highly elastic LM schedule left money having little importance when it came time to conduct policy.

7.8.2

## A Monetarists View of the IS-LM Model

Friedman countered the early Keynesians by arguing that money demand was stable and the interest elasticity was not innite. Instead he argued the interest elasticity of money demand was quite small. To understand Friedmans position we need to reinstate the quantity theory of money. Friedmans positions 122

## starts with the Cambridge money demand equations: M d = kP Y,

(7.21)

where money demand is expressed as a proportion of nominal GDP (P Y ). Friedman accepted Keynes view that money was an asset and the amount of money demand depends on the rate of return. But critiqued Keynes assumption that all assets can be grouped into money or bonds. Friedmans money demand function was: M d = L(P, Y, rB , rE , rD ), (7.22)

where P is price level, Y is output, rB is the nominal interest rate on bonds, rE is the nominal interest rate on equities, and rD is the nominal return on durable goods. Friedman assumed individuals have a choice between stocks, bonds, and durable goods (housing) and this assets oer dierent rates of return. Friedman views money demand as being stable whereas Keynes view the demand for money was unstable. Friedman does not sperate his view into the speculative, transactions, or precautionary motives as Last, Friedman allows for more than one money substitute. Keynes assumed households had a choice between money and bonds, Friedman assumes households choose between money, equities, bonds, and real assets. Combining this idea with the Cambridge equation for money demand Friedmans money demand schedule is: M d = k(rB , rE , rD )P Y, (7.23)

where instead of a constant k we now have k expressed as a function of the rates of return on the assets that are alternatives to holding money. A rise in the rate of return on any one of these assets would cause k to fall, reecting the increased desirability of the alternative asset. Friedman has reinstated the quantity theory of money demand that includes Keynesian analysis of moneys role as an asset. The modern quantity theorist diers from Keynes as they believe: 1. The money demand function is stable. 2. This money demand function plays an important role in determining the level of economic activity. 3. The quantity of money is strongly aected by money supply factors. With a stable money demand function, an exogenous increase in the money supply must either lead to a rise in P Y of cause declines in rB , rE , and rD . Eects to the real interest rate for alternative assets will aect k and indirectly change P Y .

123

Early Keynesians believed money demand was unstable; the interest elasticity of money demand was very high; and as a consequence changes in the quantity of money did not have important predictable eects on the level of economic activity. Friedman viewed money demand as stable; the interest elasticity of money demand was very low; and that the quantity of money is an important determinant of economic activity. The monetarist believe money was active in determine income, although complete determination was an exaggeration. Money was a strong determinant of national income and real income in the short-run. Further, changes in the rate of growth of money are a necessary and sucient condition for changes in the rate of growth of money income. We can graph the monetarist view in gure 7.25 r

Y Figure 7.25: A Monetarist Version of IS-LM The IS schedule is interest elastic, large changes in the interest rate were needed to increase investment. The LM schedule is interest inelastic, small changes in the money supply result in large changes in the interest rate. Early Keynesians and monetarists diered drastically in their policy views. Friedman took the view that scal policy was ineective, any changes in output Keynesians contributed to scal policy could ultimately be traced to changes in the quantity of money. Suppose there is an increase in government spending, holding all else constant, the government must nance the spending through issuing new bonds or print money. As the government issues bonds, the bond rate will increase, causing money demand to decrease. Either way, government spending directly inuenced the money supply. We can see the eects of scal policy, under the monetarist assumptions, in gure 7.26. As we can see, an increase in government spending will ultimately result in an increase in interest rates and little change in output. The increase in government spending will initially cause income to

124

Y Figure 7.26: An Increase in Government Spending - Monetarist Assumptions increase. An increase in income will increase the demand for money (through the transactions motive). Because of a low interest elasticity of money demand, an increase in money demand will result in a large increase in the interest rate to equate money supply and money demand. The higher interest rate will then crowd out private investment, investment is highly elastic in regards to changes in the interest rate. In the end, monetarists showed money does have an active role in determining real output in the short-run. Friedman was a staunch advocate of rule based monetary policy (which is what most central banks do today). Finally Friedman argued against ne tuning the economy. We do not know enough about monetary policy to use it in response to minor disturbances.

7.9

Practice Questions

1. Dene the LM curve. Dene the IS curve. Is the LM curve positively or negatively sloped? Is the IS curve positively or negatively sloped? When is the LM curve relatively steep? When is the IS curve relatively at? 2. Graphically show and analyze the eects of an increase in taxes in the IS-LM model. Utilize the IS-LM model and analyze the eects of a decrease in the quantity of money. 3. Using an IS-LM graph, illustrate how the central bank could target interest rates in response to expansionary scal policy. 4. You are given the following two situations

125

(a) Investment is very interest elastic (interest sensitive) while the demand for money is very interest inelastic (b) Investment is very interest inelastic while the demand is very interest inelastic In which situation would monetary policy be most eective in changing the level of income? In which situation would scal policy be most eective? Explain completely. 5. Assume the following equations describe the goods market of an economy C = 250 + .8(Y T ), I = 100 50r and T = G = 100. Calculate the IS curve for this economy. If G rises to 120, calculate the new IS curve for this economy. How much and in what direction has the IS curve shifted? 6. Assume that following equations describe the money market of an economy Ms = 1, 000 and Md = .2Y 100r. Calculate the LM curve for this economy. Now assume that the money supply rises to 1,200. How much and in what direction has the LM curve shifted? 7. Given the following information: G = 100, T = 0, S = 50 + 0.25Y , I = 150 10r, Md = 80 20r + 0.2Y , and Ms = 188 (a) Find the equilibrium values of Y and r. (b) If Ms is increased to 210, nd the new equilibrium values of Y and r 8. Consider the following economy: C = .6(Y T ), I = 1, 000 20r, G = 180, T = 180, Ms = 1, 500, and Md = Y 50r (a) Calculate the IS and LM curves. Use these curves to determine equilibrium interest rates and output. (b) Explain in detail the intuition behind why the IS and LM curves are sloped as they are. Provide graphs to aid your explanation. (c) Suppose that both G and T rise by 40 to G = T = 220. Calculate what will happen to Y and r? Can you explain the intuition behind what is going on here? Provide a graph to support your explanation. 9. Derive the IS curve graphically assuming taxes are lump sum. Now suppose rather than a xed level of taxes (T), we have taxes depending on income T = t0 + t1 Y where t1 is the marginal income tax rate. Will the IS schedule for this case be steeper or atter than when the level of taxes is xed? 10. Suppose the interest elasticity of investment demand is zero. What will be the resulting slope of the IS schedule? Explain. 126

11. Suppose we had a case in which the interest elasticity of money demand and investment were quite low. Would either monetary or scal policy be very eective? How would you interpret such a situation? When has such a situation arisen? 12. Why do the Keynesians prefer a policy mix of tight scal policy and easy monetary policy? Explain this preference. Since the Keynesians prefer a policy mix of relatively tight scal policy and easy monetary policy, how would they respond to an income tax cut in order to expand the economy? 13. What do Keynesians believe caused the Great Depression? 14. What do Monetarists believe about the slope of the IS and LM curves and why? What do these beliefs imply about the eectiveness of monetary policy. 15. What do early Keynesians believe about the slope of the money demand curve and why? What do these beliefs imply about the eectiveness of monetary policy. 16. Show how the IS and LM schedules look in the monetarist view. Use these schedules to illustrate the monetarists conclusions about the relative eectiveness of monetary and scal policy. 17. In what sense is a vertical LM schedule a special case of the classical model? 18. Consider the case in which the LM schedule is vertical. Suppose there is a shock that increases the demand for money for given levels of income and the interest rate. Illustrate the eect of the shock graphically and explain how income and the interest rate are aected. 19. Why might Keynesians be pessimistic about the ability of monetary policy to stimulate output in situations such as the 1930s Depression in the United States, the recessions in Japan during the 1990s, or the Great Recession in the United States during the 2000s. What type of policy would Keynesian economists expect to be eective in such situations? 20. What is meant by a liquidity trap? 21. If the central bank of an economy follows a policy of interest rate targeting, or maintaining a xed interest rate, then what will happen to the slope of the LM curve? Draw a graph to illustrate.

127