PGP Macroeconomics

Session 11

1
A rise in G by printing Money (Deficit Financing)
r
LM

LM (new)

r*

IS(new)
IS

Y*
Rise in G causes a rightward shift in IS.
Borrowing from the Central Bank increases the supply of real
balances The LM shifts downwards.
More supply of real balances reduces r as people try to convert the excess
balances into bonds. Bond prices rise, interest rate falls. For all Y, r is
2
lower.
What Happens in this Case?

• IS shift tends to increase income.

• LM shift reduces r and hence stimulates I and hence Y.

• On both counts Y should rise.

• Additional demand for real balances due to increased Y tends to

raise r. More real balances tend to reduce r.

• What happens to r ? There are two opposing forces at work.

Depends on the relative shifts. Rate of interest may go up or
down.

• What happens to the components of AD: C, I ? 3

Effective Policy in Liquidity Trap
r
LM1 LM2

IS3

A rise in M shifts
LM to the right
Liquidity Trap

IS2

IS1

If IS1 then no change in income and interest rate

Y
If IS2 then only income increases (r falls) 4
Effective Policy in Liquidity Trap

• What makes LM curve horizontal?

• When demand for money is highly interest sensitive.

• Even if nominal stock of money is increased, people do not part

with the liquidity, because they expect bond prices to fall further.

• No trading with bond and hence no change in the interest rate.

• Investment remains the same. No multiplier, hence no change in

income.

5
Effective Policy in Liquidity Trap

• What is the policy option in this liquidity trap?

• Increase govt spending thereby shift IS to the right.

• Income increases without affecting the interest rate till

the point LM is flat.

• This is called “Fiscalist” case.

• There is no “crowding out” of private investment.

6
Effective Policy in Liquidity Trap

• Consider the vertical portion of LM curve.

• This happens when money demand does not depend on
interest rate.
• Shift in IS is ineffective.
• There is full “crowding out” of private investment.
• Hence only solution is to raise M thereby shifting the
LM to the right.
• This is called “Monetarist” case.
7
Liquidity Traps and Japan’s Prolonged Recession
 Realmoney supply rose by 40%, 1996-2000.
 Income rose only by 3.2%.
 Can you explain this by using the IS-LM model?