EIA1003

MACROECONOMICS I

Lecture 7
The Keynesian System (III):

Policy Effects in the IS-LM Model

Reference: Froyen (Chapter 7)

1
 Shifts in the LM Schedule

 Increase in Ms from M0 to M1
LM(M0)
LM(M1)
 LM (M0) shifts to the right to LM
r0 A
(M1)
r1 B
 Interest rate falls from r0 to r1

IS0
 Income rises from Y0 to Y1

Y0 Y1 Y
 Equilibrium moves from A to B
Income

2
Figure 7.1: Effects of an Increase in the Quantity of Money
Shifts in the IS Schedule
r

LM0  Increase in G from G0 to G1

B  IS (G0) shifts to the right to IS

1
r1 G
1 b
(G1)
r0
A

 Interest rate rises from r0 to r1

IS(G1)
IS(G0)  Income rises from Y0 to Y1

Y0 Y1 Y’1 Y
 Equilibrium moves from A to B
Income

4
Figure 7.2: Effects of an Increase in Government Spending
Contd.
r

LM0
b
T
1 b

r0 B

r1
A

IS(T0)
IS(T1)

Y1 Y0 Y

Income

6
Figure 7.3: Effects of an Increase in Taxes
Contd.
Figure 7.4: Effects of an Autonomous Decline in Investment

I
r0

r1

r2
I0 (r)
I1(r)

I’1 I1 I0 I
Investment

r
I
1 LM0
1 b
r0
A

r1 B
IS(I0)
r2

IS(I1)
8
Y1 Y0 Y Income
Contd.
Contd.
  A tax cut from T0 to T1
r
LM(M0)  IS (T0) shifts to the right to IS (T1)

LM(M1)  Interest rate rises from r0 to r’1

r’1  If tax cut is accompanied by an increase in

A MS from M0 to M1
r0

 LM (M0) shifts to the right to LM (M1)

IS(T1)

 With these two policies:

IS(T0)
Y
Y0 Y1 o Interest rate would remain at r0
Income

o BUT income rises from Y0 to Y1

Figure 7.5: Monetary-Fiscal Policy Combination 11

Table 7.1 Effect of Monetary and Fiscal Policy
Variables

Effect of: M G T
On Y + + -
r - + -
Policy Effectiveness and the
Slope of the IS Schedule
Contd.

14
Contd.

15
 (a) Steep IS Schedule (b) Flat IS Schedule
r Low interest elasticity of investment r High interest elasticity of investment

LM0 M LM0
c1 LM1
LM1

M r0
r0 More
c1 r1 effective
r1
IS0
IS0

Y0 Y1 Y Y0 Y1 Y

r
IS0
M LM0
c1 LM1

r0 (c) Vertical IS Schedule

Zero interest elasticity of investment
r1

Y0 = Y 1 Y
17

Figure 7.6: Monetary Policy Effects and the Slope of the IS Schedule
Contd.

18
Contd.

19
Contd.

20
 (a) Steep IS Schedule (b) Flat IS Schedule
r Low interest elasticity of investment r High interest elasticity of investment

LM0 LM0

r1 1
G
1 b r1 G
1
1 b
r0 r0
More
effective

IS1
IS0 IS1 IS0

Y0 Y1 Y Y0 Y1 Y

r
IS0 IS1
LM0

r0 (c) Vertical IS Schedule

Zero interest elasticity of investment
r1
1
G
1 b

Y0 Y1 Y
22

Figure 7.7: Fiscal Policy Effects and the Slope of the IS Schedule
Contd.

23
Contd.

Less crowding
out effect

Higher crowding
out effect

24
Contd.

25
Policy Effectiveness and the
Slope of the LM Schedule
 (a) Flat LM Schedule (b) Steep LM Schedule
r r
More LM0
effective
1
G
1 b r1
1
r1 LM0 G
1 b
r0 r0

IS1
IS0 IS1 IS0

Y0 Y1 Y Y0 Y 1 Y

High interest elasticity of money demand Low interest elasticity of money demand

r
LM0

r1
1
(c) Vertical LM
G
1 b Schedule
r0 Zero interest elasticity of money demand

IS1
IS0

Y0 = Y 1 Y
28

Figure 7.8: Fiscal Policy Effects and the Slope of the LM Schedule
Contd.

29
Contd.

30
Contd.

31
Contd.

32
 (a) Flat LM Schedule (b) Steep LM Schedule
r r
M LM0
c1 LM1
M
c1 LM0
r0
r0 LM1 r1
More
r1 effective

IS0

IS0
Y0 Y1 Y Y0 Y1 Y

High interest elasticity of money demand Low interest elasticity of money demand

r
LM0 LM1

M
c1
(c) Vertical LM
r0
Schedule

Zero interest elasticity of money demand

r1

IS0

Y0 Y1 Y
34

Figure 7.9: Monetary Policy Effects and the Slope of the LM Schedule
Contd.

35
Contd.

36
Contd.

37
Contd.

38
Contd.
Table 7.2 Monetary and Fiscal Policy Effectiveness and
the Slope of the IS and LM Schedules

Monetary Policy
IS Schedule LM Schedule
Steep Ineffective Effective
Flat Effective Ineffective

Fiscal Policy
IS Schedule LM Schedule
Steep Effective Ineffective
Flat Ineffective Effective