Monetary policy within the IS-LM framework

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Surprisingly aggressive

The model also finds combinations of interest rates and output such that the goods market is in equilibrium. This creates the IS curve. The equilibrium is the interest rate and output combination that is on both the IS and the LM curves. The LM curve represents the combinations of the interest rate and income such that money supply and money demand are equal.

IS-LM Model

The demand for money comes from households, firms, and governments that use money as a means of exchange and a store of value. The law of demand holds: as the interest rate increases, the quantity of money demanded decreases because the interest rate represents an opportunity cost of holding money.

When interest rates are higher, in other words, money is less effective as a store of value. Money demand increases when output rises because money also serves as a medium of exchange. When output is larger, people have more income and so want to hold more money for their transactions. The supply of money is chosen by the monetary authority and is independent of the interest rate.

Thus it is drawn as a vertical line. The equilibrium in the money market is shown in Figure When the money supply is chosen by the monetary authority, the interest rate is the price that brings the market into equilibrium. Sometimes, in some countries, central banks target the money supply. Alternatively, central banks may choose to target the interest rate. This was the case we considered in Chapter 10 "Understanding the Fed". Figure To trace out the LM curve, we look at what happens to the interest rate when the level of output in the economy changes and the supply of money is held fixed.

At the higher level of income, money demand is shifted to the right; the interest rate increases to ensure that money demand equals money supply. At each point along the LM curve, money supply equals money demand.


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We have not yet been specific about whether we are talking about nominal interest rates or real interest rates. In fact, it is the nominal interest rate that represents the opportunity cost of holding money.

Saving and Investment Once More (The IS Curve)

When we draw the LM curve, however, we put the real interest rate on the axis, as shown in Figure The simplest way to think about this is to suppose that we are considering an economy where the inflation rate is zero. In this case, by the Fisher equation, the nominal and real interest rates are the same.

In a more complete analysis, we can incorporate inflation by noting that changes in the inflation rate will shift the LM curve. Changes in the money supply also shift the LM curve. It incorporates both the dependence of spending on the real interest rate and the fact that, in the short run, real GDP equals spending. The IS curve is shown in Figure The IS curve is downward sloping: as the real interest rate increases, the level of spending decreases. The dependence of spending on real interest rates comes partly from investment.

As the real interest rate increases, spending by firms on new capital and spending by households on new housing decreases.

MF model - float

Consumption also depends on the real interest rate: spending by households on durable goods decreases as the real interest rate increases. We should note that financial crowding out is not confined to fiscal policy changes exclusively. Any of the autonomous spending components, which can shift the IS curve and increase national income, trigger the money market mechanisms that see interest rates rise and interest-sensitive components of aggregate demand stifled. Note that the other extreme position would be a horizontal LM curve at some given interest rate. In this case there would be no financial crowding out and the fiscal stimulus to aggregate demand would be fully translated into changes in national income.

We will return to this extreme position when we discuss endogenous money theories later in the Chapter. The rise in national income is less than the change in government spending because the higher interest rates crowd out private investment.

IS-LM Model

There is complete crowding out when the LM curve is vertical and zero crowding out when the LM curve is horizontal. Our derivation of the IS-LM framework initially assumed that the price level was fixed and all changes in output were real. This is consistent with the simple income-expenditure model developed in Chapter 12 where the focus was on the manner in which output and employment responds to changes in aggregate demand. We assumed that firms were willing to supply whatever was demanded up to full capacity without changing their prices.

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty Not if the government spending increased the returns from private investment more than the increase in the interest rate. Eg new infrastructure spending etc.. He is including it in his textbook because it is widely used in the current debate and he believes it is important for students to understand it.

I am sure he will have a section with critique and analysis. This could be described in more proper language which reflects that money supply is being pushed around as a policy variable. A little below you mentioned changes in the tax rate. These should be mentioned in the above section again. Also, it might be interesting to add a quick discussion of policy effectiveness tax cuts vs fiscal stimulus — maybe in an additional box? Your email address will not be published. Notify me of follow-up comments by email. Notify me of new posts by email. Currently you have JavaScript disabled.

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IS-LM model: Impact of a contractionary fiscal policy

This site uses Akismet to reduce spam. Learn how your comment data is processed. When interest rates are higher, in other words, money is less effective as a store of value. Money demand increases when output rises because money also serves as a medium of exchange. When output is larger, people have more income and so want to hold more money for their transactions.

The supply of money is chosen by the monetary authority and is independent of the interest rate.


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  • Thus it is drawn as a vertical line. The equilibrium in the money market is shown in Figure When the money supply is chosen by the monetary authority, the interest rate is the price that brings the market into equilibrium. Sometimes, in some countries, central banks target the money supply.

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    Alternatively, central banks may choose to target the interest rate. This was the case we considered in Chapter 10 "Understanding the Fed". Figure To trace out the LM curve, we look at what happens to the interest rate when the level of output in the economy changes and the supply of money is held fixed. At the higher level of income, money demand is shifted to the right; the interest rate increases to ensure that money demand equals money supply.

    At each point along the LM curve, money supply equals money demand. We have not yet been specific about whether we are talking about nominal interest rates or real interest rates. In fact, it is the nominal interest rate that represents the opportunity cost of holding money. When we draw the LM curve, however, we put the real interest rate on the axis, as shown in Figure The simplest way to think about this is to suppose that we are considering an economy where the inflation rate is zero.

    In this case, by the Fisher equation, the nominal and real interest rates are the same. In a more complete analysis, we can incorporate inflation by noting that changes in the inflation rate will shift the LM curve. Changes in the money supply also shift the LM curve.