MBA Lectures 8 - 9

8/6/2019 MBA Lectures 8 - 9

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Intermediate

Macroeconomics

QUB, Autumn 05

Lutfun N. Khan Osmani

Lectures 7 - 8

Chapter 4

Monetary and Fiscal Policy in The IS-LM

Model


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4-2

The IS curve

The IS curve tells us that any Y can be

equilibrium depending on the value of r. Butsurely there can be only one equilibrium Y forgiven values of exogenous variables.

How can we find it? For this we need anotherrelationship between r and Y. We find it fromthe LM curve.


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4-3

The LM Curve

We get LM curve from the money market.

LM curve shows the relationship betweenthe interest rate and the level of incomethat arises in the money market.


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4-4

Money Market

Uses of money:

Medium of exchange

Store of value

Unit of account

Demand for money:

Transactions demand (+ Y)

Speculative demand (- r)

Overall:

(M/P)d = aY lr

Supply of money:

Fixed by central bank


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4-5

Money Market

Central bank has a balance sheet consistingof its assets and liabilities.

Feds assets consists of its holdings ofgovernment bonds

And its liabilities are of two kinds: currency

that it printed and the total bank reserves thatit holds on deposits for the commercial banks


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4-6

Money Market

Suppose Fed owns $400 billion ofgovernment bonds, and its liabilities consist of

$200 billion of currency and $200 billion ofbank reserves.

The total liability of the Fed is called the

monetary base which is $400 billion.


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4-7

Money Market

Money supply (Ms) consists of currency (say$200 b) and checking deposits at the banks.

Say, banks are supposed to hold 10% of theirchecking deposits as reserves. If bankreserves are $200 b, then checking depositsmust be $2000.

Thus Ms is the total of $200 b of currency and$2000 b checking deposits a total of $2200b


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4-8

Money Market

Money supply (Ms) is equal to monetary basetimes the money multiplier

(Ms) = monetary base the money multiplier.

(Ms) z monetary base = Money multiplier

Money multiplier = $2,200z

$ 400 = 5.5 (Ms) = $400 5.5 = $2,200


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4-9

Money Market

The amount of money that people demand inreal terms depends both on income andinterest rate

Real money balances equal the total moneysupply divided by the price level (Ms/P).

Demand for real money balances changes

with changes in real income.


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4-10

Money Market

Let demand for real money balances (M/P)d

equals the half of the real income (Y):

(M/P)d = 0.5Y

If real income is $8,000 billion, the demandfor real money balances is:

0.5 8,000 = $4,000


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4-11

Figure 4-1

The Demand forMoney, the InterestRate, and RealIncome

The vertical line L isdrawn on an unrealisticassumption thatdemand for real moneybalances is equal to

half of real income($8000b) but does notdepend on interestrate.


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4-12

Money Market

The downward sloping L0 line shows thatwhen rate of interest is zero, demand for real

money balances is $4,000.

As interest rate rises from zero to 5%, peoplecut down their money holdings to $3,000 and

it goes down to $2,000 when rate of interestrises to 10%.


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4-13

Money Market

We draw the equation for the demand for realmoney balances which is half the real income

minus $200 billion times the interest rate

(M/P)d = aY lr

(M/P)d = 0.5Y 200r


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4-14

Money Market

A change in the interest rate moves theeconomy up and down its real money

demand schedule

However, a change in real output (Y) shiftsthe demand schedule to the left or right.


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4-15

Figure 4-2

Effect on theMoney DemandSchedule of aDecline in Real

Income from$8,000 to$6,000 Billion:

Money demandschedule shiftsto the left of theoriginal one.


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4-16

Money Market

At any given interest rate, the change in theamount of money demanded is given by

((M/P)d = 0.5Y

Between point F and C, the interest rate is thesame, output falls by 2,000 and the demand

for money declines by $1.000.


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4-17

Money Market Equilibrium

Money market is in equilibrium when thedemand for money and the supply of it are

equal and the equilibrium rate of interest isdetermined at that equilibrium

If income rises, demand for real money

balances curve shifts to the right and withfixed Ms equilibrium occurs at higher interestrate and vice versa.


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4-18

Figure 4-3 Derivation of the LMCurve


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4-19

Derivation of the LM curve

Vertical line shows the supply of money given by the government

Equilibrium is at the crossing of the demandfor money and the supply of money schedule

When income is $8,000 billion equilibrium is

at F rate of interest is 10%.


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4-20


When income falls to $6,000 equilibriumoccurs at G rate of interest falls to 5%.

LM curve shows this relationship with incomeand the rate of interest

At lower income (demand for money is low)

rate of interest is low and vice versa.


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4-21


LM curve represents all combinations of

income (Y) and interest rate (r) where themoney market is in equilibrium that is wherethe supply of real money balances is equal tothe demand for money.


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4-22

LM Curve in Equations

Demand for money:

(M/P)d = aY - lr

Supply of money: Ms

Money market equilibrium:

Ms/P = (M/P)d = aY lr or

lr = - (Ms/P) + aY or

r = - (Ms/P)/l + (a/l)Y p the LM equation

Intercept = - Ms/l < 0

Slope = (a/l)Y > 0


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4-23

Shift in the LM curve

We take the money supply as given whilederiving the LM curve.

If government changes the supply of money, the

LM curve shifts. Increase in money supply shifts the LM curve to

the right

Decrease in money supply shifts the LM curveto the left


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4-24

The Effect on the LMCurve of an Increase inthe Real Money Supply from $2,000 Billion to

$3,000 Billion


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4-25

Figure 4-4

Generalequilibrium:

Crossing of

the IS and LMcurve givesequilibriuminterest rate

and realincome thatwill prevail inthe economy.


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4-26

IS-LM Equilibrium in Equations

IS curve:

r = Apn/h - {(1 c)/h}Y [1]

LM curve:

r = - (Ms/P)/l + (a/l)Y [2]

Solving [1] and [2], we get the {r*, Y*}combination for which the product and moneymarkets are simultaneously in equilibrium.


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4-27

Shift in the IS-LM model

The IS-LM model determine two endogenousvariables, real income and interest rate.

The exogenous variables that the model does

not explain are, the level of consumer andbusiness confidence, the money supply, govt.expenditure and tax revenue and net exports.

Whenever there is a change in one of theseexogenous variables then either of the twoendogenous variables or both of them willchange


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4-28

IS-LM Equilibrium in Equations

Monetary policy:

Expansionary monetary policy:

Money supply increases

Interest rate falls Private investment increases

Expenditure and income increases throughmultiplier effect

Contractionary monetary policy works inopposite direction


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4-29

Figure 4-5 The Effect of a $1,000 Billion Increase inthe Money Supply with a Normal LMCurve


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4-30

Expansionary Fiscal Policy and CrowdingOut

Crowding out effect describes the effect of an

increase in government spending or reductionof tax in reducing those components ofprivate spending that are sensitive to interestrate (e.g., investment and autonomous

consumption).


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4-31

Figure 4-6 The Effect on Real Income and the InterestRate of a $500 Billion Increase in Government Spending


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4-32


In the figure the IS curve shifts due to increasein govt. expenditure by $500 billion

The original multiplier of k = 4.0 would move

the economy E0 to E2 where the income is$2,000 billion higher ($9,000).

But E2 can not be equilibrium as it is off the LMcurve.

Equilibrium is at E2 where increase in incomeis 1,000) and the multiplier has become 2.0(1000z 500 = 2)


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At E2 income is higher than at E0

At higher income demand for money riseswhereas the supply of money is constant atMs/P = 2,000.

There is an excess demand for money

Therefore, interest rate must rise


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4-34


The increase in interest rate from 7.5% to 10%cuts private autonomous planned consumptionand investment spending. This is crowding out.

As a result, equilibrium income falls from E2

New equilibrium occurs at E3 where both themoney market and commodity market is in

equilibrium but income rises by $1,000 billion.

Because of crowding out income has not risenas much as it would have.


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4-35

Avoiding Crowding Out

Crowding out will not occur under twoconditions:

If for some reasons interest rate does not

rise, or

If interest rate rises but autonomous

private spending is insensitive to interestrate


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Simple solution: Increase money supply to shift the LM curverightward by the same amount as the IS curve(interest rate does not rise) or

If the demand for money did not depend on

income (interest rate does not rise) Hypothetical cases where crowding out will

not occur: (a) vertical IS curve (spending is not sensitive to

interest rate) (b) LM curve is horizontal interest rate is

infinitely responsive to demand for money (interestrate does not rise).


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Figure 4-7 The Effect of an Increasein the Money Supply With a Normal LMCurve and aVertical LMCurve


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Top frame shows the normal effect of anincrease in money supply.

Interest rate fell to r1

and real incomeincreases to Y1. Crowding out effect (Y1 Y2)

Bottom frame shows that same increase in Msleads to a greater drop in interest rate r4 and

higher increase in real income Y2;no crowdingout


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Figure 4-8

Effect of theSame Increasein the RealMoney Supplywith a High

InterestResponsivenessof the Demandfor Money and

with ZeroInterestResponsivenessof Spending


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Top frame shows higher money supply doesnot stimulate expenditures since they areassumed to be independent of the interest

rate the IS curve is vertical.

In the bottom frame the LM curve is so flatthat the same increase in money supply

hardly reduces interest rate and hardlyincreases income


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Figure 4-9

Effect of aFiscal Stimuluswhen MoneyDemand Has an

Infinite and aZero InterestResponsiveness


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Top frame - infinite interest responsiveness -the interest rate is fixed and no crowding outcan occur.

Bottom frame - same fiscal stimulus has noeffect on income when interestresponsiveness is zero.

No growth at all in income from E0 to E8 -crowding out is complete


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Using Fiscal and Monetary Policy Together

The effect of fiscal policy depends on the kindof monetary policy pursued at the same time.

Fiscal policy will shift the IS curve; but thefinal outcome depends on how the LM shiftsat the same time and that depends on whatthe Fed does with money supply and interestrate.


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Figure 4-10 The Effect on Real Incomeof a Fiscal Stimulus With Three Alternative MonetaryPolicies


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Using Fiscal and Monetary Policy Together

Figure 4-10 shows that with any given shift inthe IS curve, the level of income will dependon monetary policy as follows:

If the real money supply is held constant, the LMcurve does not shift rise in income is partlycrowded out (top left frame).

If a fixed interest rate is maintained, LM shift to thesame extent as IS income rises fully, there is nocrowding out (top right frame).

Fed attempts to keep real income constant LMshift to the left. Interest rate rises, income does noti.e., full crowding out (bottom frame).

MBA Lectures 8 - 9

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