Policy Analysis With the IS-LM Model

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Policy Analysis Withthe IS-LM Model
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Policy Analysis with the IS-LM Model

• A Closer Look at Policy
• Fiscal Policy and Crowding Out
• Monetary Policy and the Liquidity Trap
• Real World Monetary and Fiscal Policy
• Problems of Using IS-LM in the Real World
• Interpretation Problems
• Implementation Problems

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Policy in the IS-LM Model

• Fiscal Policy
• Expansionary fiscal policy shifts the IS curve to
  the right
• Contractionary fiscal policy shifts the IS curve
  to the left
• Monetary Policy
• Expansionary monetary policy shifts the LM curve
  to the right
• Contractionary monetary policy shifts the LM
  curve to the left

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Fiscal Crowding Out
1. The multiplier is 2 and government spending
increases by 500, so the IS increases by 1000.
2. The increase in income increases money
demand which increases interest rates from 4 to
5.
LM
3. The increase in the interest rate causes a
decrease in investment so that the increase in
income is only 600, less that the full
multiplier effect.
1000
Real Interest Rate ()
5
4
IS1
IS0
6600
6000
7000
Aggregate Output
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Fiscal Policy and Crowding Out

• When government expenditures increase, output and
  income begin to increase.
• The increase in income increases the demand for
  money.
• The increase in money demand increases the
  interest rate.
• Higher interest rates cause a decrease in
  investment, offsetting some of the expansionary
  effect of the increase in government spending.

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Full Crowding Out
1. The multiplier is 2 and government spending
increases by 500, so the IS increases by 1000.
2. If the demand for money is totally insensitive
to the interest rate, the interest
rate increases from 4 to 9.
LM
9
3. The increase in the interest rate causes a
decrease in investment that completely
offsets the increase in government spending.
Real Interest Rate ()
1000
4
IS1
IS0
6000
7000
Aggregate Output
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Ineffective Fiscal Policy

• When complete crowding out occurs, fiscal policy
  is ineffective, changing only interest rates, not
  output.
• Crowding out is greater if
• Money demand is very sensitive to income changes
• Money demand is not very sensitive to interest
  rate changes

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Monetary Policy and Liquidity Traps
In a liquidity trap, increases in the money
supply do not decrease interest rates, so
investment and output do not increase.
The Fed increases the money supply which
decreases interest rates and increases investment
and output.
LM0
LM0
Real Interest Rate ()
Real Interest Rate ()
LM1
LM1
r0
r0
r1
IS
IS
Y1
Y0
Y0
Aggregate Output
Aggregate Output
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Ineffective Monetary Policy

• Investment is not sensitive to the interest
  rate
• If investment does not respond to interest rate
  changes (the IS curve is steep), monetary policy
  in ineffective in changing output.
• Liquidity trap
• If increases in the money supply fail to lower
  interest rates, monetary policy is ineffective in
  increasing output.

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Other Theories
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Problems Using IS-LM

• Interpretation Problems (what is happening?)
• Problems in knowing how to interpret real-world
  events within the IS-LM framework
• Implementation Problems (how to deal with it?)
• Problems encountered in undertaking policy

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Interpretation Problems

• Interest Rate Problem
• Credit Conditions Problems
• Budget Problems
• Cyclical and Structural Problems
• Accounting Methods

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The Interest Rate Problem

• Which interest rate, nominal or real, is
  relevant?
• Which of many interest rates in the economy is
  relevant?
• The Federal funds rate?
• The interest rate households and businesses pay
  to borrow money?

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Why Interest Rates Differ

• Default risk
• Interest rates differ according to the likelihood
  that the borrower will repay the loan.
• Term to Maturity
• The longer the term to maturity, the higher the
  interest rate that is paid because
• Bonds with longer maturities are less liquid
• Differences in expected inflation
• More uncertainty

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Typical Yield Curve Inverted Yield Curve
6
6
5.5
5.5
5
5
Yield()
Yield()
4.5
4.5
4
4
3.5
3.5
6
3
1
10 30
5
2
6
3
1
10 30
5
2
Maturities
mos. yr.
Maturities
mos. yr.
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Interest Rates (Sep. 2005)
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Monetary Policy Tools and Credit Condition
Problems

• The IS-LM model assumes that interest rates are
  the only determinant of investment.
• Investment may also depends on credit conditions,
  the willingness of banks to lend independent of
  interest rates.
• If banks raise their lending standards,
  investment may not respond to expansionary
  monetary policy.
• Mexico after 1994, Japan in the 90s.

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Cyclical and Structural Budgets

• The structural budget surplus or deficit is the
  fiscal budget balance that would exist when the
  economy is at potential output.
• The cyclical budget surplus or deficit is that
  portion of the fiscal budget balance that exists
  because output is above or below potential output.

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Recent government budgets
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Policy Implementation Problems

• Uncertainty about Potential Output
• Information Lag
• Policy Implementation Lag

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Uncertainty About Potential Output

• One macroeconomic policy goal is to keep output
  as close to potential as possible. But, what is
  potential output?
• If policymakers use contractionary policy when
  the economy is actually below potential, they
  create unnecessary unemployment.
• Using expansionary policy above potential output
  will cause inflation.

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Information Lag

• The IS-LM model assumes that policymakers see
  what is happening in the economy and can
  instantly alter policies to fix any problem.
• In the real world there is an information lag, a
  delay between a change in the economy and
  knowledge of that change.
• Example are we in a recession or a boom right
  now?

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Policy Implementation Lag

• The policy implementation lag the delay between
  the time policymakers recognize the need for a
  policy action and when the policy is actually
  instituted.
• U.S. fiscal policy has a large implementation lag
  because policy must be formulated and legislation
  passed by Congress and signed by the President.
• Monetary policy has a much shorter implementation
  lag because the Federal Open Market Committee
  decides monetary policy and implements it
  immediately.