Transcript Document

ISLM, FISCAL AND MONETARY
POLICY
Week 8
SF Intermediate Economics
Professor Dermot McAleese
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OUTLINE
 Derivation and Analysis of IS curve
 Derivation and Analysis of LM curve
 ISLM Equilibrium
 What happens if actual Y does not coincide
potential (full employment) Y?
 Policy Implications
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Definition of IS curve
• The IS curve is an equilibrium locus
showing combinations of interest rate (r)
and output/expenditure (Y) that are
consistent with equilibrium in the goods
market. I=S at all points along this curve. It
is downward-sloping because … [complete
in your own words].
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Derivation of LM
Money Supply assumed exogenous, determined by Central Bank
 Money Demand determined by a) price level, b) level of Y and c)
interest rate (r)
 Equilibrium condition: Ms = Md
 This maps into upward sloping LM curve, with r on vertical axis and
Y on horizontal
T axis
 LM is upward sloping because as Y (+)s, Md increases. But Ms is
fixed, therefore equilibrium in money market can only be maintained
if something happens elsewhere to reduce demand. The elsewhere is
the interest rate. If r (+)s, Md tends to fall. Hence for each (+) Y
there is some (+) r that will restore equilibrium. The locus of such r,Y
points is the LM curve.
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LM curve shifts outwards if …
 Money supply increases
 Price level falls
 Interest rate sensitivity of demand
increases
 Income elasticity of money falls
 Technology changes (ATMs, more use
of credit cards etc)

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STABILITY OF MONEY DEMAND
 Money demand is stable if it changes in a predictable
fashion, i.e. parameters of money demand are relatively
constant over time
 Does NOT mean that money demand is fixed, does not
change
ECB view is that Md is reasonably stable so money
supply targets are meaningful policy instrument
Bank of England and Federal Reserve Bank more
sceptical – believe money demand inherently unstable
If money demand unstable so is LM curve, thus limiting
the possibility of activist monetary policy
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NOW PLACE IS CURVE AND LM CURVE ON SAME
GRAPH TO DERIVE EQUILIBRIUM POINT E
LM
r
E
IS
Ya
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IF Ya < YF , WHAT HAPPENS?
1) Wages flexible, workers price themselves back
into jobs, unemployment falls and IS shifts
outwards
2) Price level will also decline, Ms/p will
increase, consumer spending will increase. This
is the REAL BALANCE EFFECT
3) As real money supply (+)s, interest rate will
fall, leading to (+) in total spending (see McA
330-334)
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KEYNES’ RESPONSE TO CLASSICAL
(CONVENTIONAL) POSITION
 Automatic Adjustment mechanisms operate too
slowly – in the long run we are all dead
 Need for hands-on intervention to shift AD curve
outwards
 Policies to shift IS outwards likely to be more
effective than moving LM, because IS curve slopes
downwards steeply. That is, fiscal policy more
effective than monetary policy
BIRTH OF THEORY AND PRACTICE OF
COUNTER-CYCLICAL POLICY and
EXTENDED ROLE OF STATE
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COUNTER-CYCLICAL FISCAL POLICY
The Keynesian Aggregate Supply (KAS) curve
KAS
Price
level
E1
AD1
E2
E*
AD
AD2
Y2
Y*
Output
Keynesian economics applies up to Y* (full employment);
after that point we are back to vertical AS curve and the long run
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AS model
Table. 3 Government spending (%GDP)
Pre-WWII (about
1937)
1960
1970
1984
1990
2000
EUR
29.0
32.2
37.4
50.0
48.1
44.0
Japan
US
25.4
8.6
17.1
27.0
19.4
31.6
32.9
35.6
32.3
36.8
31.8
33.4
France
29.0
34.6
38.9
52.5
50.6
47.7
Germany
Netherlands
Ireland
Italy
42.4
19.0
…
24.5
32.5
33.7
28.0
30.1
38.5
42.4
39.6
34.2
47.6
59.6
51.3
49.4
45.3
55.0
40.0
53.2
44.0
42.1
29.5
44.2
UK
30.0
32.2
37.3
45.3
40.3
36.8
Source: European Economy, Annual Report No 59, 1995; European Economy, special Supplement, Spring 1995; OECD;
pre-Second World War figures taken from Vito Tanzi and Ludger Schuknecht, ‘The Growth of Government and the
Reform of the State in Industrial Countries’, IMF Working Paper, December 1995; European Economy No. 68, 1999.
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Table. 4 General Government Net Debt (%GDP)
1978
1990
1995
2000
EU(15)
23.9
40.8
75.2
68.5
Japan
US
11.3
21.3
9.5
31.5
76.2
74.5
112.8
60.2
Belgium
Italy
57.2
62.4
124.9
103.7
129.8
123.1
109.8
112.9
Greece
29.4
89.0
108.7
103.8
Netherlands
40.2
75.6
75.5
56.5
Denmark
21.9
65.8
73.9
50.8
Portugal
Germany
France
37.6
30.1
31.0
65.3
42.0
39.5
65.9
59.1
59.3
58.8
63.5
63.9
Spain
14.4
48.5
68.4
65.7
UK
58.6
39.1
58.9
49.7
Ireland
65.7
92.6
80.8
42.9
Source: European Monetary Institute, First Annual Report, April 1995;
Outlook,, various issues.
OECD Economic
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For Interest: A Recent Paper Comments on
Total Factor Productivity (TFP)
A growing body of evidence suggests that, even
after physical and human capital accumulation are
accounted for, something else accounts for the
bulk of cross country differences in the level and
growth rate of GDP per head. Economists
typically refer to the something else as total factor
productivity
Easterly and Levine “What have we learned from a decade of empirical research on
growth?” The World Bank Economic Review No 2 2001
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3 pages of ISLM Equations
For those who prefer equations to
graphs, here is how equilibrium Y and
r can be derived
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Deriving the IS curve
• Y=C+I
• C = a + bY
• I=d–fi
Y = a + bY + d – f i

a  d  1  b 
i

Y
f
f
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Deriving the LM curve
• The LM curve summarises the relationship
between real output and real interest rates such
that the aggregate demand for money (L) is just
equated with the money stock (M)
L     Y  hi
L=M
h
i
 Y  M 
=> LM equation
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IS-LM Equilibrium

a  d  1  b 

Y
• IS equation: i 
f
h
i
 Y  M 
• LM equation:
f
• Equilibrium: a  d   1  b  Y  Y  M  
f
f
h
Y* 
h
f
a  d   M  
  h f 1  b 
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