Transcript Money and Economic Stability in the ISLM World

Chapter 25
Money and
Economic
Stability in
the ISLM
World
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Learning Objectives
• Explain the circumstances under which fiscal or
monetary policy is a more effective method of
stabilizing GDP
• Understand the importance of crowding out and
possible liquidity traps
• Define the role of prices and their impact on
economic stability
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-2
Monetary Policy, Fiscal Policy,
and Crowding Out
• Controversy within the ISLM framework relates to the
relative effectiveness of monetary and fiscal policy
• Monetarists “special case” (Figure 25.1)
– Demand for money is unresponsive to interest rates, depends
on income only
– Produces a vertical LM function
– Since velocity is constant and a fixed money supply, GDP
cannot change
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-3
FIGURE 25.1 When the LM curve is vertical,
an increase in the money supply increases
income by ∆M times velocity.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-4
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Monetarists “special case”
(Figure 25.1) (Cont.)
– Increase in the money supply shifts the LM curve to
the right along a fixed IS curve
– Income increases until all the increased money
supply is absorbed into increased transactions
demand
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-5
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Figure 25.2
– LM curve is not vertical, but is positively sloped
– Demand for money is somewhat responsive to rate of interest
– Increase in money supply will result in an increase in income,
but less than in the monetarist’s case
– Smaller increase in income is due to lowering of interest rates
inducing holding of money in “idle” balances rather than for
transactions purposes
– Therefore velocity of the total money supply falls
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-6
FIGURE 25.2 When the LM curve is not vertical, an
increase in the money supply is less powerful in
increasing income.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-7
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Keynesian reservations about monetary policy
– Liquidity trap (Figures 25.3 and 25.4)
• Money demand is non-responsive to lowering of interest
• Therefore, the LM curve is perfectly horizontal and does not shift
down following an increase in the money supply
• Increase in money supply does not lower the interest rate
• All the additional money is held as idle balances (hoarding) and
equilibrium is unchanged
• Therefore, the velocity of the money supply has decreased
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-8
FIGURE 25.3 With a liquidity trap, an increase in
the money supply from M to M does not shift the LM
curve (see Figure 25.4).
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-9
FIGURE 25.4 With a liquidity trap, an increase in the
money supply, because it does not shift the LM curve,
does not change income.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-10
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Keynesian reservations about monetary
policy (Cont.)
– Perfectly vertical IS curve (Figure 25.5)
• Investment spending is completely unresponsive to the
rate of interest
• Therefore, changes in the money supply do not affect
income even though it may change the rate of interest
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-11
FIGURE 25.5 When the IS curve is
vertical, monetary policy is ineffective.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-12
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Summary of monetary policy
– Monetary stimulus works when both the IS and LM
curve are “normal”
– Extreme cases of a horizontal LM curve and vertical
IS curve render monetary policy ineffective
– However, the impact of monetary policy with
“normal” curve may be reduced if increased money
supply causes a decline in the velocity
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-13
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Critique on Fiscal Policy (Figure 25.6)
– Fiscal policy has zero impact with a vertical LM
curve and is completely effective with a horizontal
LM curve
• Vertical LM curve
– Increased money supply will be absorbed by a higher interest rate
with an increase in GDP
– This case represents total crowding-out due to higher interest
rates
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-14
FIGURE 25.6 When the LM curve is vertical, fiscal
policy is completely ineffective; when it is horizontal,
it is totally effective.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-15
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• Critique on Fiscal Policy (Figure 25.6) (Cont.)
• Horizontal LM curve
– Increased money supply would not increase interest rates and the
impact would be entirely on GDP
– This case completely eliminates the crowding-out effect caused
by higher interest rates
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-16
Monetary Policy, Fiscal Policy,
and Crowding Out (Cont.)
• In the general case of a positively sloped LM curve
– The results lie between the two extremes described above
– While increased government spending will increase GDP, it
will be less than the “full multiplier” of the simple Keynesian
system
– The reduction in the ultimate impact in the increase of GDP is
a result of some increase in interest rates (partial crowdingout)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-17
Is the Private Sector Inherently Stable?
• Most economists agree that the LM curve is
positively sloped, although there is disagreement
as to magnitude of the slope
• These differences in the slope of the LM curve
are sufficient to demonstrate the stability or
instability of economic activity resulting from
exogenous shifts in private investment
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-18
Is the Private Sector Inherently Stable?
(Cont.)
• Figure 25.7
– There are two alternative LM curves: LMsteep and LMflat with
two IS curves representing shifts in autonomous investment
– Shift of the IS curve will result in much greater variations in
economic activity with a flat LM curve
– This is a result of greater variations in the rate of interest with
the steep LM curve inducing a large change of endogenous
investment to offset a large part of the change in exogenous
investment
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-19
FIGURE 25.7 A flatter LM curve means wider
fluctuations in GDP associated with exogenous
shifts in investment.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-20
Is the Private Sector Inherently Stable?
(Cont.)
• Figure 25.8
– When the economy operates near full employment capacity,
fluctuations in the price level help provide self-correcting
stability
– Starting at the intersection of IS and LM(P0)—E, the economy
is operating at YFE which represents full employment
– An increase in autonomous spending shifts IS to IS and raises
demand to Y, which is above full employment
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-21
FIGURE 25.8 At full employment,
fluctuations in the price level help stabilize
economic activity.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-22
Is the Private Sector Inherently Stable?
(Cont.)
• Figure 25.8 (Cont.)
– With the economy operating above capacity, there
will be an upward pressure on prices to P1
– If the supply of money is fixed, increased prices will
reduce the real supply of money which pushes the
LM curve back to LM(P1) reducing income to the
full employment level
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-23
Is the Private Sector Inherently Stable?
(Cont.)
• Figure 25.8 (Cont.)
– At the new equilibrium, E1, prices and interest rates
are higher, but output and employment revert to the
original level
– Therefore, a condition with a fixed supply of money
and flexibility of prices and interest rates indicates
the economy will be insulated from changes in
exogenous investment spending
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-24
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out
• When economy is at or near full employment,
the Keynesian interest rate mechanism supports
the classical argument of automatic adjustments
• At full employment, the rate of interest is
independent of movements in the money supply
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-25
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Figure 25.9
– Initial equilibrium at YFE and rFE
– The interest rate is the real rate since there is
an assumption of no inflationary pressure in the
economy
– An increase in the money supply will initially
push the LM curve rightward to LM, which
reduces interest rates to r
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-26
FIGURE 25.9 An increase in money
supply at full employment doesn’t lower
the interest rate.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-27
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Figure 25.9 (Cont.)
– However, since the economy is operating above
full employment (Y), prices will rise which
reduces the real supply of money
– As a result, the LM curve shifts leftward back
to the original position, increasing the rate of
interest back to rFE
– Therefore, at full employment, increases in
the money supply cannot reduce the interest
rate below rFE
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-28
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Natural rate of interest (rFE)
– That rate which equates savings and investment
at full employment
– At full employment, only saving and
investment (including government spending)
determine the interest rate and money supply
plays no role
– Since real rate is fixed at rFE, nominal rate will
rise if inflationary expectations are generated
by the increased money stock
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-29
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Fiscal policy under flexible prices
– Refer back to Figure 25.8
– Assume initial equilibrium of E and a positively
sloped LM curve
– Additional government spending shifts the IS
curve to IS
– Initial movement along LM(P0) will increase
interest rates which partially crowds investment
spending
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-30
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Fiscal policy under flexible prices (Cont.)
– Since the economy is now above YFE, there will
be an increase in prices pushing the LM curve
left to LM(P1), where P1 > P0.
– The economy will move to equilibrium
condition E, with even higher interest rates
which reduces investment spending to a level
equal to the increased government spending
(complete crowding-out)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-31
Flexible Prices, The Natural Rate of
Interest, and Real Crowding Out (Cont.)
• Fiscal policy under flexible prices (Cont.)
– Two important observations in the case of
increased government spending
• Real Interest rates at full employment are affected
by shifts in the real sector of the economy—pushed
upward by increased government spending
• Although real output returns to the full employment
level, increased government spending will increase
nominal output because of higher prices
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-32
Appendix
INTEREST RATES
VERSUS THE
MONEYSUPPLY
UNDER
UNCERTAINTY
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
APPENDIX—INTEREST RATES
VERSUS THE MONEY SUPPLY
UNDER UNCERTAINTY
• Chapter 21 discussed the advantages and disadvantages
of using the money supply versus interest rates as a
target of monetary policy
– Monetarists generally prefer money supply target
– Keynesians prefer an interest rate objective
• The basic question is it always better for the Fed to
specify a target for the money supply rather than the
interest rate
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-34
APPENDIX—INTEREST RATES
VERSUS THE MONEY SUPPLY
UNDER UNCERTAINTY (Cont.)
• Figure 25A.1
– The IS curve is shifting back and forth
– In this case, the money supply target is superior—smaller variation in
GDP when the major source of instability is in the IS curve
• Figure 25A.2
– The demand for money is highly unstable which results in a shift of the
LM curve
– In this case, the interest rate target is superior—there is no instability in
GDP
• Therefore, the choice between interest rate or money supply targets depends
on where the instability comes from—the IS or the LM curve
• The authors suggest the demand for money is unstable (LM curve) which
indicates that an interest rate target is best
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-35
FIGURE 25A.1 With an interest rate target, an unstable IS
curve leads to wider variation in GDP than if the Fed had a
money supply target.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-36
FIGURE 25A.2 With a money supply target, an unstable
LM curve leads to wider variation in GDP than if the Fed
had an interest rate target.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
25-37