IS-LM Curves, fiscal and monetary policies

it involves IS-LM Curves, their derivations in brief and monetary and fiscal policies with good and precise explanation.

1. UNIT -3

2. Properties of the IS Curve Downward sloping, i   C, I  Y* Shift variables consist of the shift variables of the E P curve, except for the nominal interest rate (i).

3. Shifting the IS Curve Increases in autonomous expenditure which shift the E P curve upward , simultaneously shift the IS curve rightward . Decreases in autonomous expenditure which shift the E P curve downward , simultaneously shift the IS curve leftward .

4. The LM Curve Depicts equilibrium in the money market (L = M). A plot of the equilibrium interest rate for various levels of output or income versus the interest rate, within the money market for a given level of the nominal money supply.

5. Properties of the LM Curve Upward sloping, Y   L  i* Shift variables consist of the shift variables of the money demand and supply curves (except for Y).

6. Shifting the LM Curve Increases in the real money supply ( M S  or P) shift the LM curve rightward . Decreases in the real money supply ( M S  or P) shift the LM curve leftward .

7. Steepness or Flatness of the LM Curve The steepness or flatness of the LM curve describes the elasticity or responsiveness of money demand (L) to the nominal interest rate. -- Steep LM curve: inelastic . -- Flat LM curve: elastic .

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9. 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

10. 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

11. Fiscal Crowding Out 1. The multiplier is 2 and government spending increases by $500, so the IS increases by $1000. $6600 IS LM Real Interest Rate (%) Aggregate Output IS 1 $1000 4% $6000 5% $7000 2. The increase in income increases money demand which increases interest rates from 4% to 5%. 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.

12. 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.

13. 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%. 3. The increase in the interest rate causes a decrease in investment that completely offsets the increase in government spending. IS LM Real Interest Rate (%) Aggregate Output IS 1 $1000 4% $6000 9% $7000

14. 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

15. 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 increases in money supply which decreases interest rates and increases investment and output. Y 1 IS LM Real Interest Rate (%) Aggregate Output Y r r 1 LM 1 IS LM Real Interest Rate (%) Aggregate Output Y r LM 1

16. Liquidity Trap The liquidity trap is the situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings, because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

17. 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.

18. Policy Effectiveness An effective policy is one that obtains a large output response for a given change . Policy effectiveness depends upon the steepness or flatness of the IS and LM curves.