1. © Pilot Publishing Company Ltd. 2005 Chapter 7 Effectiveness of Monetary Policy and Fiscal Policy

2. © Pilot Publishing Company Ltd. 2005 Contents: More about the IS-LM model Effectiveness of monetary policy & fiscal policy Advanced Material 7.1: Interest rate vs. money supply as an instrument of monetary policyAdvanced Material 7.1: Interest rate vs. money supply as an instrument of monetary policy Advanced Material 7.2: Comparison between the IS-LM model and the Y-E modelAdvanced Material 7.2: Comparison between the IS-LM model and the Y-E model

3. © Pilot Publishing Company Ltd. 2005 More about the IS-LM Model

4. © Pilot Publishing Company Ltd. 2005 Determinants of the slope of the IS curve  The slope of the IS curve:  The slope is negative. >0>0 <0<0

5. © Pilot Publishing Company Ltd. 2005 r Y 0 IS* (I is more interest elastic) IS (I is less interest elastic)  The larger the interest elasticity Interest elasticity of investment ( r E I or b ) when r changes, the larger the change in I  the larger the required change in Y (& W) to restore equilibrium, i.e., the gentler the IS curve.

6. © Pilot Publishing Company Ltd. 2005 r Y 0 IS* (S is less income elastic) IS (S is more income elastic)  The larger the income elasticity when Y changes, the larger the change in S  the larger the required change in r (& J) to restore equilibrium, i.e., the steeper the IS curve. Income elasticity of saving ( Y E S or s or MPS)

7. © Pilot Publishing Company Ltd. 2005 Determinants of the extent of shift of the IS curve Reason of the shift: (an autonomous ∆ in J or W)  e.g., an autonomous  in J  J > W 1. If r remains unchanged, Y has to  to raise W until J=W,  IS curve shifts rightward. 2. If Y remains unchanged, r has to  to lower J until J=W,  IS curve shifts upward.

8. © Pilot Publishing Company Ltd. 2005  As they have the same income elasticity, they require the same  in Y to restore equilibrium. r Y 0 IS* (I is more interest elastic) IS (I is less interest elastic) Interest elasticity of investment Consider two IS curves with different r E I but equal Y E S  An auton.  in J  The IS curve with a larger interest elasticity requires a smaller  in r to restore equilibrium  An auton.  in J  The IS curve with a larger interest elasticity requires a smaller  in r to restore equilibrium

9. © Pilot Publishing Company Ltd. 2005  As they have the same interest elasticity, they require the same  in r to restore the equilibrium. r Y 0 IS* (S is more income elastic) IS (S is less income elastic) Income elasticity of saving Consider two IS curves with different Y E S but equal r E I  An auton.  in J  The IS curve with a larger income elasticity requires a smaller  in Y to restore equilibrium  An auton.  in J  The IS curve with a larger income elasticity requires a smaller  in Y to restore equilibrium

10. © Pilot Publishing Company Ltd. 2005 Extreme case Shape of IS curve Extent of shift of the IS curve (e.g., an autonomous J  or W  that J > W) Y E s = 0Horizontal ( ∵  Y   r = 0) Upward shift: normal Rightward shift:  in Y cannot restore equilibrium Y E s =  Vertical ( ∵  Y   r =  ) Upward shift: normal Rightward shift: a negligible  in r is enough to restore equil.

11. © Pilot Publishing Company Ltd. 2005 Extreme cases of the IS curve Extreme case Shape of IS curve Extent of shift of the IS curve (when autonomous J  or W  that J > W) r E I = 0Vertical ( ∵ Δr  ΔY = 0) Upward shift:  in r cannot restore equilibrium Rightward shift: normal r E I =  Horizontal ( ∵ Δr  ΔY =  ) Upward shift: a negligible  in r is enough to restore equil. Rightward shift: normal

12. © Pilot Publishing Company Ltd. 2005 Determinants of the slope of the LM curve The slope of the LM curve:  The slope is positive. > 0 < 0

13. © Pilot Publishing Company Ltd. 2005 Q7.2: Given a two-sector economy, with S = 0.2Y – 100 and I = 10 – 20r. (a) Derive the IS equation. (b) Suppose there is an autonomous rise in I by 40. (i) What is the extent of rightward shift of the IS curve? (ii) What is the extent of upward shift of the IS curve?

14. © Pilot Publishing Company Ltd. 2005 r Y 0 LM* (M a is more interest elastic) LM (M a is less interest elastic) Interest elasticity of asset demand for money  The larger the interest elasticity, when r changes, the larger the change in M a  the larger the required change in Y (& M t ) to restore equilibrium, i.e., the gentler the LM curve.

15. © Pilot Publishing Company Ltd. 2005 Income elasticity of transactions demand for money  The larger the income elasticity, r Y 0 LM* (M t is more income elastic) LM (M t is less income elastic) when Y changes, the larger the change in M t  the larger the required change in r (& M a ) to restore equilibrium, i.e., the steeper the LM curve.

16. © Pilot Publishing Company Ltd. 2005  e.g., an autonomous  in money supply  M d < M s 1. If r remains unchanged, Y has to  to raise M t until M d = M s,  LM curve shifts rightward. 2. If Y remains unchanged, r has to  to raise M a until M d = M s,  LM curve shifts downward. Determinants of the extent of shift in the LM curve Reason of the shift: (an autonomous Δ in M d or M s )

17. © Pilot Publishing Company Ltd. 2005 r Y 0 LM 0 (M a is less interest elastic) LM 0 * (M a is more interest elastic) Interest elasticity of asset demand for money LM 1 * LM 1 Consider two LM curves with different r E Ma but equal Y E Mt An auton.  in M s The LM curve with a larger interest elasticity requires a smaller Δ in r to restore equilibrium An auton.  in M s The LM curve with a larger interest elasticity requires a smaller Δ in r to restore equilibrium As they have the same income elasticity, they require the same  in Y to restore the equilibrium

18. © Pilot Publishing Company Ltd. 2005 r Y 0 Income elasticity of transactions demand for money LM 0 *(M t is more income elastic) LM 0 (M t is less income elastic) LM 1 * LM 1 Consider two LM curves with different Y E Mt but equal r E Ma An auton.  in M s The LM curve with a larger income elasticity requires a smaller  in Y to restore equilibrium An auton.  in M s The LM curve with a larger income elasticity requires a smaller  in Y to restore equilibrium As they have the same interest elasticity, they require the same  in r to restore the equilibrium

19. © Pilot Publishing Company Ltd. 2005 Extreme cases of the LM curve Extreme case Shape of LM curve Extent of shift of the LM curve (when autonomous M d  or autonomous M s  ) r E Ma = 0Vertical ( ∵ Δr  ΔY = 0) Downward shift:  in r cannot restore the equil. Rightward shift: normal r E Ma =  Horizontal ( ∵ Δr  ΔY=  ) Downward shift: a negligible  in r is enough to restore the equil. Rightward shift: normal

20. © Pilot Publishing Company Ltd. 2005 Extreme case Shape of LM curve Extent of shift of the LM curve (when autonomous M d  or autonomous M s  ) Y E Mt = 0Horizontal ( ∵ ΔY  Δr = 0) Downward shift: normal Rightward shift:  in Y cannot restore equilibrium Y E Mt =  Vertical ( ∵ ΔY  Δr =  ) Downward shift: normal Rightward shift: a negligible  in Y is enough to restore equil.

21. © Pilot Publishing Company Ltd. 2005 Monetary policy (MP) is the government measure which achieves economic objectives through manipulating the money supply or interest rate. Fiscal policy (FP) is the government measure which achieves economic objectives through manipulating the government revenue or expenditure.

22. © Pilot Publishing Company Ltd. 2005 Effectiveness of Monetary Policy and Fiscal Policy

23. © Pilot Publishing Company Ltd. 2005 Effectiveness of monetary policy Effect of monetary policy e.g., an expansionary monetary policy (M s  ) M d <M s rr rr MaMa MaMa II II J>W YY YY WW WW  until J=W & M d =M a +M t =M s Mechanism: MtMt MtMt

24. © Pilot Publishing Company Ltd. 2005 Determinants of the effectiveness of MP 1. Multiplier 2. Interest elasticity of investment 3. Income elasticity of saving 4. Interest elasticity of asset demand for money 5. Income elasticity of transactions demand for money

25. © Pilot Publishing Company Ltd. 2005 Multiplier Δ Y = Δ I X Multiplier The larger the multiplier  The larger the change in Y  The more effective the monetary policy

26. © Pilot Publishing Company Ltd. 2005 Interest elasticity of investment ( r E I ) r Y 0 LM 0 LM 1 IS* (I is more interest elastic) IS Y0Y0 Y1Y1 Y* 1 E I  The larger the r E I, the larger the  in I & the larger the  in Y.  The more effective the MP  The more effective the MP

27. © Pilot Publishing Company Ltd. 2005 Income elasticity of saving ( Y E S ) r Y 0 LM 0 LM 1 IS* (S is less income elastic) IS Y0Y0 Y1Y1 Y* 1 E S  The smaller the Y E S, the larger the required  in Y to raise enough W to restore equil.  The more effective the MP  The more effective the MP

28. © Pilot Publishing Company Ltd. 2005 Interest elasticity of asset demand for money ( r E Ma ) Y0Y0 r Y 0 LM* 0 (M a is less interest elastic) LM* 1 LM 0 LM 1 IS Y1Y1 Y* 1  The smaller the r E Ma, the larger the required  in r to raise enough M a to restore the equil.  Then the larger the  in I & Y  The smaller the r E Ma, the larger the required  in r to raise enough M a to restore the equil.  Then the larger the  in I & Y  The more effective the MP  The more effective the MP

29. © Pilot Publishing Company Ltd. 2005 Income elasticity of transaction demand for money ( Y E Mt ) r Y 0 LM 0 *(M t is less income elastic) LM 1 LM 0 IS LM 1 * Y0Y0 Y1Y1 Y* 1  The smaller the Y E Mt, the larger the required  in Y to raise enough M t to restore the equil.  The more effective the MP  The more effective the MP

30. © Pilot Publishing Company Ltd. 2005 Effectiveness of Fiscal Policy Effect of fiscal policy e.g., an expansionary fiscal policy (G  ) MtMt MtMt rr rr J>WJ>W YYYY YYYY II II  until J=W and M d =M a +M t =M s WW WW M d >M s Mechanism: MaMa MaMa

31. © Pilot Publishing Company Ltd. 2005 Determinants of the effectiveness of FP 1. Multiplier 2. Interest elasticity of asset demand for money 3. Income elasticity of transactions demand for money 4. Interest elasticity of investment 5. Income elasticity of saving

32. © Pilot Publishing Company Ltd. 2005 Multiplier Δ Y = Δ G X G-Multiplier Δ Y = Δ T X T-Multiplier The larger the multipliers  The larger the change in Y  Fiscal Policy is more effective

33. © Pilot Publishing Company Ltd. 2005 r Y 0 Interest elasticity of asset demand for money ( r E Ma ) LM* (M a is more interest elastic) LM IS 0 IS 1 Y0Y0 Y1Y1 Y* 1  The, the to restore the equil. and the.  The larger the r E Ma, the smaller the required  in r to restore the equil. and the smaller the crowding out effect.  The more effective the FP  The more effective the FP

34. © Pilot Publishing Company Ltd. 2005 Income elasticity of transactions demand for money ( Y E Mt ) r Y 0 LM* (M t is less income elastic) LM IS 0 IS 1 Y0Y0 Y1Y1 Y* 1   The smaller the Y E Mt, the smaller the  in M t and the smaller the required  in r to restore the equil. and the smaller the crowding out effect.  The more effective the FP  The more effective the FP

35. © Pilot Publishing Company Ltd. 2005 Interest elasticity of investment ( r E I ) r Y 0 LM IS* 0 (I is less income elastic) IS* 1 IS 0 IS 1 Y0Y0 Y1Y1 Y* 1  The smaller the, the smaller the drop in I and the  The smaller the r E I, the smaller the drop in I and the smaller the crowding out effect.  The more effective the FP  The more effective the FP

36. © Pilot Publishing Company Ltd. 2005 Income elasticity of saving ( Y E S ) r Y 0 LM IS* 0 (S is less income elastic) IS* 1 Y0Y0 IS 0 IS 1 Y* 1 Y1Y1   The smaller the Y E S, the larger the required  in Y to raise enough W to restore the equil.   The smaller the Y E S, the larger the required  in Y to raise enough W to restore the equil.  The more effective the FP  The more effective the FP

37. © Pilot Publishing Company Ltd. 2005 Effectiveness of the policies in extreme cases Extreme case Effectiveness of MPEffectiveness of FP Horizontal IS Most effective r E I =   totally ineffective Y E S = 0  most effective Vertical IS Totally ineffective r E I = 0  most effective Y E S =   totally ineffective Horizontal LM r E Ma =   totally ineffective Y E Mt = 0  most effective Most effective Vertical LM r E Ma = 0  most effective Y E Mt =   totally ineffective Totally ineffective

38. © Pilot Publishing Company Ltd. 2005 Horizontal IS IS 0 LM 0 LM 1 Y0Y0 Y1Y1 r Y  Effectiveness of MP Cause of horizontal IS: r E I =  or Y E s = 0  MP is most effective  MP is most effective E.g., an expansionary MP

39. © Pilot Publishing Company Ltd. 2005 IS 0 LM 0 Y0Y0 r Y  Effectiveness of FP Horizontal IS  FP is completely ineffective  FP is completely ineffective = Y 1 = IS 1 Cause of horizontal IS: r E I =  E.g., an expansionary FP

40. © Pilot Publishing Company Ltd. 2005 IS 0 LM 0 Y0Y0 r Y  Effectiveness of FP IS 1 Y1Y1 Horizontal IS  FP is most effective  FP is most effective Cause of horizontal IS: Y E s = 0 E.g., an expansionary FP

41. © Pilot Publishing Company Ltd. 2005 Vertical IS IS 0 LM 0 r Y  Effectiveness of MP LM 1 Y0Y0 Cause of vertical IS: r E I =0 or Y E s =   MP is completely ineffective  MP is completely ineffective = Y 1 E.g., an expansionary MP

42. © Pilot Publishing Company Ltd. 2005 Vertical IS IS 0 LM 0 r Y  Effectiveness of FP Y0Y0  FP is most effective  FP is most effective IS 1 Y1Y1 Cause of vertical IS: r E I = 0 E.g., an expansionary FP

43. © Pilot Publishing Company Ltd. 2005 Vertical IS IS 0 LM 0 r Y  Effectiveness of FP Cause of vertical IS: Y E s =  Y0Y0  FP is completely ineffective  FP is completely ineffective = Y 1 = IS 1 E.g., an expansionary FP

44. © Pilot Publishing Company Ltd. 2005 Horizontal LM IS 0 LM 0 r Y Cause of horizontal LM: r E Ma =  Y0Y0  Effectiveness of MP  MP is completely ineffective  MP is completely ineffective = LM 1 = Y 1 E.g., an expansionary MP

45. © Pilot Publishing Company Ltd. 2005 IS 0 LM 0 r Y Cause of horizontal LM: Y E Mt = 0 Y1Y1  Effectiveness of MP LM 1 Y0Y0  MP is most effective  MP is most effective Horizontal LM E.g., an expansionary MP

46. © Pilot Publishing Company Ltd. 2005 Horizontal LM IS 0 r Y Cause of horizontal LM: Y E Mt = 0 or r E Ma =   Effectiveness of FP LM 0 Y0Y0 IS 1 Y1Y1  FP is most effective  FP is most effective E.g., an expansionary FP

47. © Pilot Publishing Company Ltd. 2005 Vertical LM IS 0 r Y Cause of vertical LM: r E Ma = 0  Effectiveness of MP LM 0 Y0Y0 Y1Y1 LM 1  MP is most effective  MP is most effective E.g., an expansionary MP

48. © Pilot Publishing Company Ltd. 2005 Vertical LM IS 0 r Y Cause of vertical LM: Y E Mt =   Effectiveness of MP LM 0 Y0Y0  MP is completely ineffective  MP is completely ineffective = LM 1 = Y 1 E.g., an expansionary MP

49. © Pilot Publishing Company Ltd. 2005 Vertical LM IS 0 r Y  Effectiveness of FP LM 0 Y0Y0 Cause of vertical LM: Y E Mt =  or r E Ma = 0 IS 1  FP is completely ineffective  FP is completely ineffective = Y 1 E.g., an expansionary FP

50. © Pilot Publishing Company Ltd. 2005 Advanced Material 7.1 Interest rate versus money supply as an instrument of monetary policy  Money supply as an instrument of MP  Money supply is fixed & is adjusted deliberately. The LM curve is upward sloping.  An expansionary MP shifts the LM curve rightward or downward.  M s is exogenous but interest rate is endogenous.

51. © Pilot Publishing Company Ltd. 2005 Advanced Material 7.1 Interest rate versus money supply as an instrument of monetary policy  Interest rate as an instrument of MP  Interest rate is fixed & is adjusted deliberately. The LM curve is horizontal at that fixed rate.  An expansionary MP lowers the interest rate & shifts the LM curve downward to the new rate.  Interest rate is exogenous but M s is endogenous.

52. © Pilot Publishing Company Ltd. 2005 Advanced Material 7.2 Comparison between the IS-LM model and the Y-E Model  Differences between the two models  The Y-E model considers the goods market only, while the IS-LM model considers both the goods market & the money market.  In the Y-E model, I is a constant independent of r, while in the IS-LM model, I is a variable negatively related to r.

53. © Pilot Publishing Company Ltd. 2005 Advanced Material 7.2 Comparison between the IS-LM model and the Y-E Model  Superiority of the IS-LM model  can investigate the effects of monetary forces (changes in M d & M s )  can predict the value of the equil. interest rate  can give a more accurate prediction on the value of the equil. Y

54. © Pilot Publishing Company Ltd. 2005  The Y-E model is a special case of the IS-LM model  When r E Ma =  (horizontal LM), Y E Mt = 0 (horizontal LM) or r E I = 0 (vertical IS)  No crowding-out effect  The Y-E model gives the same (& accurate) prediction as the IS-LM model on how real forces (in the goods market) affect the equil. Y.  Notice that when r E I = 0 and r E Ma, monetary forces are neutral, having no effect on Y. In other words, the goods market & the money market are separated.

55. © Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 1. For the same amount of autonomous change in J or W causing J > W, the IS curve will shift rightward (upward) by the same amount. 2. For the same amount of autonomous change in M d or M s causing M d < M s, the LM curve will shift rightward (downward) by the same amount.

56. © Pilot Publishing Company Ltd. 2005 3. The flatter the IS curve, the more effective the monetary policy but the less effective the fiscal policy. Correcting Misconceptions: 4. The steeper the LM curve, the less effective the fiscal policy but the more effective the monetary policy.