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**Efficacy of Stabilization Policies**

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Learning Objectives Understand how the interest sensitivity of spending affects the effectiveness of fiscal and monetary policy. Understand how the interest and income sensitivity of money demand affects the effectiveness of fiscal and monetary policy. Understand how the size of the multiplier affects the effectiveness of fiscal and monetary policy.

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**Fiscal Policy: Demand Side Transmission Mechanism**

Investment Spending Falls Government Spending Rises Aggregate Spending Increases Interest Rates Rise Deficit Increases Taxes Decrease Export Spending Falls Expansionary Fiscal Policy

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**IS/LM: Expansionary Fiscal Policy**

An increase in spending shifts the IS curve to the right. If interest rates do not rise, Y rises from Y1 to Y2. The change in Y equals the change in spending times the simple multiplier of the AE/AS model. As interest rates rise, investment and export spending are crowded out. r LM r2 E2 E1 B r1 IS2 IS1 Y1 Y Y2 Y

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**Fiscal Policy The impact of fiscal policy on Y depends on:**

The slope of the IS curve The slope of the LM curve The steeper the IS curve and the flatter the LM curve, the more effective fiscal policy is in changing income.

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**IS Curve: Slope The slope of the IS curve depends on:**

The size of the multiplier. Determines the initial change in Y. The interest sensitivity of investment and other interest sensitive spending. Determines the amount of crowding out that occurs as interest rates rise. The interest sensitivity of net exports. Determines the decrease in net exports that occurs as rising interest rates cause the dollar to rise.

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IS Curve: Slope The slope of the IS curve depends in part on the size of the MPC. Changes in aggregate spending are greater as the value of the MPC rises. Larger values of the MPC tend to make the slope of the aggregate expenditure line steeper and the slope of the IS curve flatter. Changes in aggregate spending are smaller as the value of the MPC falls. Smaller values of the MPC tend to make the slope of the aggregate expenditure line flatter and the slope of the IS curve steeper.

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AS AE AE(r1) AE(r2) AE(r1) AE(r2) Y Y2 Y3 r2 r1 IS2 IS1 Y Y2 Y3

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**IS Equation 1 Y = a + I – dr + G + X – nr – M – mY 1 – b(1 – t) + m**

As the MPC (b) rises (falls), (1 – b) falls (rises) and other things remaining the same the value of the multiplier rises (falls). Therefore, any change in aggregate spending will result in a larger (smaller) change in Y.

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IS Curve: Slope The slope of the IS curve depends in part on the interest elasticity of investment spending. As the economy expands, interest rates rise. If investment is interest elastic, the IS curve is flatter and rising rates cause more crowding out of private spending. If investment is interest inelastic, the IS curve is steeper and rising rates cause less crowding out of private spending.

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AS AE AE(r1) AE(r1) AE(r2) AE(r2) Y Y2 Y3 r2 r1 IS2 IS1 Y Y2 Y3

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IS Curve: Slope The slope of the IS curve depends in part on the response of net exports to changes in the value of the dollar as interest rates rise. As the economy expands, interest rates rise, causing the dollar to rise. If net exports are sensitive to changes in the exchange rate, the IS curve is flatter and rising exchange rates cause more crowding out of exports If investment are less sensitive to changes in the exchange rate, the IS curve is steeper and rising exchange rates cause less crowding out of exports.

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Net Exports and the IS Net exports are assumed to be determined by domestic interest rates and domestic GDP. Exports: X = X – nr As interest rates rise, the dollar rises, and exports fall by n times the change in r. Imports: M = M + mY As GDP rises, imports rise by m times the change in Y. Net Exports: X – M = X – nr – ( M + mY) = NX = X – nr – M – mY

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**Explaining Exchange Rates with Interest Rate Parity**

Interest rate parity says that the higher domestic real rates of interest are relative to foreign real interest rates, the higher will be the value of the domestic currency, other things remaining the same.

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**IS Equation 1 Y = a + I – dr + G + X – nr – M 1 – b(1 – t) + m dY dr**

– (d + n) 1 – b(1 – t) + m = dr dY 1 – b(1 – t) + m – (d + n) =

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**Monetary Policy: Interest Rate Channel**

Increase in the Decrease in Rise in Money Supply Interest Rates GDP Fall in Exchange Rates Expansionary Monetary Policy

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**IS/LM: Expansionary Monetary Policy**

An increase in the money supply, other things remaining the same, means that at r1 and Y1, money demand is less than money supply. The excess supply puts downward pressure on interest rates, and as r falls, interest sensitive spending and Y rise. r1 r2 IS Y1 Y Y

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**Monetary Policy The impact of monetary policy on Y depends on:**

The slope of the LM curve The slope of the IS curve The flatter the IS curve and the steeper the LM curve, the more effective monetary policy is in changing income.

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**LM Curve: Slope The slope of the LM curve depends on:**

The interest sensitivity of money demand. As the interest sensitivity of money demand increases, the money demand curve and the LM curve become flatter. The income sensitivity of money demand. As the income sensitivity of money demand increases, the LM curve becomes steeper.

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r LM r1 b b Md(Y1) r0 a a Md(Y0) MS Md, MS Y Y Y r LM r1 d d r0 c c Md(Y0) MS Md, MS Y Y Y

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**LM: The Algebra LM M/P = L(r,Y) M/P = eY – fr r = (e/f)Y – (1/f) M/P**

L(r,Y) = eY – fr where e and f >0 M/P = eY – fr r = (e/f)Y – (1/f) M/P dr dY e f =

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LM Curve: Slope A small (large) value for f means that as Y rises, large (small) changes in r are necessary to re-equilibrate the money market. A small (large) value for e means that as Y rises, small (large) changes in money demand occur that require small (large) changes in r to re-equilibrate the money market.

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r LM2 r4 r3 LM1 r2 r1 Y1 Y Y3 Y Y

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Fiscal Policy Fiscal policy is most effective when the IS curve is steep and the LM curve is flat. A steep IS ensures that crowding out of investment and exports is minimized. A flat LM ensures that the fiscal stimulus does not cause large increases in interest rates.

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Monetary Policy Monetary policy is most effective when the LM curve is steep and the IS curve is flat. A steep LM ensures that any change in monetary policy causes a large change in interest rates. A flat IS ensures that the change in interest rates have a significant impact on interest sensitive spending.

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