22.1 Shifting The IS-LM Curves #Notebook

22.1 Shifting The IS-LM Curves #Notebook

The IS-LM model can help policymakers to decide between two major types of policies such as government expenditure and tax, or monetary (interest rates and money supply). 

An autonomous expenditure describes the components of an economy's aggregate expenditure that are not impacted by the level of income. This type of spending is considered automatic and necessary.

The classical economic theory states that any rise in autonomous expenditures will create at least an equivalent rise in aggregate output, such as GDP, if not a greater increase.

The LM curve, the equilibrium points in the market for money, shifts for two reasons: changes in money demand, and changes in the money supply. 

If the money supply increases (decreases), ceteris paribus, the interest rate is lower (higher) at each level of aggregate output.

The LM curve shifts right (left), means at any given level of output Y, more money (less money) means a lower (higher) interest rate. 

An autonomous change in money demand (not related to the price level, aggregate output, or i) will also affect the LM curve such as stocks get riskier or the transaction costs of trading bonds increases. 

The theory of asset demand tells us that the demand for money will increase (shift right), thus increasing interest rates.

Interest rates could also decrease if money demand shifted left because stock returns increased or bonds became less risky.

An increase in autonomous money demand will shift the LM curve left, with higher interest rates at each Y; a decrease will shift it right, with lower interest rates at each Y.

The IS curve shifts whenever an autonomous change occurs in Consumer spending, Investment, Government spending, Net exports. 

The IS curve shifts right (left). When taxes increases (decreases), all else constant, the IS curve shifts left (right) because taxes effectively decrease consumption. 

These are changes that are not related to output or interest rates, which merely indicate movements along the IS curve. 

Changes in consumer preferences will change the output at each interest rate and shift the entire IS curve.

How Government Policies Can Affect Output?

In the short run, an increase in the money supply will shift the LM curve to the right, thereby lowering interest rates and increasing output. Decreasing the MS would have precisely the opposite effect. 

Fiscal stimulus such as decreasing taxes or increasing government expenditures will also increase output but, unlike monetary stimulus (increasing MS), will increase the interest rate. This way, it works by shifting the IS curve upward rather than shifting the LM curve. 

Since Y = Aggregate demand = Consumer and household consumption expenditures + Investment + Government spending + NExpo -Taxes. If taxes increases, the IS curve will shift left, decreasing interest rates but also aggregate output. 

During financial panics, people often complain of high interest rates and declining economic output. Use the IS-LM model to describe why panics have those effects?

The LM curve will shift left during financial panics, raising interest rates and decreasing output, because the demand for money increases as economic agents scramble to get liquid.

During financial panics, the LM curve shifts left as people flee risky assets for money, thereby inducing the interest rate to climb and output to fall. Hamilton and Bagehot argued that monetary authorities should respond by increasing MS directly, shifting the LM curve back.

The LM curve shifts right (left) when the money supply, or demand (real money balances) increases (decreases).

The IS curve shifts right (left) when Consumption expenditures, Investment, Government, or Net exports increase (decrease), or Taxes decreases (increases). This relates directly to the Keynesian cross diagrams.

Reference

Wright, R. E., & Quadrini, V. (2009).Money and Banking. Flat World Knowledge Inc.