22.2 Implications for Monetary Policy #Notebook

22.2 Implications for Monetary Policy #Notebook

The IS-LM model has a major implication for monetary policy. When the IS curve is unstable, a money supply target will lead to greater output stability, and when the LM curve is unstable, an interest rate target will produce greater macro stability.

The policy power of the IS-LM is severely limited by its short-run assumption that the price level doesn’t change. 

The key is the addition of a new concept, called the natural rate level of output, Ynrl, the rate of output at which the price level is stable in the long run. 

When actual output (Y*) is below the natural rate, prices will fall; when it is above the natural rate, prices will rise.

The IS curve is stated in real terms because it represents equilibrium in the goods market, therefore changes in the price level do not affect consumption expenditures, investment, government spending, Taxes, or net exports or the IS curve.

However, the LM curve is affected by changes in the price level, shifting to the left when prices rise and to the right when they fall. 

Holding the nominal MS constant, rising prices decrease real money balances, shifts the LM curve to the left.

Suppose an economy is in equilibrium at the natural rate level of output (Ynrl), when the monetary stimulus increase the MS shifts the LM curve to the right. In the short term, interest rates will come down and output will increase. But because actual output Y* is greater than Ynrl, prices will rise, shifting the LM curve back. As a result, the output and the interest rate are the same but prices are higher. Economists call this long-run monetary neutrality.

Fiscal stimulus shifts the IS curve to the right, increasing output but also the interest rate. Because Y* is greater than Ynrl, prices will rise and the LM curve will shift left, reducing output, increasing the interest rate higher still, and raising the price level.

Under the IS-LM Model, looks like policymakers just can’t win in the long run, since policymakers cannot make Y* exceed Ynrl. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

21.1 Aggregate Output and Keynesian Cross Diagrams #Notebook

21.1 Aggregate Output and Keynesian Cross Diagrams #Notebook

Developed in 1937 by economist and Keynes disciple John Hicks, the IS-LM model is still used today to model aggregate output (GDP, or GNP) and interest rates in the short run. It begins with John Maynard Keynes’s recognition that

AoS = AD = Cs + Inv + Gs + NExpo

Aggregate output (Supply) = Aggregate demand = Consumer expenditure + Investment + Governemnt spending + Net exports

Keynes further explained that Consumer expenditure can be calculated by:

Consumer expenditure = Autonomous consumer expenditure (food, clothing, shelter, and necessaries) + ( Marginal propensity to consume X Disposable income )

For example, during the Great Depression, the investment fell from $232 billion to $38 billion (in 2000 USD), so the aggregate output fell by more than $232 billion − $38 billion = $194 billion. 

We know that because investment fell and the marginal propensity to consume was > 0, so, the fall was more than $194 billion.

An increase in exports over imports will increase aggregate output by the increase in NExpo times the expenditure multiplier. Likewise, a decrease in NExpo will decrease aggregate output by the decrease in NExpo times the multiplier.

Government spending (Gs) also increases aggregate output. However, some government spending comes from taxes, which consumers view as a reduction in income. With taxation, the consumption must to minus the taxations.

Many governments, including that of the United States, responded to the Great Depression by increasing tariffs. Today we know that such policies beggared everyone. What were policymakers thinking?

They were thinking that tariffs would decrease imports and thereby increase NExpo and aggregate output. That would make their trading partner’s NExpo decrease, thus beggaring them by decreasing their aggregate output.

But, in reality, it was dead wrong. Other countries retaliated with tariffs of their own. Even if they did not do it, it was a losing strategy because by making trading partners poorer.

In short, the policy limited their own ability to import and led to no long-term change in NExpo.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

Build The IS-LM Model

Assume that we have the following data:

C=100+0.50Y 

Ip=100-20r 

Mt=0.10Y 

Ms=100-10r 

M=80

a. Build the IS-LM function

Suppose the government spending, and the net export(NExpo) is o, then the model will be:

IS Model:

Y = Aggregate demand = Consumer and household consumption expenditures + Investment + Government spending + NExpo

Y = (100 + 0.5Y) + (100 - 20r) = 200 +0.5Y -20r

0.5Y = 200 - 20r

Y = 400 - 40r (The IS Equation)

The LM Model:

Money demand (speculative, transaction demand) is equal to the Money supply.

Money demand = Money supply

100 - 10r + 0.1Y = 80

0.1Y = 10r - 20

Y = 100r - 200 (The LM Equation)

The IS & LM intersection

400 - 40r = 100r - 200

140r = 600

r = 4.29

Y = 100r - 200

Y = (100 * 4.29) - 200

Y = 429 - 200

Y = 229

The intersection is (229, 4.29), which means the equilibrium interest rate 4.29% and the eqiilibrium output 229.

b. If we assume an increase in Investments by 100 units, please calculate again the IS-LM functions.

Assume an increase in Investments by 100 units, then....

The original IS Equation = Y = 400 - 40r

The new IS Equation = Y = 400 - 40r +100 = 500 - 40r

Y = 500 - 40r 

For every given data, the IS Equation will shift rightward (+100), and cause the equilibrium to have a larger aggregate output and larger interest rate which will also increase the supply of goods. 

c. The intersection of IS-LM functions defines four areas. Please analyze the behavior of the markets for goods and money for each area. 

Normally, there are four areas on the graph, separate by the equilibrium point of the intersection of the LM Equation line and the IS Equation line.

Region AB represents the pressure on the interest rate to fall down since it's higher than the theoretical equilibrium interest rate. As the interest rate goes down, the IS or LM curve respectively moving by their causes.

Region CD represents the pressure on the interest rate to increase since it's lower than the theoretical equilibrium interest rate. As the interest rate goes up, the IS or LM curve respectively moving by their causes.

Region BC represents the pressure on the output and supply to fall down since it's higher or lower than the theoretical equilibrium output and demand. 

Region AD represents the pressure on the output and supply to increase since it's lower than the theoretical equilibrium output and demand. 

Reference

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

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.