is-lm model and policy effectiveness[1].pdf

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International Monetary Policy

9 IS-LM Model and Policy Effectiveness 1

Michele Piffer

London School of Economics

1Course prepared for the Shanghai Normal University, College of Finance, April 2011Michele Piffer (London School of Economics) International Monetary Policy 1 / 1
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Lecture topic and references

In this lecture we use the IS - LM model to understand the real

effectiveness of monetary and fiscal policies

Mishkin, Chapter 21

Michele Piffer (London School of Economics) International Monetary Policy 2 / 1
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On the Effectiveness of Demand-side Economic Policies

The results that we have shown in the previous lecture might inspirean excessive optimism on the possibilities of policymakers to affect

aggregate output

In this lecture we review some of the reasons that could makedemand-side policies ineffective, or at least effective only in the shortrun



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Effectiveness of Fiscal Policy

Consider a case where money demand is very interest rate inelastic(people do not want assets, as they do not trust them). In this case

the LM curve is almost vertical

This is because as Y increases money demand increases, so need ahuge increase in interest rate to take money demand back to startinglevel

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In this case the effectiveness of fiscal policy is very limited: an increasein G will increase output and hence money demand. As firms struggleto raise funds they will have to offer very high interest rates (giventhat money demand is inelastic). This will discourage investments

In this case the crowding out effect can be very strong, and almost noreal effect produced. Monetary policy will be instead effective

The less interest-sensitive is money demand and the more effective ismonetary relative to fiscal policy

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Effectiveness of Monetary Policy

Consider a case where investments are very interest rate inelastic. Inthis case the IS curve is almost vertical

This is because as r decreases investments will increase by a smallamount. Alternatively, a small increase in output will require a hugedrop in interest rate

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In this case the effectiveness of monetary policy is very limited: anincrease in Ms will reduce the interest rate. As firms dont take thisas an extra incentive to borrow and invest, the level of investmentswill remain unchanged.

In this case monetary policy will be ineffective, while fiscal policy willbe effective

The less interest-sensitive are investments and the more effective isfiscal relative to monetary policy

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Exercise 2 on IS-LM and Economic Policies

Show that the effect of a fiscal expansion on equilibrium output isincreasing in the sensitivity of money demand to the interest rate

(remember, the slope of the LM curve is decreasing in suchelasticity). Does the equilibrium interest rate vary more or less whenmoney demand is very sensitive to the interest rate?



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What happens in the Long Run

So far, the point of the model was to show that, under certainconditions, active economic policies on the aggregate demand canlead the economy towards a desired outcome

We have seen that there are certain situations that might makepolicies ineffective

An alternative source of prudence for an excessive reliance ondemand-side policies is that in the long run prices are not fixed, as

assumed in the IS-LM model

What happens in the long run when prices adjust?



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On this matter, we have to leave the Keynesian way of thinking andrely on Classical economic theory

This theory predicts that, in the long run, the economy stays on thenatural level of output Yn, independently on what the aggregatedemand is

This means that any difference between aggregate demand and thenatural level of aggregate supply will be matched by price variations

Yn is defined as the level of output where prices have no tendency toadjust, and reflects the potentials of the supply side of the economy

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According to this theory, if output is above Yn then prices willincrease, and if output is below Yn prices will decrease

This means that any economic policy that tries to to boost outputpermanently above Yn will run into inflationary pressures that willcause a disequilibrium on the money market, increase interest rateand discourage investment, taking Y back to Yn

The mechanism works through a variation in the real money supply



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Effectiveness of Fiscal Policy in the Long Run

Consider a fiscal expansion that attempts to increase equilibriumoutput by shifting the IS curve to the right

We have seen that the increase in output will put upward pressure onthe interest rate

If we start from a situation where output is equal to its natural level,the fiscal policy will take the economy above its natural level, causing

inflationary pressures

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This will reduce the real money supply, shifting the LM curve up,increasing equilibrium interest rate and reducing output

The long run effect is only on prices, as output gets back to hisoriginal level

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Effectiveness of Monetary Policy in the Long Run

Consider a monetary expansion that attempts to increase equilibriumoutput by shifting the LM curve to the right

We have seen that the increase money supply will put downwardpressure on the interest rate and increase output

If we start from a situation where output is equal to its natural level,the monetary policy will take the economy above its natural level,

causing inflationary pressures

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This will reduce the real money supply, shifting the LM curve up,increasing equilibrium interest rate and reducing output, until the LM

curve reaches its starting position

The long run effect is only on prices, as output gets back to hisoriginal level

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The only useful economic policy in the long run is the one targeted atincreasing the natural level of output (reforms on the labor market,

free trade areas, pension reforms,...)

Monetary and fiscal policies can affect output in the short run, not inthe long run

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Plan for the Future

This basically completes our analysis of monetary policy in a closedeconomy

How does all this change as we move from closed to open economy?

Many things will be different. To understand we first have to study abit of international economics

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is-lm model and policy effectiveness[1].pdf

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