Chapter Overview1

Chapter 4
Strong and Weak Policy Effects
in the IS-LM Model

 Chapter Outline

4-1Introduction: The Power of Monetary and Fiscal Policy

4-2Income, the Interest Rate, and the Demand for Money

a.Income and the Demand for Money

b.The Interest Rate and the Demand for Money

c.Other Factors That Shift the Demand for Money Schedule

4-3The LM Curve

a.How to Derive the LM Curve

Box: Learning About Diagrams: The LM Curve

b.What the LM Curve Shows

4-4The IS Curve Meets the LM Curve

Global Economic Crisis Focus: Causes of a Leftward Shift in the IS Curve

4-5Monetary Policy in Action

a.Normal Effects of an Increase in the Money Supply

b.The LM Curve Can Also Be Shifted by Changes in the Demand for Money

4-6How Fiscal Expansion Can “Crowd Out” Private Investment

a.Expansionary Fiscal Policy Shifts the IS Curve

b.The Crowding-Out Effect

c.Can Crowding Out Be Avoided?

Global Economic Crisis Focus: How Monetary Policy Can Be Ineffective in the IS-LM Model

4-7Strong and Weak Effects of Monetary Policy

a.Strong Effects of Monetary Expansion

b.Weak Effects of Monetary Policy

Understanding the Global Economic Crisis: How Easy Money Helped to Create the Housing Bubble and Bust

©2012 Pearson Education, Inc. Publishing as Addison Wesley

Chapter Overview1

4-8Strong and Weak Effects of Fiscal Policy

a.Summary of Crowding Out

4-9Using Fiscal and Monetary Policy Together

a.The Fiscal Multiplier Depends on the Monetary Response

b.The Monetary-Fiscal Mix and Economic Growth

Box:International Perspective

(Monetary Policy Hits the Zero Lower Bound in Japan and in the United States)

c.Summary of Monetary-Fiscal Interactions

Summary

Appendix: The Elementary Algebra of the IS-LM Model

 Chapter Overview

Because the material covered in this chapter is essential in comprehending the policy analysis of later chapters, careful coverage of this chapter is strongly recommended. This chapter provides a complete and straightforward presentation of the IS-LM model, which continues to be an important tool of macroeconomic analysis. The IS-LM model is used to analyze the implications of different macroeconomic policies. It is also for the development and application of the static and dynamic theory of aggregate demand and aggregate supply as discussed in detail in Chapters 7 and 8. Having presented the IS curve in Chapter 3, Gordon explains in the introduction to Chapter 4 that the LM curve is the second important relationship needed to determine real GDP and the interest rate simultaneously.

Section 4-2 provides the “missing relation” that is needed to determine the equilibrium levels of income and the interest rate. The money supply consists of currency and transactions accounts. He discusses in detail that the amount of money that people demand in real terms depends both on income and on the interest rate.It follows from the essential role of money as a medium of exchange, store of value, and unit of account.In Section 4-2, Gordon discusses the role of income and in Section4-3,he discusses the role of interest rate for determining the demand for real balances. The term “demand for money” sometimes confuses students. Emphasize that money demand refers to holding money, either physically or in checking accounts, rather than holding interest-bearing assets such as stocks, bonds, or saving accounts. Interest rates are simply the cost of holding money rather than interest-yielding assets. Figure 4-1 shows that money demand is negatively related to the interest rate and Figure 4-2 shows that a decrease in income implies a leftward shift of the money-demand function. This occurs because the demand for money is directly related to income, but income is not a variable on either of the axes. It also discusses the role of other factors such as wealth of the household, expected future inflation, and payments. Technologies may also affect the position of the demand for money curve.

Section 4-3 explains in detail how to derive the LM curve, which shows the combinations of interest rates and real income levels which keep money market in equilibrium always. The analysis assumes that the real money supply is an exogenous variable determined by the Fed because the Fed directly controls Ms and the price level, P, is assumed to be fixed. The equilibrium interest rate is determined by the intersection of the money-demand curve and the vertical money-supply curve in the graph of the interest rate against real money balances. Thus, changes in money supply affect the equilibrium interest rate. From here, the graphical derivation of the LM curve in Figure 4-3 is straightforward. It simply shows that a higher income level shifts the money-demand function and raises the equilibrium rate of interest. Therefore, the LM curve represents every combination of interest rate and income consistent with money-market equilibrium. Although the graphical explanation of why the LM curve is upward sloping is clear, the intuition behind the diagram is a bit more difficult to explain. The demand for money is covered in greater detail in Chapter 13. It might be helpful, however, to supplement the text by combining the money-market equilibrium equation, Equation (4.1), with a distinction between the transactions and asset-holding motives for holding money. Explain that as income increases, the demand for money rises to finance more transactions. Because of a fixed money supply, however, the quantity of money demanded exceeds the quantity supplied. Thus, Equation (4.1) no longer holds, and the economy is to the right of the LM curve as at Point D in Figure 4-3. Money-market equilibrium requires an increase in the interest rate. This would entice asset holders to switch from money to interest-yielding assets. This process continues until Equation (4.1) is satisfied and money demand is again equal to money supply. Be sure students can distinguish between movements along the LM curve (caused by changes in Y and r) and shifts in the LM curve (caused by changes in the real money supply (Ms/P)). This is covered in the “Learning About Diagrams” box in Section 4-4. Also, be sure students understand why points above and below the LM curve are not points of money-market equilibrium. You might wish to relate the velocity of money to movements along the LM curve.

Section 4-4 combines the IS and LM schedules to establish a general equilibrium income and interest rate for this economy. Explain that the IS and LM curves represent combinations of the interest rate and income level consistent with equilibrium in the commodity market and money market, respectively. Neither of the schedules alone can determine both the interest rate and income, just as no single equation can be solved for two unknowns. General equilibrium is the simultaneous equilibrium of the commodity and money markets. Thus, the general-equilibrium income and interest rate are those consistent with the simultaneous equilibrium of the commodity and money markets. This equilibrium occurs at the intersection of the IS and LM curves in Figure 4-4. Students may have difficulty remembering what is true of points off both the IS and LM curves in Figure 4-4. It would be helpful if the instructor labeled what is true in each of the four quadrants of the diagram (see Figure 4-A in this manual). The Appendix to Chapter 4 provides an algebraic treatment of the IS-LM model; it is covered in this manual directly following Chapter 4. Consider teaching the algebra and graphs simultaneously so that students can see how each equation corresponds to the graphs.

In the Global Recession Focus, Gordon has explained how IS-LM model helps to sort out the causes of business cycles and sources of Global Recession of 2008-09.

Sections 4-5 and 4-6 look at the “normal” effects of monetary and fiscal policy when the IS and LM curves have their normal slopes. Section 4-5 shows that expansionary monetary policy shifts the LM curve outward, lowering the interest rate and raising equilibrium income. A box in Section 4-5, How Easy Money Helped to Create the Housing Bubble and Bust explains how easy monetary policy actually worked in the period 2001–2007 in creating the mortgage market problem. Thus this box represents a chance to display the usefulness of the IS-LM model and affords the instructor

Figure 4-A

an opportunity to apply the model to current and practical real-world policy issues. Section 4-6 explains that expansionary fiscal policy shifts the IS curve outward, raising both equilibrium income and the interest rate. “Crowding out” is explained and illustrated in Figure 4-6. Stress the fact that interest rates must rise following an increase in government spending to keep the money market in equilibrium. The crowding-out effect implies that equilibrium income will rise by less than the full amount of the horizontal shift in the IS curve. It is important for students to understand that because of this, the simple autonomous spending multipliers of the previous chapter, which assumed constant interest rates, are now too large. The chapter emphasizes fiscal policy as a source of crowding out. It should be clear to students, however, that an equal rise in any of the other components of autonomous spending will have the same effect. As a final note, you might wish to extend the material by introducing the notion of “crowding in,” which arises from an accelerator specification of investment. You would explain that if investment depends on the change in GDP and if an expansionary fiscal policy results in a large increase in GDP, investment could possibly be crowded in through the increase of “induced investment.”

Now that the students have learned how the IS-LM model works, Sections 4-7, 4-8, and 4-9 use the
IS-LM model to analyze the factors that determine the effectiveness of monetary and fiscal policy, and in particular those factors that make the effects of policy deviate from the “normal” outcomes examined in previous sections. The issue of the strong and weak effects of monetary and fiscal policy centers on how much real income and the interest rate change in response to given policy actions. The text explains this intuitively and graphically in Sections 4-7 and 4-8. (An algebraic approach to teaching the material is provided in the Appendix.) Stress the roles that the slopes of the IS and LM curves play in determining the effectiveness of both monetary and fiscal policy. For example, the stronger the expansionary monetary policy (has a larger effect on income) the steeper the LM curve (see Figure 4-7). The LM curve becomes steeper as the interest responsiveness of the demand for money declines. That this makes monetary policy more potent is explained in reference to money-market equilibrium. If the money supply increases (exogenously), the demand for money must increase (endogenously) as well, requiring some combination of a lower interest rate and a higher income level. Explain to students that in the normal case, a lower interest rate causes autonomous planned spending and hence income to rise. The lower interest rate and the higher income work jointly to increase the demand for money. However, a lower interest rate will have less effect on the demand for money the lower its interest responsiveness. Thus, as the interest responsiveness of the demand for money falls, a larger increase in income must occur to boost the demand for money and maintain equilibrium in the money market. Figure 4-7 illustrates the importance of the slope of the LM curve by comparing the case of a normally sloped LM curve with the extreme case of a vertical LM curve representing a zero interest responsiveness of the demand for money. If the LM curve is vertical, a given increase in the money supply produces a larger decline in the interest rate. Although this has no direct effect on the demand for money, it generates a sufficiently larger increase in autonomous planned spending and income that provides the required increase in the demand for money.

Figure 4-8 shows that monetary policy will have weak effects if the LM curve is flat, caused by a highly interest-responsive demand for money, or if the IS curve is vertical, reflecting a zero interest- responsiveness of autonomous planned spending. If a relatively small drop in the interest rate when the money supply increases spawns a relatively large increase in the demand for money, the extent to which the interest rate declines and autonomous planned spending and income rise is truncated. And, if autonomous planned spending is totally unresponsive to the interest rate, income will be unaffected no matter how much the interest rate falls.

Section 4-8 takes up the question of the strong and weak effects of fiscal policy, which hinge on the extent of crowding out. This is shown to depend on the slope of the LM curve. The extreme cases of no crowding out (strong fiscal policy) when the LM curve is horizontal and complete crowding out (weak fiscal policy) when it is vertical are illustrated in Figure 4-9. The text argues that the “normal” case illustrated in Figure 4-6, in which expansionary fiscal policy produces partial crowding out, provides the most accurate description of the results of fiscal policy.

You might point out to your students the empirical nature of these issues. What effects should policymakers expect to result from monetary and fiscal policy? Though theoretically possible, the extreme cases of vertical IS and vertical or horizontal LM curves are unlikely; the real question policymakers face is “How steep or flat are the IS and LM curves?” You might also point out that this issue resurfaces later in the text, in conjunction with discussion of the effects of financial deregulation on the slopes of the curves and of multiplier uncertainty in the context of stabilization policy.

Section 4-9 takes up the fiscal–monetary policy mix. Three alternative monetary policies might accompany a fiscal stimulus: leaving the money supply unchanged (a money supply target) and creating a partial crowding-out effect, increasing the money supply to prevent a rise in the interest rate (an interest rate target) thus no crowding-out effect at all, or decreasing the money supply to avoid an increase in income (an income target) or a complete crowding-out effect. The effects of the fiscal stimulus depend on which alternative the Fed chooses. Consideration of the zero real GDP gaptarget leads to the general observation that the economy could achieve a given level of income with a number of different combinations of fiscal and monetary policy. “Easy” (more expansionary) fiscal policies would be accompanied by “tight” (less expansionary) monetary policies and hence higher interest rates. Point outto students the implications of the policy mix for the interest rate, the level of investment, and the future level of productivity growth. These long-run macroeconomic concerns are treated at length in Chapters 10 through 12.

©2012 Pearson Education, Inc. Publishing as Addison Wesley

Answers to Problems in Textbook1

An IP Box examines policy paralysis in Japan and in United States. The long economic slump in Japan during the 1990s and in the United States in the 1930s and after 2009 is discussed with attention to the paralysis confronting policymakers. Monetary policymakers are paralyzed because they believe that with interest rates so close to zero that there is nothing left for them to do. With short-term Japanese interest rates at extremely low levels, there is speculation that the Japanese economy is experiencing a liquidity trap. Same is also true for the U.S. economy since 2008. Explain to your students that if this is the case, monetary policy is impotent to lower interest rates and stimulate autonomous planned spending. Fiscal policymakers, on the other hand, believe that there is little that they can do because public debt in Japan is now over 100 percent of GDP. The IPBox starts by comparing the interest rate situation of Japan in the 1990s with the situation of the United States in the 1930s and in the United States during 2000–2010. Graphs also exhibit the same information. It is suggested that the Bank of Japan could “monetize” the debt—introduce a fiscal stimulus, paid for by an issue of government bonds which the Bank of Japan then buys. Show that a mix of easy fiscal and monetary policies would shift both the IS and LM curves to the right and raise the level of income without the need to lower interest rates and without increasing the level of publicly held debt.

The IPBox concludes by suggesting that in 2010–2011 the United States faced a similar dilemma, as the economic recovery appeared to be too weak to achieve the swift decline in the unemployment rate that was needed.

 Changes in the Twelfth Edition

Chapter 4 in the 12th edition begins with an introduction explaining that the LM curve is the second relationship needed to determine real GDP and the interest rate simultaneously, just like the 11th edition. However, this chapter has also gone through significant changes from the 10th edition. In all equations and figures numerical references have been eliminated.

Section 4-1 has been severely shortened by deleting several paragraphs of discussion about LM curve. Section 4-2 has been deleted and Section 4-3 has been changed to Section 4-2. And the subsequent sections have been renumbered. New Section 4-2 discusses the relation between income, interest rate, and the demand for money.