115-1The IS – LM Model,Part 415-2Agenda• Policy Analysis with the IS – LM Model15-3Policy Analysis with the IS – LM Model• Monetary policy:¾ Changes in the nominal money supply.• Fiscal policy:¾ Changes in government purchases.¾ Changes in taxes.15-4Policy Analysis with the IS – LM Model• Expansionary policies:¾ Increases in the nominal money supply.¾ Increases in government purchases.¾ Decreases in taxes (no Ricardian equivalence).• Contractionary policies:¾ Decreases in the nominal money supply.¾ Decreases in government purchases.¾ Increases in taxes (no Ricardian equivalence).215-5Policy Analysis with the IS – LM Model• Expansionary monetary policy:¾ Increases in the nominal money supply.15-6Expansionary monetary policyYrY0r0FELM0IS015-7Expansionary monetary policy• An expansionary monetary policy shifts the LM curve to the right.¾ This increases Ms/P directly.¾ At the initial real interest rate (r0), M > L, and rbegins to fall.¾ A falling r decreases Sdand increases Cdand Id, ¾ which increases Y, Cd, and Md/P.¾ This process continues until general equilibrium is re-established.15-8Expansionary monetary policy• Net result:¾ An increase in Y and a decrease in r.¾ Composition of spending has changed:• Consumption is higher,• Investment is higher,• Government spending is the same.315-9Policy Analysis with the IS – LM Model• Monetary policy objectives:¾ Money supply, Ms, targeting.¾ Interest rate, r, targeting.¾ Economic activity, Y, targeting.• A stabilizing central bank.15-10Policy Analysis with the IS – LM Model• Monetary policy objectives:¾ Money supply, MS, targeting.• With a goods market shock.• With a demand for money shock.15-11Mstargeting, Goods market shockYrY0r0FELM0IS015-12Mstargeting, MdshockYrY0r0FELM0IS0415-13Policy Analysis with the IS – LM Model• Monetary policy objectives:¾ Interest rate, r, targeting.• With a goods market shock.• With a demand for money shock.15-14Interest rate targeting, Goods market shockYrY0r0FELM0IS015-15Interest rate targeting, MdshockYrY0r0FELM0IS015-16Policy Analysis with the IS – LM Model• Monetary policy objectives:¾ Economic activity, Y, targeting.• With a goods market shock.• With a demand for money shock.515-17Y targeting, Goods market shockYrY0r0FELM0IS015-18Y targeting, MdshockYrY0r0FELM0IS015-19Policy Analysis with the IS – LM Model• Expansionary fiscal policy:¾ Increases in government purchases.15-20Expansionary fiscal policy (gov’t purchases)YrY0r0FELM0IS0615-21Expansionary fiscal policy (gov’t purchases)• An expansionary fiscal policy shifts the IS curve to the right.¾ This increases Y directly ¾ and increases Cdby the marginal propensity to consume,¾ which also increases Md/P.¾ At the initial interest rate (r0), L > M, and r begins to rise.¾ A rising r increases Sdand decreases Cdand Id, ¾ which reduces Y and Md/P.¾ This process continues until general equilibrium is re-established.15-22Expansionary fiscal policy (gov’t purchases)• Net result:¾ An increase in both Y and r.¾ Composition of spending has changed:• Consumption is higher,• Investment is lower,• Government spending is higher.15-23Policy Analysis with the IS – LM Model• Expansionary fiscal policy:¾ Decreases in taxes (no Ricardian equivalence).15-24Expansionary fiscal policy (taxes)YrY0r0FELM0IS0715-25Expansionary fiscal policy (taxes)• An expansionary fiscal policy shifts the IS curve to the right.¾ This increases YD directly ¾ and increases Cdby the marginal propensity to consume,¾ which also increases Md/P.¾ At the initial interest rate (r0), L > M, and r begins to rise.¾ A rising r increases Sdand decreases Cdand Id, ¾ which reduces Y and Md/P.¾ This process continues until general equilibrium is re-established.15-26Expansionary fiscal policy (taxes)• Net result:¾ An increase in both Y and r.¾ Composition of spending has changed:• Consumption is higher,• Investment is lower,• Government spending is constant.15-27Expansionary fiscal policy, Crowding out• Expansionary fiscal policies lead to:¾ An increase in both Y and r.¾ Composition of spending has changed:• Consumption is higher,• Investment is lower,• Government spending is constant.¾ Higher interest rates have “crowded out”investment.15-28Expansionary fiscal policy, Crowding outYrY0r0FELM0IS0815-29Expansionary fiscal policy, Crowding out• Can “crowding out” of investment be avoided when using an expansionary fiscal policy?15-30Avoiding Crowding OutYrY0r0FELM0IS015-31Expansionary fiscal policy, Crowding out• “Crowding out” of investment can be avoided when using an expansionary fiscal policy by combining it with an expansionary monetary policy.¾ This is called “accommodating monetary policy.”15-32Policy Analysis with the IS – LM Model• By using monetary and fiscal policy in conjunction, any desired level of economic output can be achieved.¾ Depending on the policy combination used, different interest rates will result.¾ This also implies a different composition of output.915-33Monetary Expansion, Fiscal ContractionYrY0r0FELM0IS015-34Monetary Expansion, Fiscal Contraction• A monetary expansion and fiscal contraction can maintain the same level of economic activity but with a lower real interest rate.¾ What happens to the composition of output?15-35Monetary Contraction, Fiscal ExpansionYrY0r0FELM0IS015-36Monetary Contraction, Fiscal Expansion• A monetary contraction and fiscal expansion can maintain the same level of economic activity but with a higher real interest rate.¾ What happens to the composition of output?1015-37Policy Analysis with the IS – LM Model• Which composition of output is better?¾ Higher or lower investment?¾ What kind of investment?¾ What kind of government purchases?¾ What kind of