IS-LM Model 4

MOOCS by Dr. Subir Maitra
Course Name: M.Com Year: First
Session: 2017-18
Paper- 1.3
Macroeconomics and Business Environment
Module: One
Lecture-12
Department of Commerce
University of Calcutta
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, subirmaitra.wixsite.com/moocs

General Equilibrium: Aspects of Closed Economy--
Commodity Market and Money Market Equilibrium--
IS-LM Approach.
EFFECTIVENESS OF FISCAL AND MONETARY POLICIES,
FISCAL AND MONETARY MIX

Monetary Policy Effectiveness and the Slope of the IS Schedule
The effectiveness of monetary policy depends on the slope of the IS schedule.
Flatter the IS curve, greater is the effect of monetary policy on income level and
vice versa.
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, University of Calcutta, subirmaitra.wixsite.com/moocs

In Figure a, the IS schedule is steep, reflecting a low interest elasticity of
investment. Monetary policy is relatively ineffective in this case. Income rises
very little as a result of the
increase in the money
supply. Monetary policy
affects income by lowering
the interest rate and
stimulating investment. If
investment is little affected
by interest-rate changes,
which is the assumption in
Figure a, monetary policy
will be ineffective.

In Figure b, where the interest sensitivity of investment is substantially greater,
monetary policy has correspondingly greater effects. Therefore, our first
result is that monetary
policy is LESS EFFECTIVE
when the IS schedule is
steep—that is, when
investment is interest-
inelastic.
Monetary policy is MORE
EFFECTIVE the higher the
interest elasticity of
investment and thus the
flatter the IS schedule.

Monetary Policy Completely Ineffective: When IS Schedule is vertical
The IS schedule is vertical if investment is
completely insensitive to changes in the
interest rate (interest elasticity equals zero).
If the IS schedule is vertical, increasing the
money supply simply shifts the LM
schedule down along the IS schedule.
The interest rate falls until money demand
increases by enough to restore equilibrium
in the money market, but income is
unchanged.

Monetary Policy Completely Ineffective: When IS Schedule is vertical
To increase income, the increase in the
money supply and the resulting fall in
the interest rate must stimulate
investment. When the IS schedule is
vertical, investment is not affected by
monetary policy because, by
assumption, investment does not
depend on the interest rate. The
steeper the IS schedule, the closer we
come to this extreme case.

Fiscal Policy Effectiveness and the Slope of the IS Schedule
The effectiveness of fiscal policy depends on the slope of the IS schedule. Steeper the
IS curve, greater is the effect of fiscal policy on income level and vice versa.

The effectiveness of fiscal policy also depends on the slope of the IS
schedule. Steeper the IS curve, greater is the effect of fiscal policy on
income level and vice versa.

The steep IS schedule occurs when investment is relatively interest inelastic. The less sensitive
investment is to the interest rate, the greater the effect of a given fiscal policy action is. As
income increases, the interest rate must rise to keep the money market in equilibrium.
This rise in the interest rate causes
investment to decline, partially offsetting
the expansionary effect of the government
spending increase. This interest-rate
induced decline in investment causes the
income response in the IS – LM model to
fall short of the response given by the
multiplier from the simple Keynesian
system. This effect on investment, which
is often referred to as Crowding Out.

One factor determining the importance of such crowding out of private investment is the
slope of the IS schedule. If investment is not very sensitive to changes in the interest rate,
the assumption in Figure a , then the interest-rate increase will cause only a slight drop
in investment, and income will rise by
almost the full amount of the
horizontal shift in the IS schedule.
Alternatively, if investment is highly
interest sensitive, the assumption in
Figure b , then the rise in the interest
rate will reduce investment
substantially, and the increase in
income will be reduced significantly
relative to the prediction of the
simple Keynesian model.

Fiscal Policy Fully Effective: No Crowding Out of Investment
The case of the vertical IS schedule is
shown in Figure c . Here investment is
completely interest insensitive. The
increase in government spending causes
the interest rate to rise, but this rise does
not result in any decline in investment.
Income increases by the full amount of
the distance of the horizontal shift in the
IS schedule; there is NO CROWDING
OUT of investment.

Fiscal Policy Effectiveness and the Slope of the LM Schedule
With the slope of the IS schedules same and the size of the increase in government
expenditure also being the same in the following two graphs, the effect on income
of an expansionary
fiscal policy action is
LARGER when the
LM schedule is
RELATIVELY FLAT(Fig
a) and SMALLER when
the schedule is
RELATIVELY STEEP
(Fig b).

Fiscal policy is more effective when the interest elasticity of money demand is high, making the LM
schedule relatively flat. The reason behind this: An increase in government spending causes income to rise.
As income rises, the demand for transactions balances increases, and to reequilibrate the money market
with an unchanged supply of money requires a rise in the interest rate. If money demand is highly sensitive
to changes in the interest rate, only a small
rise in the interest rate is required to restore
equilibrium in the money market. This is the
case in Fig a, where the interest rate rises
by a small amount, from r0 to r1.As there is a
small increase in the interest rate, other
things being equal, the decline in
investment will be small. With little crowding
out of private investment, income rises by
nearly the full amount of the horizontal shift
in the IS schedule.

When money demand is relatively
interest-inelastic (Fig b), a greater
increase in the interest rate (from r0
to r1 in Fig b) is required to
reequilibrate the money market as
income rises. The larger increase in
the interest rate leads to a larger
decline in investment, offsetting more
of the expansionary effect of the
increase in government spending.
Consequently, the increase in
income for the steeper LM schedule
(Fig b) is smaller.

Since speculative demand for money is not sensitive to rate of
interest, as LM is vertical (which is also known as the
CLASSICAL CASE), there will be no change in both transaction
and speculative demand of money. Thus, a new equilibrium will
be attained at a sufficiently higher interest rate which can adjust
aggregate demand such that it remains at its initial level even
after increase in government expenditure. In Fig c , this occurs
at interest rate r1 . At that point, private investment has declined
by an amount just equal to the increase in government
spending. Thus, there is FULL CROWDING OUT and Fiscal
policy is COMPLETELY INEFFECTIVE
If money demand is completely insensitive to changes in the interest rate (Fig c), fiscal policy is
COMPLETELY INEFFECTIVE and there occurs FULL CROWDING OUT. As G is increased, T remaining the
same government’s budget deficit increases. To meet this budget deficit, the government starts selling bonds,
which increases supply of bonds in the bond market pushing its prices down and interest rate up.

Monetary Policy Effectiveness and the Slope of the LM Schedule
Monetary policy is more effective when the interest elasticity of money demand is less, making the LM
schedule relatively steep. In Fig a , the LM schedule is relatively flat. In Fig b , the schedule is steeper. In
each case, the increase in the money supply shifts the LM schedule by an equal amount from LM0 to LM1 .
Monetary policy is least effective in Fig a ,
where the LM schedule is relatively flat (the
interest elasticity of money demand is
high). The effect on income of the increase
in the money supply is relatively greater
In Fig b , where the interest elasticity of
money demand is lower.

At the initial level of income and interest rate, the increase in the money supply will create an excess supply
of money, causing the interest rate to fall. This fall will stimulate investment and, hence, income. The
interest rate must decline to a point where the lower interest rate and higher income level have increased
money demand by an amount equal to the increase in the money supply. In Fig a , where money demand
is very interest sensitive, a small drop in the
interest rate is all that is required for this
purpose. Consequently, the increase in
investment, and hence income, will be
small in this case. In Fig b , the interest
elasticity of money demand is lower, and a
larger fall in the interest rate is required to
reequilibrate the money market after the
money supply increases. As a
consequence, investment, and therefore
income, increase by a greater amount.

In Fig c , where the interest elasticity of money demand is zero and the
LM schedule is vertical. At the initial level of income and interest rate,
the increase in the money supply will create an excess supply of
money, causing the interest rate to fall. This fall will stimulate
investment and, hence, income. Here the fall in the interest rate itself
does nothing to increase the demand for money as money demand
does not depend on the interest rate. The fall in the interest rate,
however, causes investment and income to rise. The rise in income
will continue until all the new money is absorbed into additional
transactions balances. This is the maximum possible increase in
income for a given increase in the money supply, because all of the
new money balances end up as transactions balances required by the
higher income level. None of the new money is siphoned off as an
increase in speculative demand as the interest rate falls.

Monetary and Fiscal Policy Effectiveness and the Slopes of the IS and
LM Schedules

The Monetary–Fiscal Policy Mix
Both monetary or fiscal policy can affect income in the IS-
LM model. But the effects of the two on the interest rate,
and therefore on investment, are different. In the case of
expansionary monetary policy, the interest rate declines and
investment increases. With an expansionary fiscal policy
action—an income tax cut, for example—the interest rate
rises and investment declines. This is a significant
difference because the level of investment determines the
rate of capital formation and is important to long-term
growth of the economy. Policymakers often go for a policy
mix of relatively “tight” fiscal policy and “easy” monetary
policy to keep the interest rate low and to encourage
investment. Moreover

Moreover, whenever fiscal policy actions such as
income tax cuts are used to expand the economy, the
policymakers would prefer to have an accommodating
monetary policy—an accompanying increase in the
money supply that will prevent the interest rate from
rising and thus prevent the crowding out of
investment. Such a monetary–fiscal policy
combination is illustrated in Figure. At the same time
that the IS schedule is shifted to the right by a tax cut,
the money supply is increased sufficiently so that the
LM schedule shifts far enough to the right to prevent a
rise in the interest rate.

A tax cut from T0 to T1 shifts the IS schedule
from IS(T0) to IS(T1). By itself, this fiscal policy
shift would push the interest rate up to r1 . If the
tax cut were accompanied by an increase in
the money supply from M0 to M1 , the LM
schedule would shift to the right from LM(M0)
to LM (M1). Together, the two policy actions
would increase output to Y1, with the interest
rate remaining at r0. Thus, effect of fiscal policy
will be the same as that in the Simple
Keynesian Model. There is no Crowding Out.

End of Lecture 12

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