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Chapter 23Chapter 23Monetary and Fiscal Policy in the ISLM Model

1. Factors that Shift the IS Curve

• A change in autonomous factors that is unrelated to the interest rate– Changes in (autonomous) consumer expenditure unrelated

to income: C

– Changes in (planned) investment spending unrelated to the interest rate: I

– Changes in government spending: G

– Changes in taxes: T

– Changes in net exports: NX

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Summary: What shifts IS?

• IS(C+I+G+X-M; T)

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2. What Shifts LM Curve?

• Changes in the money supply: M - Expansionary Monetary Policy shifts LM to the right - Contractionary Monetary Policy shifts LM to the left • Autonomous changes in money demand= Shocks/Disturbances in Monetary Markets: u

-More Money Demand sends LM to the left

-Less Money Demand sends LM to the right

• Changes in the Price Level: P

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*Sum: What shift LM curve?

(MS/P, u)

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Example 1) Shift in the LM Curve from an Increase in the Money Supply

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Example 2) Shift in the LM Curve from anIncrease in Money Demand

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The above case of an increased money demand is highly relevant to the current financial crisis:

• Recall that Money Market and Bond Market are closely related(substitutes)

An increase in demand for cash = decrease in demand for financial assets such as bonds

• The LM curve shifts to the ‘left’• The net impact on the Money Market is equivalent to a

decrease in Money Supply

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3. Combining IS and LM shift

What will happen to the equilibrium Y and the equilibrium i if LM shifts?

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(1) Response to a Change in Monetary Policy

• An increase in the money supply creates an excess supply of money

-The interest rate declines -Investment spending and net exports rise - Y rises in the IS-LM.

-Aggregate demand side of National Income rises

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Response of National Income and Interest Rate to an Increase in the Money Supply

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* Effects from Various Factors That Shift (the IS and) LM Curves

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(3) Effectiveness of (Expansionary) Monetary Policy on Interest Rate and Y

• With a normally shaped upward-sloping LM curve and a variety shapes of IS curves:

• With a normally shaped IS and a speicial form of LM curve:

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Monetary Policy

• The less interest-sensitive money demand is, the more effective monetary policy is relative to fiscal policy

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4. Long-Run IS-LM

1) Flexible Price Level in LR

So far, we have assumed that the Price Level is fixed- it is justifiable in the Short-run

In the Long-run, the Price Level is flexible.Thus, the LM curve adjusts itself so that the

equilibrium Y is equal to the full employment national income(Yf)1)

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(2) Yn in the Long Run

• Full employment nantional income is called ‘Natural rate level of output (Yn)’

– It is called ‘Full Employment National Income’ Yf as well

– Rate of output at which the price level has no tendency to change

– Neither monetary nor fiscal policy affects output in the long run

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(3) Which adjusts?

• The IS curve is based on real values, so when the price level changes, the IS curve does not change

• The LM curve is affected by the price level– As the price level rises, the quantity of money in real

terms falls, and the LM curve shifts to the left until it reaches Yn (long-run monetary neutrality)

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(4) Illustration: ISLM in the Long Run

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• This is the end of IS-LM model.

• The rest of chapter 23 serves as an introduction of Chapter 24

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5. Ultimately, AS-AD Model

(1) AS and AD• Aggregate Supply Short-run AS Long-run AS

• Aggregate Demand

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(1) AS Curve• There are two AS curves: One is the Short-run AS curve, and the other

corresponds to Yf or Yn

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(2) AD

First, focus on Deriving AD curve,

And then shifting AD

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(i) deriving the AD Curve by changing Price Level

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(ii) Shifts of Aggregate Demand Curve

For a given price level

- change in C, I, G, NX,and/or T shifts IS curve and then AD curve(illustrated in b)

- changes in M, u shifts LM curve and then AD curve(illustrate in a)

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(a) Shift in the Aggregate Demand Curve from a Shift in the LM Curve

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(b) Shift in the Aggregate Demand Curve from a Shift in the IS Curve

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In sum, AD shifts due toΔ in C, I, G, NX, T and M, u.

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(3) Equilibrium of AS-AD

• (i) Basic

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(ii) Changes to an increased MS• In the short-run, Y rises. • In the long-run, it depends on where the initial Y is compared to Yf.

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