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Ch a p ter 24 PREVIEW Monetary and Fiscal Policy in the ISLM Model Since World War II, government policymakers have tried to promote high employment without causing inflation. If the economy experiences a recession such as the one that began in March 2001, policymakers have two principal sets of tools that they can use to affect aggregate economic activity: monetary policy, the control of interest rates or the money supply, and fiscal policy, the control of government spending and taxes. The ISLM model can help policymakers predict what will happen to aggregate output and interest rates if they decide to increase the money supply or increase government spending. In this way, ISLM analysis enables us to answer some important questions about the usefulness and effectiveness of monetary and fiscal policy in influencing economic activity. But which is better? When is monetary policy more effective than fiscal policy at controlling the level of aggregate output, and when is it less effective? Will fiscal policy be more effective if it is conducted by changing government spending rather than changing taxes? Should the monetary authorities conduct monetary policy by manipulating the money supply or interest rates? In this chapter, we use the ISLM model to help answer these questions and to learn how the model generates the aggregate demand curve featured prominently in the aggregate demand and supply framework (examined in Chapter 25), which is used to understand changes not only in aggregate output but in the price level as well. Our analysis will show why economists focus so much attention on topics such as the stability of the demand for money function and whether the demand for money is strongly influenced by interest rates. First, however, let’s examine the ISLM model in more detail to see how the IS and LM curves developed in Chapter 23 shift and the implications of these shifts. (We continue to assume that the price level is fixed so that real and nominal quantities are the same.) Factors That Cause the IS Curve to Shift You have already learned that the IS curve describes equilibrium points in the goods market—the combinations of aggregate output and interest rate for which aggregate output produced equals aggregate demand. The IS curve shifts whenever a change in autonomous factors (independent of aggregate output) occurs that is unrelated to the interest rate. (A change in the interest rate that affects equilibrium aggregate output 561 562 PART VI Monetary Theory http://cepa.newschool.edu /het/essays/keynes /hickshansen.htm A detailed discussion of ISLM analysis. causes a movement only along the IS curve.) We have already identified five candidates as autonomous factors that can shift aggregate demand and hence affect the level of equilibrium output. We can now ask how changes in each of these factors affect the IS curve. 1. Changes in Autonomous Consumer Expenditure. A rise in autonomous consumer expenditure shifts aggregate demand upward and shifts the IS curve to the right (see Figure 1). To see how this shift occurs, suppose that the IS curve is initially at IS1 in panel (a) and a huge oil field is discovered in Wyoming, perhaps containing more oil than in Saudi Arabia. Consumers now become more optimistic about the future health of the economy, and autonomous consumer expenditure rises. What happens to the F I G U R E 1 Shift in the IS Curve The IS curve will shift from IS1 to IS2 as a result of (1) an increase in autonomous consumer spending, (2) an increase in planned investment spending due to business optimism, (3) an increase in government spending, (4) a decrease in taxes, or (5) an increase in net exports that is unrelated to interest rates. Panel (b) shows how changes in these factors lead to the rightward shift in the IS curve using a Keynesian cross diagram. For any given interest rate (here iA ) , these changes shift the aggregate demand function upward and raise equilibrium output from YA to YA. Interest Rate, i A iA A IS2 IS1 YA (a ) Shift of the IS curve YA Aggregate output, Y Aggregate Demand, Y ad Y=Y ad Y 2ad A Y 1ad A (b) Effect on goods market equilibrium when the interest rate is i A 45° YA YA Aggregate Output, Y CHAPTER 24 Monetary and Fiscal Policy in the ISLM Model 563 equilibrium level of aggregate output as a result of this rise in autonomous consumer expenditure when the interest rate is held constant at iA? The IS1 curve tells us that equilibrium aggregate output is at YA when the interest rate is at iA (point A). Panel (b) shows that this point is an equilibrium in the goods market because the aggregate demand function Y 1ad at an interest rate iA crosses the 45° line Y  Y ad at an aggregate output level of YA. When autonomous consumer expenditure rises because of the oil discovery, the aggregate demand function shifts upward to Y 2ad and equilibrium output rises to YA. This rise in equilibrium output from YA to YA when the interest rate is iA is plotted in panel (a) as a movement from point A to point A. The same analysis can be applied to every point on the initial IS1 curve; therefore, the rise in autonomous consumer expenditure shifts the IS curve to the right from IS1 to IS2 in panel (a). A decline in autonomous consumer expenditure reverses the direction of the analysis. For any given interest rate, the aggregate demand function shifts downward, the equilibrium level of aggregate output falls, and the IS curve shifts to the left. 2. Changes in Investment Spending Unrelated to the Interest Rate. In Chapter 23, we learned that changes in the interest rate affect planned investment spending and hence the equilibrium level of output, but this change in investment spending merely causes a movement along the IS curve and not a shift. A rise in planned investment spending unrelated to the interest rate (say, because companies become more confident about investment profitability after the Wyoming oil discovery) shifts the aggregate demand function upward, as in panel (b) of Figure 1. For any given interest rate, the equilibrium level of aggregate output rises, and the IS curve will shift to the right, as in panel (a). A decrease in investment spending because companies become more pessimistic about investment profitability shifts the aggregate demand function downward for any given interest rate; the equilibrium level of aggregate output falls, shifting the IS curve to the left. 3. Changes in Government Spending. An increase in government spending will also cause the aggregate demand function at any given interest rate to shift upward, as in panel (b). The equilibrium level of aggregate output rises at any given interest rate, and the IS curve shifts to the right. Conversely, a decline in government spending shifts the aggregate demand function downward, and the equilibrium level of output falls, shifting the IS curve to the left. 4. Changes in Taxes. Unlike changes in other factors that directly affect the aggregate demand function, a decline in taxes shifts the aggregate demand function by raising consumer expenditure and shifting the aggregate demand function upward at any given interest rate. A decline in taxes raises the equilibrium level of aggregate output at any given interest rate and shifts the IS curve to the right (as in Figure 1). Recall, however, that a change in taxes has a smaller effect on aggregate demand than an equivalent change in government spending. So for a given change in taxes, the IS curve will shift less than for an equal change in government spending. A rise in taxes lowers the aggregate demand function and reduces the equilibrium level of aggregate output at each interest rate. Therefore, a rise in taxes shifts the IS curve to the left. 5. Changes in Net Exports Unrelated to the Interest Rate. As with planned investment spending, changes in net exports arising from a change in interest rates merely cause a movement along the IS curve and not a shift. An autonomous rise in net exports unrelated to the interest rate—say, because American-made jeans become more chic than French-made jeans—shifts the aggregate demand function upward and causes the IS curve to shift to the right, as in Figure 1. Conversely, an autonomous 564 PART VI Monetary Theory fall in net exports shifts the aggregate demand function downward, and the equilibrium level of output falls, shifting the IS curve to the left. Factors That Cause the LM Curve to Shift http://web.mit.edu/rigobon /www/Pdfs/islm.pdf Visit this web site for an additional discussion of factors that cause shifts in the LM curve. The LM curve describes the equilibrium points in the market for money—the combinations of aggregate output and interest rate for which the quantity of money demanded equals the quantity of money supplied. Whereas five factors can cause the IS curve to shift (changes in autonomous consumer expenditure, planned investment spending unrelated to the interest rate, government spending, taxes, and net exports unrelated to the interest rate), only two factors can cause the LM curve to shift: autonomous changes in money demand and changes in the money supply. How do changes in these two factors affect the LM curve? 1. Changes in the Money Supply. A rise in the money supply shifts the LM curve to the right, as shown in Figure 2. To see how this shift occurs, suppose that the LM curve is initially at LM1 in panel (a) and the Federal Reserve conducts open market purchases that increase the money supply. If we consider point A, which is on the initial LM1 curve, we can examine what happens to the equilibrium level of the interest rate, holding output constant at YA. Panel (b), which contains a supply and demand diagram for the market for money, depicts the equilibrium interest rate initially as iA at the intersection of the supply curve for money M 1s and the demand curve for money M d. The rise in the quantity of money supplied shifts the supply curve to M 2s , and, holding output constant at YA, the equilibrium interest rate falls to iA. In panel (a), this decline in the equilibrium interest rate from iA to iA is shown as a movement from point A to point A. The same analysis can be applied to every point on the initial LM1 curve, leading to the conclusion that at any given level of aggregate output, the equilibrium interest rate falls when the money supply increases. Thus LM2 is below and to the right of LM1. Reversing this reasoning, a decline in the money supply shifts the LM curve to the left. A decline in the money supply results in a shortage of money at points on the initial LM curve. This condition of excess demand for money can be eliminated by a rise in the interest rate, which reduces the quantity of money demanded until it again equals the quantity of money supplied. 2. Autonomous Changes in Money Demand. The theory of asset demand outlined in Chapter 5 indicates that there can be an autonomous rise in money demand (not caused by a change in the price level, aggregate output, or the interest rate). For example, an increase in the volatility of bond returns would make bonds riskier relative to money and would increase the quantity of money demanded at any given interest rate, price level, or amount of aggregate output. The resulting autonomous increase in the demand for money shifts the LM curve to the left, as shown in Figure 3. Consider point A on the initial LM1 curve. Suppose that a massive financial panic occurs, sending many companies into bankruptcy. Because bonds have become a riskier asset, people want to shift from holding bonds to holding money; they will hold more money at all interest rates and output levels. The resulting increase in money demand at an output level of YA is shown by the shift of the money demand curve from M d1 to M d2 in panel (b). The new equilibrium in the market for money now indicates that if aggregate output is constant at YA, the equilibrium interest rate will rise to iA, and the point of equilibrium moves from A to A. CHAPTER 24 Interest Rate, i Monetary and Fiscal Policy in the ISLM Model Interest Rate, i LM1 LM2 A iA iA M 1s M 2s A iA A iA A 565 M d ( YA ) M1/P YA Aggregate Output, Y M2 / P Quantity of Real Money Balances, M/P (a) Shift of the LM curve (b) Effect on the market for money when aggregate output is constant at YA F I G U R E 2 Shift in the LM Curve from an Increase in the Money Supply The LM curve shifts to the right from L M1 to L M2 when the money supply increases because, as indicated in panel (b), at any given level of aggregate output (say, YA ) , the equilibrium interest rate falls (point A to A). Interest Rate, i iA iA LM2 Interest Rate, i Ms LM1 A A iA A iA A M d2 ( YA ) d M 1( YA ) M1/P YA Aggregate Output, Y (a) Shift in the LM curve Quantity of Real Money Balances, M/P (b) Effect on the market for money when aggregate output is constant at YA F I G U R E 3 Shift in the LM Curve When Money Demand Increases The LM curve shifts to the left from LM1 to LM2 when money demand increases because, as indicated in panel (b), at any given level of aggregate output (say, YA) , the equilibrium interest rate rises (point A to A). 566 PART VI Monetary Theory Conversely, an autonomous decline in money demand would lead to a rightward shift in the LM curve. The fall in money demand would create an excess supply of money, which is eliminated by a rise in the quantity of money demanded from a decline in the interest rate. Changes in Equilibrium Level of the Interest Rate and Aggregate Output You can now use your knowledge of factors that cause the IS and LM curves to shift for the purpose of analyzing how the equilibrium levels of the interest rate and aggregate output change in response to changes in monetary and fiscal policies. Response to a Change in Monetary Policy F I G U R E 4 Response of Aggregate Output and the Interest Rate to an Increase in the Money Supply The increase in the money supply shifts the LM curve to the right from LM1 to LM2 ; the economy moves to point 2, where output has increased to Y2 and the interest rate has declined to i2. Figure 4 illustrates the response of output and interest rate to an increase in the money supply. Initially, the economy is in equilibrium for both the goods market and the market for money at point 1, the intersection of IS1 and LM1. Suppose that at the resulting level of aggregate output Y1, the economy is suffering from an unemployment rate of 10%, and the Federal Reserve decides it should try to raise output and reduce unemployment by raising the money supply. Will the Fed’s change in monetary policy have the intended effect? The rise in the money supply causes the LM curve to shift rightward to LM2, and the equilibrium point for both the goods market and the market for money moves to point 2 (intersection of IS1 and LM2 ) . As a result of an increase in the money supply, the interest rate declines to i2, as we found in Figure 2, and aggregate output rises to Y2; the Fed’s policy has been successful in improving the health of the economy. For a clear understanding of why aggregate output rises and the interest rate declines, think about exactly what has happened in moving from point 1 to point 2. LM1 Interest Rate, i LM2 i1 1 2 i2 IS1 Y1 Y2 Aggregate Output, Y CHAPTER 24 Monetary and Fiscal Policy in the ISLM Model 567 When the economy is at point 1, the increase in the money supply (rightward shift of the LM curve) creates an excess supply of money, resulting in a decline in the interest rate. The decline causes investment spending and net exports to rise, which in turn raises aggregate demand and causes aggregate output to rise. The excess supply of money is eliminated when the economy reaches point 2 because both the rise in output and the fall in the interest rate have raised the quantity of money demanded until it equals the new higher level of the money supply. A decline in the money supply reverses the process; it shifts the LM curve to the left, causing the interest rate to rise and output to fall. Accordingly, aggregate output is positively related to the money supply; aggregate output expands when the money supply increases and falls when it decreases. Response to a Change in Fiscal Policy F I G U R E 5 Response of Aggregate Output and the Interest Rate to an Expansionary Fiscal Policy Expansionary fiscal policy (a rise in government spending or a decrease in taxes) shifts the IS curve to the right from IS1 to IS2 ; the economy moves to point 2, aggregate output increases to Y2 , and the interest rate rises to i2 . Suppose that the Federal Reserve is not willing to increase the money supply when the economy is suffering from a 10% unemployment rate at point 1. Can the federal government come to the rescue and manipulate government spending and taxes to raise aggregate output and reduce the massive unemployment? The ISLM model demonstrates that it can. Figure 5 depicts the response of output and the interest rate to an expansionary fiscal policy (increase in government spending or decrease in taxes). An increase in government spending or a decrease in taxes causes the IS curve to shift to IS2 , and the equilibrium point for both the goods market and the market for money moves to point 2 (intersection of IS2 with LM1 ) . The result of the change in fiscal policy is a rise in aggregate output to Y2 and a rise in the interest rate to i2 . Note the difference in the effect on the interest rate between an expansionary fiscal policy and an expansionary monetary policy. In the case of an expansionary fiscal policy, the interest rate rises, whereas in the case of an expansionary monetary policy, the interest rate falls. Interest Rate, i L M1 2 i2 i1 1 IS2 IS1 Y1 Y2 Aggregate Output, Y 568 PART VI Monetary Theory Why does an increase in government spending or a decrease in taxes move the economy from point 1 to point 2, causing a rise in both aggregate output and the interest rate? An increase in government spending raises aggregate demand directly; a decrease in taxes makes more income available for spending and raises aggregate demand by raising consumer expenditure. The resulting increase in aggregate demand causes aggregate output to rise. The higher level of aggregate output raises the quantity of money demanded, creating an excess demand for money, which in turn causes the interest rate to rise. At point 2, the excess demand for money created by a rise in aggregate output has been eliminated by a rise in the interest rate, which lowers the quantity of money demanded. A contractionary fiscal policy (decrease in government spending or increase in taxes) reverses the process described in Figure 5; it causes aggregate demand to fall, which shifts the IS curve to the left and causes both aggregate output and the interest rate to fall. Aggregate output and the interest rate are positively related to government spending and negatively related to taxes. Study Guide As a study aid, Table 1 indicates the effect on aggregate output and interest rates of a change in the seven factors that shift the IS and LM curves. In addition, the table provides schematics describing the reason for the output and interest-rate response. ISLM analysis is best learned by practicing applications. To get this practice, you might try to develop the reasoning for your own Table 1 in which all the factors decrease rather than increase or answer Problems 5–7 and 13–15 at the end of this chapter. Effectiveness of Monetary Versus Fiscal Policy http://ingrimayne.saintjoe .edu/econ/optional/ISLM /Limitations.html A paper discussing limitations of ISLM analysis, posted by the Federal Reserve. Monetary Policy Versus Fiscal Policy: The Case of Complete Crowding Out Our discussion of the effects of fiscal and monetary policy suggests that a government can easily lift an economy out of a recession by implementing any of a number of policies (changing the money supply, government spending, or taxes). But how can policymakers decide which of these policies to use if faced with too much unemployment? Should they decrease taxes, increase government spending, raise the money supply, or do all three? And if they decide to increase the money supply, by how much? Economists do not pretend to have all the answers, and although the ISLM model will not clear the path to aggregate economic bliss, it can help policymakers decide which policies may be most effective under certain circumstances. The ISLM model developed so far in this chapter shows that both monetary and fiscal policy affect the level of aggregate output. To understand when monetary policy is more effective than fiscal policy, we will examine a special case of the ISLM model in which money demand is unaffected by the interest rate (money demand is said to be interest-inelastic) so that monetary policy affects output but fiscal policy does not. Consider the slope of the LM curve if the demand for money is unaffected by changes in the interest rate. If point 1 in panel (a) of Figure 6 is such that the quantity of money demanded equals the quantity of money supplied, then it is on the LM curve. If the interest rate rises to, say, i 2 , the quantity of money demanded is unaffected, and it will continue to equal the unchanged quantity of money supplied only if CHAPTER 24 SUMMARY Monetary and Fiscal Policy in the ISLM Model Table 1 Effects from Factors That Shift the IS and LM Curves Factor Consumer expenditure C Autonomous Change in Factor Response Reason ↑ Y ↑, i ↑ C ↑ ⇒ Y ad ↑ ⇒ IS shifts right i i2 i1 ← L M1 IS2 IS1 Investment I ↑ Y ↑, i ↑ I ↑ ⇒ Y ad ↑ ⇒ IS shifts right Y1 Y2 i i2 i1 ← Y L M1 IS2 IS1 Government spending G ↑ Y ↑, i ↑ G ↑ ⇒ Y ad ↑ ⇒ IS shifts right Y1 Y2 i i2 i1 ← Y L M1 IS2 IS1 Taxes T Net exports N X ↑ ↑ Y ↓, i ↓ Y ↑, i ↑ T ↑ ⇒ C↓ ⇒ Y ad ↓ ⇒ IS shifts left NX ↑ ⇒ Y ad ↑ ⇒ IS shifts right Y1 Y2 Y i L M1 ← i1 i2 IS2 IS1 Y2 Y1 i i2 i1 Y ← L M1 IS2 IS1 Money supply M s ↑ Y ↑, i ↓ Ms↑ ⇒ i ↓ ⇒ L M shifts right Y1 Y2 i Y L M1 L M2 i1 i2 IS1 Money demand M d ↑ Y ↓, i ↑ M d↑ ⇒ i ↑ ⇒ LM shifts left Y1 Y2 i i2 i1 ← L M2 L M1 IS1 Y2 Y1 Note: Only increases (↑) in the factors are shown. The effect of decreases in the factors would be the opposite of those indicated in the “Response” column. Y Y 569 570 PART VI Monetary Theory F I G U R E 6 Effectiveness of Monetary and Fiscal Policy When Money Demand Is Unaffected by the Interest Rate When the demand for money is unaffected by the interest rate, the LM curve is vertical. In panel (a), an expansionary fiscal policy (increase in government spending or a cut in taxes) shifts the IS curve from IS1 to IS2 and leaves aggregate output unchanged at Y1. In panel (b), an increase in the money supply shifts the LM curve from LM1 to LM2 and raises aggregate output from Y1 to Y2 . Therefore, monetary policy is effective, but fiscal policy is not. Interest Rate, i LM1 i2 2 i1 1 IS2 IS1 (a) Response to expansionary fiscal policy Y1 Aggregate Output, Y Interest Rate, i LM1 i1 1 LM2 2 i2 IS1 Y1 (b) Response to expansionary monetary policy Y2 Aggregate Output, Y www.bothell.washington.edu /faculty/danby/islm /animation.html An animated explanation of ISLM. aggregate output remains unchanged at Y1 (point 2). Equilibrium in the market for money will occur at the same level of aggregate output regardless of the interest rate, and the LM curve will be vertical, as shown in both panels of Figure 6. Suppose that the economy is suffering from a high rate of unemployment, which policymakers try to eliminate with either expansionary fiscal or monetary policy. Panel (a) depicts what happens when an expansionary fiscal policy (increase in government spending or cut in taxes) is implemented, shifting the IS curve to the right from IS1 to IS2. As you can see in panel (a), the fiscal expansion has no effect on output; aggregate output remains at Y1 when the economy moves from point 1 to point 2. In our earlier analysis, expansionary fiscal policy always increased aggregate demand and raised the level of output. Why doesn’t that happen in panel (a)? The