Money and Banking Chapter 22 IS-LM in Action

Chapter 22 in Action CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Explain what causes the liquidity ( curve to shift and why . Explain what causes the ( IS ) curve to shift and why . Explain the difference between monetary and fiscal stimulus in the short term and why the difference is important . Explain what happens when the model is used to tackle the long term by taking changes in the price level into account . Describe the aggregate demand curve and explain what causes it to shift . URL books 453

Shifting Curves Causes and Effects LEARNING OBJECTIVE . What causes the and IS curves to shift and why ?

can use the model developed in Chapter 21 to help them decide between two major types responses , or government expenditure and tax ) or monetary ( interest rates and money ) As you probably noticed when playing around with the IS and curves at the end of the previous chapter , their relative positions matter quite a bit for interest rates and aggregate output Time to investigate this matter further . The curve , the equilibrium points in the market for money , shifts for two reasons changes in money demand and changes in the money supply . If the money supply increases ( decreases ) the interest rate is lower ( higher ) at each level , or in other words , the curve shifts right ( left ) That is because at any given level of output , more money ( less money ) means a lower ( higher ) interest rate . Remember , the price level doesn change in this model . To see this , look at Figure Effect of money on interest rates when output is constant . Figure of on interest rates output is URL books ' 454

Interest Rate , i , Quantity of Real Money Balances , Effect on the market for money when aggregate output is constant at YA An autonomous change in money demand ( that is , a change not related to the price level , aggregate output , or i ) will also the curve . Say that stocks get riskier or the transaction costs of trading bonds increases . The theory of asset demand tells us that the demand for money will increase ( shift right ) thus increasing i . Interest rates could also decrease if money demand shifted left because stock returns increased or bonds became less risky . To see this , examine Figure Effect of an autonomous change in money demand when output is constant . An increase in autonomous money demand will shift the curve left , with higher interest rates at each a decrease will shift it right , with lower interest rates at each . Figure ofan ( in money output is constant URL books , 455

Interest Rate , i Quantity of Real Money Balances , Effect on the market for money when aggregate output is constant at YA The IS curve , by contrast , shifts whenever an autonomous ( unrelated to or i ) change occurs in , I , or . Following the discussion cross diagrams in Chapter 21 , when , I , or increases ( decreases ) the IS curve shifts right ( left ) When ( decreases ) all else constant , the IS curve shifts left ( right ) because taxes decrease consumption . Again , these are changes that are not related to output or interest rates , which merely indicate movements along the IS curve . The discovery of new caches of natural resources ( which will increase ) changes in consumer preferences ( at home or abroad , which will affect ) and numerous other shocks , positive and negative , will change output at each interest rate , or in other words shift the entire IS ' URL books 456

We can now see how government policies can affect output . As noted above , in the short run , an increase in the money supply will shift the curve to the right , thereby lowering interest rates and increasing output . Decreasing the would have precisely the opposite effect . Fiscal stimulus , that is , decreasing taxes ( or increasing government expenditures ( will also increase output but , unlike monetary stimulus ( increasing ) will increase the interest rate . That is because it works by shifting the IS curve upward rather than shifting the curve . Of course , if increases , the IS curve will shift left , decreasing interest rates but also aggregate output . This is part of the reason why people get hot under the collar about taxes . Of course , individual considerations are paramount ! Stop and Think Box During panics , economic agents complain of high interest rates and declining economic output . Use the model to describe why panics have those effects . The curve will shift left during panics , raising interest rates and decreasing output , because demand for money increases as economic agents scramble to get liquid in the face of the declining and volatile prices of other assets , particularly securities with positive default risk . Figure Predicted effects of changes in major variables . Figure cots in ' URL books 457

Stop and Think Box Describe Hamilton Law ( Law ) in terms of the Hamilton and argued that , during a panic , the lender of last resort needs to increase the money supply by lending to all comers who present what would be considered adequate collateral in normal times . During panics , the curve shifts left as people risky assets for money , thereby inducing the interest rate to climb and output to fall . Hamilton and argued that monetary authorities should respond by nipping the problem in the bud , so to speak , by increasing directly , shifting the curve back to somewhere near its position . KEY TAKEAWAYS I The curve shifts right ( left ) when the money supply ( real money balances ) increases ( decreases ) I It also shifts left ( right ) when money demand increases ( decreases ) I The easiest way to see this is to first imagine a graph where money demand is fixed and the money supply increases ( shifts right ) leading to a lower interest rate , and vice versa . I Then imagine a fixed and a shift upward in money demand , leading to a higher interest rate , and vice . URL books 458

The IS curve shifts right ( left ) when , I , or increase ( decrease ) or decreases ( increases ) This relates directly to the cross diagrams and the equation I discussed in Chapter 21 , and also to the analysis of taxes as a decrease in consumption expenditure URL books , 459

Implications for Monetary Policy LEARNING OBJECTIVES . In the short term , what is the difference between monetary and fiscal stimulus and why is it important ?

What happens when the model is used to tackle the long term by taking changes in the price level into account ?

The model has a major monetary policy when the IS curve is unstable , a money supply target will lead to greater output stability , and when the curve is unstable , an interest rate target greater macro stability . To see this , look at Figure Effect of IS curve instability and Figure Effect of curve instability . Note that when is and IS moves left and right , an interest rate target will cause to vary more than a money supply target will . Note too that when IS is and moves left and right , an interest rate target keeps stable but a money supply target ( shifts in the curve ) will cause to swing wildly . This helps to explain why many central banks abandoned money supply targeting in favor of interest rate targeting in the and , a period when autonomous shocks to were pervasive due to innovation , deregulation , and loophole mining . An important implication of this is that central banks might it prudent to shift back to targeting monetary if the IS curve ever again becomes more unstable than the curve . Figure ' I ' URL books 460

Interest Rate , i Money Supply Target , Target , Aggregate Output , Figure Effect curve ) URL books 461 Interest Rate I , Money Supply Target Target Aggregate Output , As noted in Chapter 21 , the policy power ofthe is severely limited by its assumption that the price level doesn change . Attempts to tweak the model to accommodate price level changes led to the creation ofan entirely new model called aggregate demand and supply . The key is the addition of a new concept , called the natural rate level of output , the rate of output at which the price level is stable in the long run . When actual output ( is below the natural rate , prices will fall when it is above the natural rate , prices will rise . The IS curve is stated in real terms because it represents equilibrium in the goods market , the real part of the economy . Changes in the price level therefore do not affect , I , or or the IS curve . The curve , however , is by changes in the price level , to the left when prices rise and to the right when they fall . This is because , holding the nominal constant , rising prices decrease real money balances , which we know shifts the curve to the left . So suppose an economy is in equilibrium at , when some monetary stimulus in the form of an increased shifts the curve to the right . As noted above , in the short term , interest rates will URL books 462

come down and output will increase . But because is greater than i , prices will rise , shifting the curve back to where it started , give or take . So output and the interest rate are the same but prices are higher . Economists call this monetary neutrality . Fiscal stimulus , as we saw above , shifts the IS curve to the right , increasing output but also the interest rate . Because is greater than , prices will rise and the curve will shift left , reducing output , increasing the interest rate higher still , and raising the price level ! You just cant win in the long run , in the sense that can not make exceed . Rendering impotent did not win the model many friends , so researchers began to develop a new model that relates the price level to aggregate output . Stop and Think Box As explained in Chapter 19 International Monetary Regimes , under the gold standard ( money in and out of countries automatically , in response to changes in the price of international bills of exchange . From the standpoint of the model , what is the problem with that aspect of the ?

As noted above , decreases in lead to a leftward shift of the curve , leading to higher interest rates and lower output . Higher interest rates , in turn , could lead to a panic or a decrease in or I , causing a shift left in the IS curve , further reducing output but relieving some of the pressure on i . Note that would not be affected under the because the exchange rate was fixed , moving only within very tight bands , so a higher i would not cause the domestic currency to strengthen . KEY TAKEAWAYS Monetary stimulus , that is , increasing the money supply , causes the curve to shift right , resulting in higher output and lower interest rates . Fiscal stimulus , that is , increasing government spending decreasing taxes , shifts the IS curve to the right , raising interest rates while increasing output . The higher interest rates are problematic because they can crowd out , and , moving the IS curve left and reducing output . The model predicts that , in the long run , are impotent . URL books 463

can raise the price level but they ca get permanently above Ym . or the natural rate level of output . That is because whenever exceeds Ym , prices rise , shifting the curve to the left by reducing real money balances ( which happens when there is a higher price level coupled with an unchanged ) That , in turn , eradicates any gains from monetary or fiscal stimulus . URL books , 454

Aggregate Demand Curve LEARNING OBJECTIVE . What is the aggregate demand ( AD ) curve and what causes it to shift ?

Imagine a IS curve and an curve shifting hard left due to increases in the price level , as in Figure Deriving the aggregate demand curve . As prices increase , and i rises . Now plot that outcome on a new graph , where aggregate output remains on the horizontal axis but the vertical axis is replaced by the price level The resulting curve , called the aggregate demand ( AD ) curve , will slope downward , as below . curve is a very powerful tool because it indicates the points at which equilibrium is achieved in the goods and money ata given price level . It slopes downward because a high price level , means a small real money supply , high interest rates , and a low level of output , while a low price level , all else constant , is consistent with a larger real money supply , low interest rates , and output . Figure ( Interest Rate , I Aggregate Output , Aggregate Output , a ) diagram ( Aggregate demand curve Because the AD curve is essentially just another way of stating the model , anything that would change the IS or curves will also shift the AD curve . More , curve shifts in the same direction as the IS curve , so it shifts right ( left ) with autonomous increases ( decreases ) in , I , and and decreases ( increases ) in curve also shifts in the same direction as the curve . URL books 465

So if increases ( decreases ) it shifts right ( left ) and if increases ( decreases ) it shifts left ( right ) as in Figure Predicted effects of changes in major Variables . KEY TAKEAWAYS The aggregate demand curve is a downward sloping curve plotted on a graph with on the horizontal axis and the price level on the vertical axis . The AD curve represents equilibrium points , that is , equilibrium in the market for both goods and money . It slopes downward because , as the price level increases , the curve shifts left as real money balances fall . AD shifts in the same direction as the IS or curves , so anything that shifts those curves shifts AD in precisely the same direction and for the same reasons . URL books 466

Suggested Reading , Robert , Edward Nelson , Robert Lucas , David Colander , Warren Young , et al , The Model Its Rise , Fall , and Strange Persistence . Raleigh , Duke University Press , 2005 . Young , Warren , and . and Modern . New York Springer , 2001 . URL books 467