ECO 502

BRAC University,
Spring, 2006
Lutfun N. Khan Osmani

Lectures 9 - 10

Chapter 4

Monetary and Fiscal Policy in The IS-LM

Model
 The IS curve

The IS curve tells us that any Y can be

equilibrium depending on the value of r. But
surely there can be only one equilibrium Y for
given values of exogenous variables.

How can we find it? For this we need another

relationship between r and Y. We find it from
the LM curve.

4-2
The LM Curve

• We get LM curve from the money market.

• LM curve shows the relationship between

the interest rate and the level of income
that arises in the money market.

4-3
 Money Market
• Uses of money:
– Medium of exchange
– Store of value
– Unit of account

• Demand for money:

– Transactions demand (+ Y)
– Speculative demand (- r)
– Overall:
(M/P)d = aY – lr

• Supply of money:
– Fixed by central bank
4-4
 Money Market

Central bank has a balance sheet consisting

of its assets and liabilities.

• Fed’s assets consists of its holdings of

government bonds

• And its liabilities are of two kinds: currency

that it printed and the total bank reserves that
it holds on deposits for the commercial banks

4-5
 Money Market

• Suppose Fed owns $400 billion of government

bonds, and its liabilities consist of $200 billion
of currency and $200 billion of bank reserves.

• The total liability of the Fed is called “the

monetary base” which is $400 billion.

4-6
Money Market

• Money supply (Ms) consists of currency (say

$200 b) and checking deposits at the banks.

• Say, banks are supposed to hold 10% of their

checking deposits as reserves. If bank
reserves are $200 b, then checking deposits
must be $2000.

• Thus Ms is the total of $200 b of currency and

$2000 b checking deposits – a total of $2200b

4-7
 Money Market

• Money supply (Ms) is equal to monetary base

times the money multiplier

• (Ms) = monetary base × the money multiplier.

• (Ms)  monetary base = Money multiplier
• Money multiplier = $2,200  $ 400 = 5.5
• (Ms) = $400 × 5.5 = $2,200

4-8
Money Market

• The amount of money that people demand in

real terms depends both on income and
interest rate
Real money balances equal the total money
supply divided by the price level (Ms/P).
• Demand for real money balances changes
with changes in real income.

4-9
Money Market

• Let demand for real money balances (M/P)d

equals the half of the real income (Y):
• (M/P)d = 0.5Y
• If real income is $8,000 billion, the demand
for real money balances is:

0.5 × 8,000 = $4,000

4-10
Figure 4-1

The Demand for

Money, the Interest
Rate, and Real
Income

The vertical line L′ is

drawn on an unrealistic
assumption that
demand for real money
balances is equal to
half of real income
($8000b) but does not
depend on interest
rate.

4-11
Money Market

• The downward sloping L0 line shows that

when rate of interest is zero, demand for real
money balances is $4,000.

• As interest rate rises from zero to 5%, people

cut down their money holdings to $3,000 and
it goes down to $2,000 when rate of interest
rises to 10%.

4-12
Money Market

• We draw the equation for the demand for real

money balances which is half the real income
minus $200 billion times the interest rate

(M/P)d = aY – lr

• (M/P)d = 0.5Y – 200r

4-13
Money Market

• A change in the interest rate moves the

economy up and down its real money
demand schedule

• However, a change in real output (Y) shifts

the demand schedule to the left or right.

4-14
Figure 4-2

Effect on the
Money Demand
Schedule of a
Decline in Real
Income from
$8,000 to
$6,000 Billion:

Money demand
schedule shifts
to the left of the
original one.
4-15
Money Market

• At any given interest rate, the change in the

amount of money demanded is given by

 (M/P)d = 0.5Y

• Between point F and C, the interest rate is the

same, output falls by 2,000 and the demand
for money declines by $1.000.

4-16
 Money Market Equilibrium

• Money market is in equilibrium when the

demand for money and the supply of it are
equal and the equilibrium rate of interest is
determined at that equilibrium

• If income rises, demand for real money

balances curve shifts to the right and with
fixed Ms equilibrium occurs at higher interest
rate and vice versa.

4-17
Figure 4-3 Derivation of the LM Curve

4-18
 Derivation of the LM curve

• Vertical line shows the supply of money – given

by the government
• Equilibrium is at the crossing of the demand for
money and the supply of money schedule
• When income is $8,000 billion equilibrium is at
F – rate of interest is 10%.

4-19
Derivation of the LM curve

• When income falls to $6,000 equilibrium occurs

at G – rate of interest falls to 5%.
• LM curve shows this relationship with income
and the rate of interest
• At lower income (demand for money is low)
rate of interest is low and vice versa.

4-20
Derivation of the LM curve

• LM curve represents all combinations of

income (Y) and interest rate (r) where the
money market is in equilibrium – that is where
the supply of real money balances is equal to
the demand for money.

4-21
 LM Curve in Equations
• Demand for money:
(M/P)d = aY - lr
• Supply of money: Ms
• Money market equilibrium:
Ms/P = (M/P)d = aY – lr or
lr = - (Ms/P) + aY or
r = - (Ms/P)/l + (a/l)Y  the LM equation
Intercept = - Ms/l < 0
• Slope = (a/l)Y > 0
4-22
Shift in the LM curve

• We take the money supply as given while

deriving the LM curve.
• If government changes the supply of money, the
LM curve shifts.
• Increase in money supply shifts the LM curve to
the right
• Decrease in money supply shifts the LM curve
to the left

4-23
The Effect on the LM Curve of an Increase in
the Real Money Supply from $2,000 Billion to
$3,000 Billion

4-24
Figure 4-4

General
equilibrium:
Crossing of
the IS and LM
curve gives
equilibrium
interest rate
and real
income that
will prevail in
the economy.
4-25
IS-LM Equilibrium in Equations

• IS curve:
r = Apn/h - {(1 – c)/h}Y [1]

• LM curve:
r = - (Ms/P)/l + (a/l)Y [2]

• Solving [1] and [2], we get the {r*, Y*}

combination for which the product and money
markets are simultaneously in equilibrium.

4-26
Shift in the IS-LM model

• The IS-LM model determine two endogenous

variables, real income and interest rate.

• The exogenous variables that the model does

not explain are, the level of consumer and
business confidence, the money supply, govt.
expenditure and tax revenue and net exports.

• Whenever there is a change in one of these

exogenous variables then either of the two
endogenous variables or both of them will
change

4-27
IS-LM Equilibrium in Equations
• Monetary policy:

• Expansionary monetary policy:

– Money supply increases
– Interest rate falls
– Private investment increases
– Expenditure and income increases through
multiplier effect

– Contractionary monetary policy works in

opposite direction

4-28
Figure 4-5 The Effect of a $1,000 Billion Increase in
the Money Supply with a Normal LM Curve

4-29
Expansionary Fiscal Policy and Crowding
Out

• Crowding out effect describes the effect of an

increase in government spending or reduction
of tax in reducing those components of
private spending that are sensitive to interest
rate (e.g., investment and autonomous
consumption).

4-30
Figure 4-6 The Effect on Real Income and the Interest
Rate of a $500 Billion Increase in Government Spending

4-31
 Expansionary Fiscal Policy and Crowding
Out
• In the figure the IS curve shifts due to increase in
govt. expenditure by $500 billion
• The original multiplier of k = 4.0 would move the
economy E0 to E2 where the income is $2,000
billion higher ($9,000).
• But E2 can not be equilibrium as it is off the LM
curve.
• Equilibrium is at E2 where increase in income is
1,000) and the multiplier has become 2.0 (1000 
500 = 2)
•
4-32
Expansionary Fiscal Policy and Crowding
Out

• At E2 income is higher than at E0

• At higher income demand for money rises

whereas the supply of money is constant at
Ms/P = 2,000.

• There is an excess demand for money

• Therefore, interest rate must rise

4-33
 Expansionary Fiscal Policy and Crowding
Out
• The increase in interest rate from 7.5% to 10%
cuts private autonomous planned consumption
and investment spending. This is crowding out.

• As a result, equilibrium income falls from E2

• New equilibrium occurs at E3 where both the

money market and commodity market is in
equilibrium but income rises by $1,000 billion.

• Because of crowding out income has not risen

as much as it would have.
4-34
Avoiding Crowding Out
• Crowding out will not occur under two
conditions:

– If for some reasons interest rate does not

rise, or

– If interest rate rises but autonomous

private spending is insensitive to interest
rate

4-35
Avoiding Crowding Out
• Simple solution:
– Increase money supply to shift the LM curve
rightward by the same amount as the IS curve
(interest rate does not rise) or
– If the demand for money did not depend on
income (interest rate does not rise)

• Hypothetical cases where crowding out will

not occur:
– (a) vertical IS curve (spending is not sensitive to
interest rate)
– (b) LM curve is horizontal – interest rate is
infinitely responsive to demand for money (interest
rate does not rise).

4-36
Figure 4-7 The Effect of an Increase
in the Money Supply With a Normal LM Curve and a
Vertical LM Curve

4-37
Avoiding Crowding Out

• Top frame shows the normal effect of an

increase in money supply.

• Interest rate fell to r1 and real income

increases to Y1. Crowding out effect (Y1 – Y2)

• Bottom frame shows that same increase in Ms

leads to a greater drop in interest rate r4 and
higher increase in real income Y2;no crowding
out

4-38
Figure 4-8

Effect of the
Same Increase
in the Real
Money Supply
with a High
Interest
Responsiveness
of the Demand
for Money and
with Zero
Interest
Responsiveness
of Spending

4-39
Avoiding Crowding Out

• Top frame shows higher money supply does

not stimulate expenditures since they are
assumed to be independent of the interest
rate – the IS curve is vertical.

• In the bottom frame the LM curve is so flat

that the same increase in money supply
hardly reduces interest rate and hardly
increases income

4-40
Figure 4-9

Effect of a
Fiscal Stimulus
when Money
Demand Has an
Infinite and a
Zero Interest
Responsiveness

4-41
Avoiding Crowding Out

• Top frame - infinite interest responsiveness -

the interest rate is fixed and no crowding out
can occur.

• Bottom frame - same fiscal stimulus has no

effect on income when interest
responsiveness is zero.

• No growth at all in income from E0 to E8 -

crowding out is complete

4-42
Using Fiscal and Monetary Policy Together

• The effect of fiscal policy depends on the kind

of monetary policy pursued at the same time.

• Fiscal policy will shift the IS curve; but the

final outcome depends on how the LM shifts
at the same time – and that depends on what
the Fed does with money supply and interest
rate.

4-43
Figure 4-10 The Effect on Real Income
of a Fiscal Stimulus With Three Alternative Monetary
Policies

4-44
Using Fiscal and Monetary Policy Together
• Figure 4-10 shows that with any given shift in
the IS curve, the level of income will depend
on monetary policy as follows:

– If the real money supply is held constant, the LM

curve does not shift – rise in income is partly
crowded out (top left frame).
– If a fixed interest rate is maintained, LM shift to the
same extent as IS – income rises fully, there is no
crowding out (top right frame).
– Fed attempts to keep real income constant – LM
shift to the left. Interest rate rises, income does not
i.e., full crowding out (bottom frame).

4-45