2.  A Closer Look at Policy
• Fiscal Policy and Crowding Out
• Monetary Policy and the Liquidity Trap
 Real World Monetary and Fiscal Policy
 Problems of Using IS-LM in the Real
World
• Interpretation Problems
• Implementation Problems

3.  Fiscal Policy
• Expansionary fiscal policy shifts the IS
curve to the right
• Contractionary fiscal policy shifts the IS
curve to the left
 Monetary Policy
• Expansionary monetary policy shifts the
LM curve to the right
• Contractionary monetary policy shifts the
LM curve to the left

4. 1. The multiplier is 2 and
government spending increases by 2. The increase in income
$500, so the IS increases by $1000. increases money demand
which increases interest
LM
Real Interest Rate (%)
rates from 4% to 5%.
$1000 3. The increase in the interest
rate causes a decrease in
investment so that the increase
5%
in income is only $600, less that
the full multiplier effect.
4% IS1
IS0
$6000 $6600 $7000
Aggregate Output

5.  When government expenditures increase,
output and income begin to increase.
 The increase in income increases the
demand for money.
 The increase in money demand increases
the interest rate.
 Higher interest rates cause a decrease in
investment, offsetting some of the
expansionary effect of the increase in
government spending.

6. 1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000. 2. If the demand for money
is totally insensitive to the
interest rate, the interest rate
Real Interest Rate (%)
LM increases from 4% to 9%.
9% 3. The increase in the interest
rate causes a decrease in
investment that completely offsets
the increase in government spending.
$1000
4%
IS1
IS0
$6000 $7000
Aggregate Output

7.  When complete crowding out
occurs, fiscal policy is ineffective,
changing only interest rates, not
output.
 Crowding out is greater if:
• Money demand is very sensitive to income
changes
• Money demand is not very sensitive to
interest rate changes

8. The Fed increases the In a liquidity trap, increases
money supply which in the money supply do not
decreases interest rates decrease interest rates, so
and increases investment investment and output do
Real Interest Rate (%)
Real Interest Rate (%)
and output. not increase.
LM0 LM0
LM1
LM1
r0 r0
r1
IS IS
Y0 Y1 Y0
Aggregate Output Aggregate Output

9.  Investment is not sensitive to the
interest rate
• If investment does not respond to interest
rate changes (the IS curve is steep),
monetary policy in ineffective in changing
output.
 Liquidity trap
• If increases in the money supply fail to
lower interest rates, monetary policy is
ineffective in increasing output.

11.  Interpretation Problems (what is
happening?)
• Problems in knowing how to interpret
real-world events within the IS-LM
framework
 Implementation Problems (how to
deal with it?)
• Problems encountered in undertaking
policy

12.  Interest Rate Problem
 Credit Conditions Problems
 Budget Problems
• Cyclical and Structural Problems
• Accounting Methods

13.  Which interest rate, nominal or
real, is relevant?
 Which of many interest rates in the
economy is relevant?
• The Federal funds rate?
• The interest rate households and
businesses pay to borrow money?

14.  Default risk
• Interest rates differ according to the
likelihood that the borrower will repay the
loan.
 Term to Maturity
• The longer the term to maturity, the higher
the interest rate that is paid because
 Bonds with longer maturities are less liquid
 Differences in expected inflation
 More uncertainty

15. 6 6
5.5 5.5
5 5
Yield(%)
Yield(%)
4.5 4.5
4 4
3.5 3.5
3 6 1 2 5 10 30 3 6 1 2 5 10 30
mos. yr. Maturities mos. yr. Maturities

17.  The IS-LM model assumes that interest
rates are the only determinant of
investment.
 Investment may also depends on credit
conditions, the willingness of banks to
lend independent of interest rates.
 If banks raise their lending standards,
investment may not respond to
expansionary monetary policy.
 Mexico after 1994, Japan in the 90s.

18.  The structural budget surplus or deficit is
the fiscal budget balance that would exist
when the economy is at potential output.
 The cyclical budget surplus or deficit is
that portion of the fiscal budget balance
that exists because output is above or
below potential output.

20.  Uncertainty about Potential
Output
 Information Lag
 Policy Implementation Lag

21.  One macroeconomic policy goal is to
keep output as close to potential as
possible. But, what is potential output?
 If policymakers use contractionary
policy when the economy is actually
below potential, they create
‘unnecessary’ unemployment.
 Using expansionary policy above
potential output will cause inflation.

22.  The IS-LM model assumes that
policymakers see what is happening in
the economy and can instantly alter
policies to fix any problem.
 In the real world there is an information
lag, a delay between a change in the
economy and knowledge of that change.
• Example: are we in a recession or a boom
right now?

23.  The policy implementation lag: the delay
between the time policymakers recognize the
need for a policy action and when the policy is
actually instituted.
 U.S. fiscal policy has a large implementation
lag because policy must be formulated and
legislation passed by Congress and signed by
the President.
 Monetary policy has a much shorter
implementation lag because the Federal Open
Market Committee decides monetary policy
and implements it immediately.