CHAPTER 9



CHAPTER 9

POLICY ANALYSIS WITH THE IS/LM MODEL

OVERVIEW

This chapter introduces some problems associated with using the IS/LM model in the real- world. Using the IS/LM model, the chapter discusses the Fed’s actions in the late 1990s and early 2000 to see how these real-world problems affected its monetary policy.

The previous chapter discussed the concept of the multiplier and its use. The analysis showed that an increase in government expenditures, for example, increases equilibrium income by an amount equals to the initial increase in government expenditures times the multiplier. In the real world, a rise in income causes a rightward shift in the money demand curve. This causes the equilibrium interest rate to rise, thus causing to decline. A decline in investment reduces equilibrium output (income), which partly offsets the rise in income caused by the increase in government spending. This process illustrates the concept of crowding out—the decline in investment caused by the rise in interest rate when the government increases spending.

The degree of crowding out depends on the slopes of the IS and the LM curves. In general, the steeper the LM curve and the flatter the IS curve, the greater the degree of crowding out. When the LM curve is horizontal, an increase in government spending causes output to increase by the multiplier times the increase in government spending. In this case, there is no crowding out. If the LM curve is vertical, a rise in government spending causes no change in equilibrium output. In this case, there is complete crowding out.

As for monetary policy, we know that an expansionary monetary policy cause output to increase and the interest rate to decrease. However, in some cases monetary policy has no effect on output. This is when money demand is extremely sensitive to interest rate causing the LM curve to be very flat. This special case is called the liquidity trap—a situation where monetary policy has no effect on output and interest rate.

Generally speaking, fiscal policy is more effective with a flat LM curve, and monetary policy is more effective with a flat IS curve. Fiscal policy and monetary policy can be more effective if policymakers know about the shapes of the IS and the LM curves. However, in the real world, it is very difficult to estimate the slopes of both curves because the sensitivity of money demand and investment demand to changes in the interest rate is hard to measure and is in a continuous change.

The IS/LM framework provides us with a general idea of what would happen when fiscal and monetary policies are implemented. An expansionary monetary policy increases both output and the interest rate. A contractionary fiscal policy decreases both output and the interest rate. An expansionary monetary policy raises output and lowers the interest rate. A contractionary monetary policy lowers output and raises the interest rate. Sometimes, policymakers may implement an accommodative policy to offset an undesirable policy outcome. For example, if the economy is at potential and the government implemented a contractionary fiscal policy by raising taxes, the Fed may implement an accommodative policy by easing money supply and shifting the LM curve to the right.

The real world presents two problems associated with using the IS/LM model. They are implementation problems and interpretation problems. Interpretation problems are problems with knowing how to interpret real-world events using the IS/LM model. Implementation problems are problems with designing and undertaking the right economic policy.

There are interpretation problems with both monetary and fiscal policy. The first problem is how the IS/LM model interprets the interest rate. The existence of inflation causes the real interest rate and the nominal interest rate to differ. Additionally, there are many types of interest rates in the economy. They range from a 3-months interest rate on Treasury bills to 30-year interest rate on a government bond. The IS/LM model assumes that whenever the government or the Fed implements a policy, all types of interest rates change similarly. Very often this is not true. The actual yield curve is either upward sloping or downward sloping, suggesting that the impact of monetary policy on short-term interest rate, for example, is different than its effect on long-term interest rate.

The second interpretation problem is the fact that the IS/LM model fails to take into consideration people’s expectations of policy actions. For instance, if people expect the Fed to lower the interest rate in the second period, they will purchase bonds now to benefit from the higher bond prices in the future. Their action causes the price of bonds to increase and the interest rate to decrease in the current period. The third interpretation problem stems from the assumption that interest rate is the only determinant of investment. In the real world, there are other factors that determine investment, such as the borrower’s credit rating.

Another interpretation problem has to do with the real slope of the LM curve. The Fed, and many other central banks around the world, target the interest rate instead of money supply. They choose an interest rate they believe is good for the economy, and they stand ready to change money supply to accommodate any pressures caused by the IS curve to change the interest rate. For example, if an increase in autonomous expenditures causes the interest rate in the economy to move up, the Fed accommodates this by increasing the money supply to maintain a pre-determined level of interest rate. If this is the case, the LM curve (known here as the effective LM curve) is horizontal at the level of interest rate determined by the Fed.

There are interpretation problems with fiscal policy when using the IS/LM model. The IS/LM model suggests that when the government uses an expansionary fiscal policy, it is running budget deficit. When it is using a contractionary fiscal policy, it is running a budget surplus. In reality, there are two types of budget surpluses/deficits. The structural budget surplus, for example, occurs when the economy is operating at potential and there is a surplus in the budget. The cyclical budget surplus occurs when the economy is above potential, and the cyclical budget deficit occurs when the economy is below potential. The type of budget surplus/deficit that shifts the IS curve is the structural budget surplus/deficit only.

The second problem with interpreting surpluses and deficits as a measure of fiscal policy is that surpluses and deficits depend on the accounting methods used to determine the U.S. government budget. The current practice in reporting the budget is through using the cash flow budget. It is based on accounting system where revenues and expenses are counted only when cash is received and spent. This method does not include future obligations in the sense that it ignores the expected value of future expenditures and revenues. These kinds of future obligation can be reported if the government uses an obligation budget. This type of budget reporting is especially important when people base their spending decisions on lifetime earnings, not on cash income. If people base their spending decisions on their lifetime earnings and the government reduces taxes and runs a budget deficit, the IS curve will not shift to the right. People will not spend the additional disposable income created by the tax cut. The reason is that people know that in the future, the government will raise taxes again by an amount equal to the initial drop in taxes to pay for the deficit. This argument is known as the Ricardian equivalence.

There are implementation problems associated with using monetary and fiscal policies. The general goal of these policies is to reduce fluctuations in output and to keep output around its potential level. The problem with this is that policymakers are not quite sure where potential output is and whether the economy is above or below it. This kind of uncertainty makes it difficult to design the appropriate policy. The second problem is that, in real world, it takes policymakers some time to recognize the problem in the economy—known as the information lag. Failure to recognize the problem may delay the adoption of policies, which, in turn, minimize their impact on the economy. Furthermore, and even if policymakers recognize the problem in the economy quickly, it usually takes them a long time to decide on the appropriate course of action—known as the implementation lag. Fiscal policy has a longer implementation lag than monetary policy.

Although discretionary fiscal policy is rarely used, it still influences the economy through its automatic stabilizers. They are programs that are built into the budget that change expenditures or revenues countercyclically without the need for new legislative action. Unemployment insurance, temporary assistance for needy families, and the progressive tax system are all examples of automatic stabilizers.

The IS/LM model does not provide us with the necessary tools to understand the workings of economic policies and their short-term influences on the economy. However, following the IS/LM model provides a major step forward to understand the macro economy and its complexities.

OUTLINE

I. A CLOSER LOOK AT FISCAL POLICY AND MONETARY POLICY

- Expansionary (contractionary) fiscal policy shifts the IS curve to the right (left), casing the interest rate to increase (decrease) and the output level to increase (decrease).

- Expansionary (contractionary) monetary policy shifts the LM curve to the right (left), causing the interest rate to decrease (increase) and the output level to increase (decrease).

A. Fiscal Policy

- A rightward shift in the IS curve caused an expansionary fiscal policy does not change equilibrium output by the full multiplier times the rise in government spending.

- The reason is the rise in government spending causes income to increase, which causes the money demand and the interest rate to rise.

- The rise in the interest rate lowers investment, which reduces the impact on output of the initial expansionary fiscal policy.

- This case is known as the crowding-out effect.

- The degree of crowding out depends on the shapes of the LM and IS curves. The steeper the LM curve and the flatter the IS curve, the greater the degree of crowding out.

- Complete crowding out exists when the LM curve is vertical. No crowding out exists when the LM curve is horizontal.

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B. Monetary Policy

- The effectiveness of monetary policy also depends on the shapes of the IS and LM curves.

- Monetary policy is most effective when investment is insensitive to changes in the interest rate—that is when the IS curve is steep.

- Monetary policy has no effect on output when the LM curve is horizontal. In this case, monetary policy has no effect on interest rate and investment. This case is known as the liquidity trap.

C. Achieving Short-Run Policy Goals with Monetary and Fiscal Policy

- Effective fiscal policy is associated with a flat LM curve.

- Effective monetary policy is associated with a flat IS curve.

- Very often, policymakers cannot determine the shapes of the IS and LM curves because the sensitivities of money demand and investment to changes in the interest rate are difficult to observe and can change unpredictably.

- An accommodative policy is a policy that the government undertakes to minimize some adverse effects that the other policy may cause.

II. REAL-WORLD MONETARY AND FISCAL POLICY

- Policy in the 1940s. The government increased defense expenditures during World War II. The Fed accommodated this by an expansionary monetary policy to keep interest rates constant.

- Policy in the 1950s. The Fed used contractionary monetary policy to fight inflation.

- Policy in the 1980s. The Fed used contractionary monetary policy to fight inflation. At the same time, government spending increased.

III. PROBLEMS OF USING IS/LM TO ANALYZE POLICY IN THE REAL WORLD

- There are two types of problems that emerge when using the IS/LM model to explain real-world policy: interpretation problems and implementation problems.

A. Interpretation Problems

- These problems arise because sometimes the assumptions that were used to develop the IS/LM model don’t fit the real world.

1. The Interest Rate Problem

- There are two types of interest rates; nominal interest rate and real interest rate. Fiscal and monetary policies have different effects on both types of interest rates.

- The IS/LM model does not specify which interest rate is changing whenever an economic policy is used.

a. Why Interest Rates Differ

- Interest rates differ for two main reasons: (1) the likelihood that the borrower will repay the loan, i.e., the risk factor, and (2) the term of maturity of different loans.

b. The Yield curve

- The yield curve, which shows the relationship between bonds and interest rates, suggests that policies have different effects on different interest rates. For example, an expansionary monetary policy will lower short-term interest rates, but may not affect long-term interest rates.

2. Anticipation of Policy Problems

- If people expect a policy action, they may adjust their decision in anticipation, which could offset the goals of the policy.

- The IS/LM model does not take into account people’s expectations of policy actions.

3. Monetary Tools and Credit Condition Problems

- The IS/LM model assumes that investment depends on interest rate only.

- In the real world, borrowing money to invest can be affected by the credit rating of the borrower, and the amount of loans available.

4. The Interest Rate Target Problem

- Central banks often target the interest rate, not the money supply.

- They make sure that the interest rate remains at a pre-determined level.

- By doing so, they force the LM curve to become horizontal--known as the effective LM curve. Changing monetary policy in this case implies an upward or downward shift in the LM curve.

5. The Budget Problem: Cyclical and Structural Budgets

- Cyclical deficit is the type of deficit that would exist if the economy were potential.

- Structural deficit is the type of deficit that would exist if the economy were at potential.

- The sum of both budgets is the actual budget.

- Movements in the structural budget balance are what are represented by shifts in the IS curve.

- The IS/LM model does not differentiate between the two types.

6. The Budget Problem: Accounting Methods

- The cash-flow budget and the obligation budget.

a. Problems with the Cash-Flow Budget

- The cash-flow budget, which is what the government uses, does not take into consideration the expected value of future expenditures and revenues.

- The obligation budget does.

- The choice of which accounting method is appropriate become important when people base their consumption decision on their lifetime earnings, not their cash income.

b. Ricardian Equivalence

- If people base their spending decisions on their lifetime earnings and the government reduces taxes and runs a budget deficit for example, the IS curve will not shift to the right because people will not spend the additional disposable income created by the tax cut.

- The reason is that people know that in the future, the government will raise taxes again by an amount equal to the initial drop in taxes to pay for the deficit.

7. Using IS/LM in the Real World: Summarizing the Interpretation Problem

- Monetary policy:

1) It affects many interest rates.

2) It is often implemented by a rule, i.e., targeting the interest rate.

3) It affects borrowing in the economy in ways other than through interest rate.

4) It affects credit conditions.

- Fiscal policy:

1) Using the budget balance as a guide to the direction of fiscal policy can be misleading. Only structural budget balance can be used as an indicator of the direction of fiscal policy.

2) The budget balance is a result of accounting rules that might not show the effect of the budget on the economy.

B. Implementation Problems of Monetary and Fiscal Policy

- There are three types of implementation problems associated with monetary and fiscal policy.

1. Uncertainty about Potential Output

- The goal of policies is reduce fluctuations in output and maintain around its potential level.

- Policymakers don't have a very good idea where potential output is, or whether the economy is above it or below it.

2. Information Lag

- If there is a problem in the economy, it takes policymakers a considerable amount of time to identify it.

- This delay may minimize the effects of any policy that attempts to correct the problem.

3. Implementation Lag

- After policymakers recognize the problem in the economy, it takes them some time to decide on the optimal course of action.

- Generally, fiscal policy has a longer implementation lag than monetary policy.

C. How Policymakers Deal with the Interpretation and Implementation Problems

- Policymakers use policies to move the economy in a generally desirable direction

- Discretionary fiscal policy is not used very often.

- Fiscal policy affects the economy through its automatic stabilizers. They are programs that are built into the budget that don't require a legislative action to implement.

- Examples of automatic stabilizers include unemployment insurance, Temporary Assistance for Needy Families, and the progressive tax system.

IV. THE POWER OF IS/LM

- Understanding the IS/LM model does not necessarily enable students to understand the workings of short-term policy in the real world.

- The model is a major step forward towards understanding the macro economy.

V. POLICY PERSPECTIVE: UNCERTAINTY AND POLICY IN THE 1990s

- The very active monetary policy during the 1990s is a testimony on the uncertainty surrounding the economy.

- The Fed had to reverse the direction of monetary policy twice in three years due to the uncertainty about potential output, uncertainty about the effect of the global slowdown on the economy, and the uncertainty about the effect of its own policy.

CONCLUSION

- It is difficult to apply the IS/LM model in the real world.

- It is very useful to use the model to understand the basics of short-term changes in the economy.

- A good understanding of the implementation and the interpretation problems is required to make sense of economic policy and its effectiveness.

EXTENSIONS

Crowding Out—Numerical Examples

Use the same model as in “Extensions” in Ch.8.

For simplicity, let t = b0 = m = zero

C = 100 + 0.5 (Y – T)

I = 0.25Y – 500(r)

G0 = 200, T0 = 100, X0 = 200, M0 = 200

MD = 10Y – 20,000(r)

MS0 = 200

The IS equation is Y = 1,000 – 2,000(r), and the LM equation is Y = 20 + 2,000(r).

The equilibrium interest rate is 24.5% and the equilibrium output level is 510.

Step 1:

Suppose the government used and expansionary fiscal policy to increase output by raising its expenditures from 200 to 300.

The new IS equation is Y = 1,400 – 2,000(r).

Solve for equilibrium interest rate and output yields r = 34.5% and Y = 710.

Equilibrium output increases by 200 (710 – 510)

Step 2:

Before the changes in Step 1, assume that the IS curve is steeper. This can be done by changing the investment demand equation, since the slope of the investment demand curve determines the slope of the IS curve.

Let I = 0.25Y – 400(r).

The new IS (steeper) curve is Y = 1,000 – 1,600(r).

Solving for the equilibrium interest rate and equilibrium output using this new IS curve and the original LM curve (from Step 1) yields r = 27.22%, and Y = 564.44.

Step 3:

Suppose the government used and expansionary fiscal policy to increase output by raising its expenditures from 200 to 300. Calculate the equilibrium interest rate and output using the steeper IS curve (from Step 2) and the original LM curve (from Step 1).

The new IS curve is Y = 1,400 – 1,600(r)

Solve for equilibrium interest rate and output yields r = 38.33% and Y = 786.67

The change in equilibrium output = 222.23 (786.67 – 564.44).

Conclusion:

The steeper is the IS curve, the smaller is the crowding out effect. Fiscal policy is more effective in changing equilibrium output when the IS curve is steep. The opposite is true.

[pic]

The graph above shows that along the steep IS curve, an expansionary fiscal policy is more effective. Equilibrium output increased from Y1 to Y3 along IS (steep), where it only increased from Y1 to Y2 along IS (flat). This is due to the fact that large crowding out effect is associated with a flat IS curve.

Step 4:

Now assume a different slope for the LM curve. The slope of the money demand curve determines the slope of the LM curve. Go back to the original model, but now assume that the money demand curve is in the form MD = 10Y – 30,000(r).

The new LM curve is Y = 20 + 3,000(r). Notice that the LM curve is flatter than the original curve. The IS equation is the same as before, which is Y = 1,000 – 2,000(r).

Solving for equilibrium interest rate and equilibrium output yields r = 19.6%, and Y = 608.

Step 5:

Now, assume the government implemented an expansionary fiscal policy by raising expenditures from 200 to 300. We need to calculate the change in equilibrium output twice; once with a steep LM curve, and the other with a flat LM curve.

The first instance was calculated in Step 1. An increase in government spending caused equilibrium output to increase from 510 to 710—a change of 200.

With a flatter LM curve (Y = 20 + 3,000(r)) and the new IS curve (Y = 1,400 – 2,000(r)), the equilibrium interest rate is 27.6%, and equilibrium output is 848.

Equilibrium output increased from 608 to 848—a change of 240.

Conclusion:

The flatter is the LM curve, the smaller is the crowding out effect. Fiscal policy is more effective when the LM curve is flat.

[pic]

The graph above shows that along the flat LM curve, an expansionary fiscal policy is more effective. Equilibrium output increased from Y1 to Y3 along LM (flat), where it only increased from Y1 to Y2 along LM (steep). This is due to the fact that large crowding out effect is associated with a steep LM curve.

INTERNET EXERCISES

1- Go to the web site of the Congressional Budget Office (). Under Data Highlights, select Historical Budget Data.

a. Table 1 shows data on the budget, actual GDP, and potential GDP during 1961-2000. Identify the years for which actual GDP exceeds potential GDP.

b. From Table 2, add Cyclical Adjustment and Other Adjustment (columns 2 and 3). This is cyclical deficit. Find a correlation between cyclical deficit/surplus and the difference between actual and potential GDP.

c. Table 2 also shows the structural deficit (labeled as standardized deficit/surplus). In which decade did the structural deficit experience the largest deficit? Explain why?

2- Go to the web site of the Federal Reserve Bank of St. Louis (). Select FRED/Data from bottom menu and then click on Interest Rate. You will find over 20 types of interest rates that the Fed monitors.

a. Which interest rate has the shortest term of maturity? What is the historical value of this interest rate?

b. Which interest rate has the longest term of maturity? What is the historical value of this interest rate?

c. Find reasons why the two interest rates you selected in parts a and b differ.

CASE STUDY

Recent remarks by the chairman of the Fed and their impacts on the economy can be analyzed using the IS/LM model.

1. In July, 2001, Greenspan told the U.S. House Financial Services Committee in his twice-yearly report on the economy "We need ... to be aware that our front-loaded policy actions this year, coupled with the tax cuts under way, should be increasingly affecting economic activity as the year progresses."

[pic]

When the statement was made, the economy was believed to be at Y1 (below potential). According the Greenspan, the expansionary monetary policy should shift the LM curve from LM1 to LM2, and the tax policy should shift the IS curve from IS1 to IS2. Both policies aim to move the economy closer to potential output.

2. In February 2001, Greenspan told the Senate Banking Committee "If the forces contributing to long-term productivity growth remain intact, the degree of retrenchment will presumably be limited. Prospects for high productivity growth should, with time, bolster both consumption and investment demand." He also said that "for the period ahead, downside risks predominate. In addition to the possibility of a break in confidence, we don't know how far the adjustment of the stocks of consumer durables and business capital equipment has come."

[pic]

Suppose the economy was producing output level Y1 when the statement was made. The first part of the statement says that if productivity continued to grow, income rises, both consumption and investment rise, and, as a result, the IS curve shifts from IS1 to IS2, and the economy get closer to potential output (Ypotential).

The second part of the statement says that if the risk of a recession continues, consumer and producer confidence may witness further deterioration. If this happens, then the reduction in spending driven by the lost confidence level may offset (or overwhelm) the gain in spending caused by growth in productivity. In this case, the IS curve will shift back to IS1, or it may shift all the way back to IS3.

3. In February 2001, Greenspan told the Congress that the sharp economic slowing at the end of 2000 "seemed less evident" in January and February. But, he said, "even after the policy actions we took in January, the risks continue skewed toward the economy's remaining on a path inconsistent with satisfactory economic performance." He said, "although the sources of long-term strength of our economy remain in place," excess inventories built up by companies facing a slowdown in demand, "have engendered a retrenchment that has yet to run its full course."

[pic]

Suppose the economy was producing output level Y1 when the statement was made. The first part of the statement says that the expansionary monetary policy the Fed took during late 2000 should move the economy closer to potential output. The second part warns that if business inventories continue to increase, firms may start cutting spending on capital. In this case, the IS curve will shift from IS1 to IS2, undermining the Fed’s efforts to take the economy to potential output.

QUESTIONS FOR THOUGHT AND REVIEW

1. IN THE IS/LM MODEL, WOULDN’T AN INCREASE IN AUTONOMOUS EXPENDITURES CAUSE OUTPUT TO RISE BY THE FULL MULTIPLIER TIMES THE CHANGE IN EXPENDITURES?

An increase in autonomous expenditures causes aggregate income to rise. As aggregate income rises the demand for money rises as well. If the Fed holds the money supply constant, the rise in money demand causes the interest rate to rise. The increase in the interest rate causes investment expenditures to decline thus offsetting some (or in some cases, all) of the initial rise in output due to the increase in expenditures.

2. Under what conditions will fiscal policy have no effect on output in the IS/LM model?

Fiscal policy has no effect on output when the LM curve is vertical. A vertical LM curve arises when the demand for money is not sensitive to interest rate changes. An increase in government spending will cause income to rise, which will cause the demand for money to rise as well. If the demand for money is not sensitive to interest rates, a rise in the interest rate cannot, by itself, bring about equilibrium in the money market. Instead, the interest rate must rise by enough to push investment expenditures down by the same amount as the initial increase in government spending. Thus, in the end, the increase in government spending has no effect on output. The same result holds for a decrease in taxes.

3. What is a liquidity trap? Under what conditions will one exist?

A liquidity trap is a situation in which monetary policy has no effect on interest rates (and therefore no effect on aggregate output). Liquidity traps are thought to exist when the interest rate is unusually low. At unusually low interest rates, people expect interest rates can only rise. Thus, when the Fed increases the money supply, people will hold onto the new money instead of buying bonds because a rise in interest rates would make the price of bonds fall. If people hold the new money instead of buying bonds the interest rate will not change and if the interest rate does not change then aggregate output will remain unchanged.

4. Why does an increase in the money supply reduce interest rates, and an increase in government spending increase interest rates?

An increase in the money supply causes the interest rate to fall because people take the new money and buy bonds (or other interest earning assets). As they buy bonds they bid up the price of bonds and as the price of bonds rises the interest rate falls. An increase in government spending causes the interest rate to rise. As the government spends more, additional income is generated in the economy. As income increases people demand more money. With a fixed money supply, an increase in the demand for money will cause the interest rate to rise.

5. Policymakers want to increase equilibrium output without increasing interest rates. What policy or combination of policies would you recommend?

If policymakers want to increase income without increasing interest rates they would have to increase the money supply and either reduce taxes or increase government spending.

6. Policymakers want to lower interest rates but keep equilibrium output the same. What policy or combination of policies would you recommend?

If policymakers want to reduce interest rates but keep equilibrium output the same they would have to increase the money supply and either reduce government spending or increase taxes.

7. What monetary policy would the Fed use to accommodate an increase in government spending? Describe a real world example of when the Fed used this type of policy.

The Fed would increase the money supply to accommodate an increase in government spending. The Fed accommodated the large increase in government spending during World War II.

8. What monetary policy would the Fed use to offset an increase in government spending? Describe a real world example of when the Fed used this type of policy.

The Fed would reduce the money supply to offset an increase in government spending. During the early 1980s the Fed offset expansionary fiscal policy by tightening monetary policy.

9. What are the two reasons why interest rates on bonds of different maturities usually differ?

Interest rates differ according to the likelihood that the borrower will repay the loan and they differ by their term to maturity. Prices of longer maturity bonds fluctuate more than do prices of shorter maturity bonds and therefore generally have higher interest rates.

10. What is the yield curve? Name one reason the yield curve could become inverted.

The yield curve shows the differences in interest rates for bonds of various maturities, holding default risk constant. When long-term interest rates are lower than short-term interest rates the yield curve is said to be inverted. If investors believe inflation will fall sufficiently, the yield curve could become inverted.

11. Why is the Fed concerned about how its policies affect the yield curve?

The Fed pays close attention to how the yield curve reacts to its policies because it only directly controls the short end of the yield curve (the federal funds rate and to a lesser extent 3 month Treasury Bills). But aggregate expenditures react to interest rates all along the yield curve so it is important for the Fed to consider how a movement in short term interest rates will impact other longer-term interest rates.

12. How can an increase in the money supply lead to an increase in interest rates and still be consistent with the predictions of the IS/LM model?

An increase in the money supply may have different effects on interest rates depending on what people expected prior to the increase. If people expect the Fed to increase the money supply by a lot then the interest rate will fall prior to the Fed’s actual increase because people will buy bonds. If the Fed ends up increasing the money supply by less than people expected then the interest rate adjust upwards as people sell bonds once they see the Fed did not increase the money supply as much as anticipated. Thus, an increase in the money supply can look like it leads to an increase in interest rates.

13. Why might contractionary monetary policy reduce investment spending by more than would be suggested by the resulting rise in interest rates?

Contractionary monetary policy might have more of a contractionary effect on output than is suggested by the IS/LM model if credit conditions tighten as well. Tightening credit conditions means that banks reduce the number of loans they are willing to make at the prevailing interest rate by raising the requirements for getting a loan (by requiring a larger down payment or higher income to get a loan).

14. What is the effective LM curve, and under what assumptions about the conduct of monetary policy is it the relevant curve to use in the IS/LM model? What is the shape of the effective LM curve when there is an interest rate target?

The effective LM curve is the LM curve that exists when monetary policy is determined by a monetary policy rule. It is relevant to use the effective LM curve when the Fed (or central bank) conducts policy by targeting a short-term interest rate. The effective LM curve is horizontal at the targeted interest rate.

15. Why does the government’s budget balance automatically change with the level of economic activity?

When aggregate income rises, tax revenues automatically rise and government expenditures (on unemployment insurance, food stamps and other social safety net programs) automatically fall making the budget surplus rise or the budget deficit fall. When aggregate income falls, tax revenues automatically decline and government expenditures automatically rise making the budget surplus fall or the budget deficit rise.

16. In what way might the reported budget deficit or surplus be a misleading guide to whether fiscal policy is expansionary or contractionary?

Because the economy affects government expenditures and taxes automatically, the government budget balance can be a misleading indicator of the stance of fiscal policy. For example, the surplus may rise automatically because aggregate income is rising and not because the government is raising tax rates or cutting expenditures. Similarly, the surplus may fall automatically because aggregate income is falling and not because the government is cutting taxes or raising expenditures. Other explanations that distinguish a cash flow budget from an obligations budget are possible.

17. What is the difference between a structural deficit and a cyclical deficit?

The structural deficit is the deficit that would exist if the economy were at potential. The cyclical deficit is the deficit that exists because the economy is not at potential.

18. What is the difference between a cash flow budget and an obligation budget? What kind of budget is the U.S. government budget?

A cash flow budget is a budget based on an accounting system where revenues and expenses are counted only when cash is received or spent. An obligation budget is a budget based on an accounting system that includes the value of future obligations. In an obligation budget the value of future obligations are counted as current expenses. The government budget is currently a cash-flow budget.

19. Why does Ricardian equivalence imply that a tax cut will not affect the economy?

According to the Ricardian Equivalence theory, a tax cut will have no impact on aggregate expenditures or income because people perceive a tax cut financed by issuing bonds as an increase in future tax liabilities. They therefore save any tax cut to pay future taxes. By saving the proceeds of the tax cut expenditures remain unchanged and the tax cut has no effect on the economy.

20. What are the three main implementation problems associated with using fiscal and monetary policy to manage aggregate demand?

The three main implementation problems associated with fiscal and monetary policy are: uncertainty about potential output, the information lag and the policy implementation lag.

21. How does uncertainty about potential output affect the ability of policymakers to implement policy?

Uncertainty about potential output makes it difficult to implement policy in the real world. For example, if output is growing fast but policymakers are not sure whether output is above or below potential output, they will not know whether they should use contractionary policy to slow the economy.

22. How do how automatic stabilizers help to overcome the implementation lag associated with fiscal policy?

Automatic stabilizers are changes in taxes and government expenditures that automatically vary with the level of income in the economy. For example, when the economy grows rapidly, people are automatically pushed into higher tax brackets causing an automatic slowdown in consumption expenditures. When the economy slows, people are pushed into lower tax brackets, which automatically cushion the fall in consumer spending. Automatic stabilizers do not require legislative action, and therefore help to overcome the legislative lag.

23. Which has a longer implementation lag, monetary or fiscal policy? Why?

Fiscal policy has a longer implementation lag than monetary policy. In order to use fiscal policy to steer the economy, Congress and the President must pass legislation. That process can take months. The Fed can change monetary policy immediately by ordering the Federal Reserve Bank of New York to execute an open market operation.

24. Defend the following: the IS/LM model is a useful tool for analyzing the real world despite the problems associated with interpreting and implementing its policy recommendations.

Despite the interpretation and implementation problems associated with fiscal and monetary policy the IS/LM model is still a useful guide for understanding policy in the real world. The main lesson of this chapter is that the IS/LM model should be used as a first step in an analysis of policy in the real world. A complete analysis requires an understanding of the implementation and interpretation problems discussed in this chapter.

25. How did uncertainty about potential output affect Fed policy in the last half of the 1990s?

Throughout the end of the 1990s and into early 2000 the Federal Reserve was concerned that the economy was growing too fast. Based on standard estimates of potential output, the economy had been operating above potential output since 1996. But of course there is a great deal of uncertainty about exactly where potential output is at any point in time. In the late 1990s that uncertainty was especially large because productivity growth appeared to be increasing but policymakers were not sure whether that increase was permanent or temporary. Nonetheless the Fed began tightening monetary policy in 1999 in order to slow growth and bring the economy back to potential output. Of course by early 2001 it was clear that the economy was growing too slowly and the Fed began lowering interest rates. The rapid reversal in Fed policy illustrates the Fed’s uncertainty about potential output.

PROBLEMS AND EXERCISES

1. CONGRATULATIONS! YOU HAVE JUST BEEN APPOINTED HEAD OF THE COUNCIL OF ECONOMIC ADVISERS IN FUNLANDIA. DEMONSTRATE, GRAPHICALLY, THE POLICY OR POLICIES YOU WOULD RECOMMEND TO YOUR PRESIDENT IN EACH OF THE FOLLOWING SITUATIONS.

a. The economy is below potential and interest rates are high. The president would like to bring the economy back to potential and lower interest rates.

To raise output to potential and lower interest rates policymakers would have to use monetary policy. An increase in the money supply would shift the LM curve from LM0 to LM1 raising output from Y0 to Y1 and lowering the interest rate from r0 to r1. This policy is illustrated in the graph.

b. The economy is above potential, but interest rates are just right. The president would like to bring the economy back to potential but keep interest rates the same.

To lower output but keep interest rates the same policymakers would have to use contractionary monetary and fiscal policy. Contractionary monetary policy would shift the LM curve from LM0 to LM1 and contractionary fiscal policy would shift the IS curve from IS0 to IS1. As a result of these shifts output would fall from Y0 to Y1 and interest rates would remain at r0 as shown in the graph to the right:

c. The economy is at potential, but interest rates are high. The president would like to keep the economy at potential but lower the interest rate.

To keep output unchanged at potential and lower interest rates policymakers would have to use contractionary fiscal policy and expansionary monetary policy. Contractionary fiscal policy would shift the IS curve from IS0 to IS1 and contractionary monetary policy would shift the LM curve from LM0 to LM1. Output would remain unchanged and interest rates would fall from r0 to r1 as shown in the graph to the right:

d. Now that you have shown the president how she can manage aggregate demand on paper by shifting the IS and LM curves, explain to her why conducting policy in the real world is not so easy.

Once you have shown the President the mechanics of shifting the IS and LM curves to achieve the stated goals in (a) through (c) you must break the bad news that using policy in the real world is not so easy for two reasons. First there are interpretation problems—the interest rate and budget balance movements predicted by the model do not necessarily correspond to interest rate and budget balance movements in the real world. Second there are implementation problems—it is not clear where potential output is and even if one could determine where it is with certainty it often takes time to implement policies in the real world. It also often takes time to implement fiscal policy—especially contractionary fiscal policy as shown in (b) and (c). By the time the policy is implemented the economy may have changed.

2. Suppose the economy is currently below potential output. What type of policy would you recommend to bring it back to potential output in each of the following cases? Demonstrate your answers graphically:

a. The demand for money is completely insensitive to interest rate changes (does not respond at all to changes in the interest rate).

If money demand is completely unresponsive to interest rate changes the LM curve is vertical and fiscal policy is completely ineffective. In this case policymakers would have to use expansionary monetary policy to bring the economy back to potential output. Expansionary monetary policy would shift the LM curve from LM0 to LM1 bringing output from Y0 to Y1 as shown in the graph to the right:

b. The demand for money is infinitely responsive (extremely responsive) to changes in the interest rate.

If money demand is infinitely responsive to changes in interest rates the LM curve is horizontal and monetary policy is completely ineffective. In this case policymakers would have to use expansionary fiscal policy to bring the economy back to potential output. Expansionary fiscal policy would shift the IS curve to the right from IS0 to IS1 bringing output from Y0 to Y1 as shown in the graph to the right:

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3. Suppose it is an election year and the President and Congress have just passed a big spending bill to boost the economy and increase their chances of re-election.

a. What policy action would the Fed take to offset the effect of this policy on output? Demonstrate your answer graphically.

Expansionary fiscal policy is represented below as a rightward shift in the IS curve from IS0 to IS1. To offset that policy the Fed would decrease the money supply shifting the LM curve from LM0 to LM1. Output would remain unchanged at Y0.

b. Now suppose the country goes to war and government spending rises even more. What policy action would the Fed take to accommodate this fiscal policy? Demonstrate your answer graphically.

Wartime spending would shift the IS curve from IS0 to IS1. To accommodate the increase in spending the Fed would increase the money supply shifting the LM curve from LM0 to LM1. Output would rise from Y0 to Y1.

4. Suppose the budget surplus rises by $10 billion for every percentage-point rise in output. Calculate the structural and cyclical budget surplus or deficit in each of the following situations.

a. The economy is currently 2 percentage points above potential and the budget deficit is $20 billion.

The economy is 2 percentage points above potential, which means that the cyclical surplus is $20 billion. The actual deficit is $20 billion so if the economy were at potential, the structural deficit would be $40 billion (the actual deficit minus the cyclical surplus).

b. The economy is currently 4 percentage points below potential and the budget deficit is $30 billion.

The economy is 4 percentage points below potential so the cyclical deficit is $40 billion. The actual deficit is $30 billion. If the economy were at potential the structural surplus would be $10 billion (the actual deficit plus the cyclical deficit).

c. The economy is at potential output, with a $10 billion surplus.

The economy is at potential with a surplus of $10 billion. The cyclical surplus or deficit is 0 and the structural surplus is $10 billion.

5. In November of 1999 the European Central Bank (ECB) contracted the money supply to raise interest rates. Short-term interest rates rose in reaction to this policy action, but long-term interest rates fell. Draw the yield curve before and after the ECB’s policy change and explain why long term and short term interest rates reacted differently to this decrease in the money supply.

Assuming the yield curve is initially upward sloping (YC0) the policy change could result in an inverted yield curve. When the ECB raised short-term interest rates long-term interest rates fell so the yield curve flattened or became inverted. The yield curve YC0 is the yield curve that might have existed prior to the tightening. The yield curve YC1 is the inverted yield curve resulting from the rate hike. A reason that long-term interest rates might have fallen is that the short-term rate hike might have led people to expect lower inflation in the future.

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6. Use the IS/LM model to demonstrate what happens when taxes are cut in each of the following situations:

a. The Ricardian equivalence does not hold.

If Ricardian Equivalence does not hold, a tax cut will cause the IS curve to shift right from IS0 to IS1 and output will rise from Y0 to Y1 as shown in the graph to the right.

b. The Ricardian equivalence holds.

If Ricardian Equivalence does hold, a tax cut will cause no shift in the IS curve because the reduction in taxes will be exactly offset by a reduction in consumption expenditures. Output will therefore remain at Y0.

7. Use the IS/LM diagram to describe U.S. fiscal and monetary policies during the 1990s.

During the 1990s the government reduced the structural deficit pushing the IS curve left from IS0 to IS1. Monetary policy offset these movements in the IS curve pushing the LM curve right from LM0 to LM1 until output rose to Y1 and the interest rate fell to r1. These movements in the IS and LM curves are illustrated in the graph to the right.

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YC0

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Yield of Maturity

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