Report

Chapter 7 Effectiveness of Monetary Policy and Fiscal Policy © Pilot Publishing Company Ltd. 2005 Contents: • More about the IS-LM model • Effectiveness of monetary policy & fiscal policy • Advanced Material 7.1: Interest rate vs. money supply as an instrument of monetary policy • Advanced Material 7.2: Comparison between the IS-LM model and the Y-E model © Pilot Publishing Company Ltd. 2005 More about the IS-LM Model © Pilot Publishing Company Ltd. 2005 Determinants of the slope of the IS curve The slope of the IS curve: 1 c i ct cq m b <0 The slope is negative. © Pilot Publishing Company Ltd. 2005 >0 Interest elasticity of investment (rEI or b ) r The larger the interest elasticity when r changes, the larger the change in I the larger the required change in Y (& W) to restore equilibrium, i.e., the gentler the IS curve. IS* (I is more interest elastic) 0 © Pilot Publishing Company Ltd. 2005 IS (I is less interest elastic) Y Income elasticity of saving (YES or s or MPS) r The larger the income elasticity when Y changes, the larger the change in S the larger the required change in r (& J) to restore equilibrium, i.e., the steeper the IS curve. IS* (S is less income elastic) 0 © Pilot Publishing Company Ltd. 2005 IS (S is more income elastic) Y Determinants of the extent of shift of the IS curve Reason of the shift: (an autonomous ∆ in J or W) e.g., an autonomous in J J > W 1. If r remains unchanged, Y has to to raise W until J=W, IS curve shifts rightward. 2. If Y remains unchanged, r has to to lower J until J=W, IS curve shifts upward. © Pilot Publishing Company Ltd. 2005 Interest elasticity of investment r Consider two IS curves with different rEI but equal YES auton. in An As they have theJ same income elasticity, theya The IS curve with require the same in Y larger interest elasticity to restoreaequilibrium. requires smaller in r to restore equilibrium IS* (I is more interest elastic) IS (I is less interest elastic) 0 © Pilot Publishing Company Ltd. 2005 Y Income elasticity of saving r Consider two IS curves with different YES but equal rEI As An they auton. in have theJ same interest elasticity, theya The IS curve with require the same in r to larger income elasticity restore thea equilibrium. requires smaller in Y to restore equilibrium IS (S is less income elastic) IS* (S is more income elastic) 0 © Pilot Publishing Company Ltd. 2005 Y Extreme Shape of case IS curve Extent of shift of the IS curve (e.g., an autonomous J or W that J > W) Es = 0 Horizontal Upward shift: normal (∵ Y Rightward shift: in Y r = 0) cannot restore equilibrium Es = Vertical (∵ Upward shift: normal Y r Rightward shift: a negligible = ) in r is enough to restore equil. Y Y © Pilot Publishing Company Ltd. 2005 Extreme cases of the IS curve Extreme Shape of case IS curve rEI = 0 rEI = Extent of shift of the IS curve (when autonomous J or W that J > W) Vertical Upward shift: in r cannot (∵Δr restore equilibrium Rightward shift: normal ΔY = 0) Horizontal Upward shift: a negligible (∵Δr in r is enough to restore equil. Rightward shift: normal ΔY = ) © Pilot Publishing Company Ltd. 2005 Determinants of the slope of the LM curve The slope of the LM curve: <0 d e The slope is positive. © Pilot Publishing Company Ltd. 2005 >0 Q7.2: Given a two-sector economy, with S = 0.2Y – 100 and I = 10 – 20r. (a) Derive the IS equation. (b) Suppose there is an autonomous rise in I by 40. (i) What is the extent of rightward shift of the IS curve? (ii) What is the extent of upward shift of the IS curve? © Pilot Publishing Company Ltd. 2005 Interest elasticity of asset demand for money The larger the interest elasticity, r LM (Ma is less interest elastic) when r changes, the larger the change in Ma the larger the required change in Y (& Mt) to restore equilibrium, i.e., the gentler the LM curve. LM* (Ma is more interest elastic) 0 © Pilot Publishing Company Ltd. 2005 Y Income elasticity of transactions demand for money The larger the income elasticity, r LM* (Mt is more income elastic) when Y changes, the larger the change in Mt the larger the required change in r (& Ma) to restore equilibrium, i.e., the steeper the LM curve. LM (Mt is less income elastic) 0 © Pilot Publishing Company Ltd. 2005 Y Determinants of the extent of shift in the LM curve Reason of the shift: (an autonomous Δ in Md or Ms) e.g., an autonomous in money supply Md < Ms 1. If r remains unchanged, Y has to to raise Mt until Md = Ms, LM curve shifts rightward. 2. If Y remains unchanged, r has to to raise Ma until Md = Ms, LM curve shifts downward. © Pilot Publishing Company Ltd. 2005 Interest elasticity of asset demand for money Consider two LM curves with different rEMa but equal YEMt r LM0 (Ma is less interest elastic) LM0* (Ma is more interest elastic) LM1 0 © Pilot Publishing Company Ltd. 2005 As they have theMsame An auton. in s elasticity, they LM1*income The LM curve with a require the same in Y larger interest elasticity to restore the equilibrium requires a smaller Δ in r to restore equilibrium Y Income elasticity of transactions demand for money Consider two LM curves with different YEMt but equal rEMa r LM0 (Mt is less income elastic) LM0*(Mt is more income elastic) LM1* 0 © Pilot Publishing Company Ltd. 2005 LM1 As have Anthey auton. the in Msame s interest elasticity, they The LM curve with a require the same in r larger income elasticity to restore the equilibrium requires a smaller in Y to restore equilibrium Y Extreme cases of the LM curve Extreme Shape of Extent of shift of the LM curve case LM curve (when autonomous Md or autonomous Ms) rEMa = 0 Vertical Downward shift: in r cannot (∵Δr restore the equil. Rightward shift: normal ΔY = 0) rEMa = Horizontal Downward shift: a negligible (∵Δr in r is enough to restore the equil. ΔY= ) Rightward shift: normal © Pilot Publishing Company Ltd. 2005 Extreme Shape of Extent of shift of the LM curve case LM curve (when autonomous Md or autonomous Ms ) EMt = 0 Horizontal Downward shift: normal (∵ΔY Rightward shift: in Y cannot Δr = 0) restore equilibrium EMt = Vertical (∵ΔY Δr = ) Y Y © Pilot Publishing Company Ltd. 2005 Downward shift: normal Rightward shift: a negligible in Y is enough to restore equil. Monetary policy (MP) is the government measure which achieves economic objectives through manipulating the money supply or interest rate. Fiscal policy (FP) is the government measure which achieves economic objectives through manipulating the government revenue or expenditure. © Pilot Publishing Company Ltd. 2005 Effectiveness of Monetary Policy and Fiscal Policy © Pilot Publishing Company Ltd. 2005 Effectiveness of monetary policy Effect of monetary policy e.g., an expansionary monetary policy (Ms) Mechanism: Md<Ms r Ma I J>W until J=W & Md=Ma+Mt=Ms © Pilot Publishing Company Ltd. 2005 Y W Mt Determinants of the effectiveness of MP 1. Multiplier 2. Interest elasticity of investment 3. Income elasticity of saving 4. Interest elasticity of asset demand for money 5. Income elasticity of transactions demand for money © Pilot Publishing Company Ltd. 2005 Multiplier ΔY = ΔI X Multiplier The larger the multiplier The larger the change in Y The more effective the monetary policy © Pilot Publishing Company Ltd. 2005 Interest elasticity of investment (rEI ) r IS LM0 LM1 The larger the rEI , the larger the in I & the larger the in Y. The more effective the MP IS* (I is more interest elastic) 0 Y0 Y1 Y*1 © Pilot Publishing Company Ltd. 2005 Y Income elasticity of saving (YES) r The smaller the YES , the larger the required LM0 in Y to raise enough LM1 W to restore equil. IS The more effective the MP IS* (S is less income elastic) 0 Y0 Y1 Y*1 © Pilot Publishing Company Ltd. 2005 Y Interest elasticity of asset demand for money (rEMa) r LM*0 (Ma is less interest elastic) IS LM0 LM*1 LM1 The smaller the rEMa , the larger the required in r to raise enough Ma to restore the equil. Then the larger the in I & Y The more effective the MP 0 Y0 Y1Y*1 © Pilot Publishing Company Ltd. 2005 Y Income elasticity of transaction demand for money (YEMt) r IS LM0 LM0*(Mt is less income elastic) LM1 0 Y0 Y1Y*1 © Pilot Publishing Company Ltd. 2005 LM1* The smaller the YEMt , the larger the required in Y to raise enough Mt to restore the equil. The more effective the MP Y Effectiveness of Fiscal Policy Effect of fiscal policy e.g., an expansionary fiscal policy (G) Mechanism: J>W Y W Mt Md>Ms until J=W and Md=Ma+Mt=Ms © Pilot Publishing Company Ltd. 2005 r I Ma Determinants of the effectiveness of FP 1. Multiplier 2. Interest elasticity of asset demand for money 3. Income elasticity of transactions demand for money 4. Interest elasticity of investment 5. Income elasticity of saving © Pilot Publishing Company Ltd. 2005 Multiplier ΔY = ΔG X G-Multiplier ΔY = ΔT X T-Multiplier The larger the multipliers The larger the change in Y Fiscal Policy is more effective © Pilot Publishing Company Ltd. 2005 Interest elasticity of asset demand for money (rEMa) r IS1 IS0 The larger the rEMa , the smaller the required LM in r to restore the equil. and the smaller LM* (Ma is more the crowding out effect. interest elastic) 0 Y0 Y1Y*1 © Pilot Publishing Company Ltd. 2005 The more effective the FP Y Income elasticity of transactions demand for money (YEMt) r IS1 IS0 LM LM* (Mt is less income elastic) 0 Y0 Y1Y*1 © Pilot Publishing Company Ltd. 2005 The smaller the YEMt , the smaller the in Mt and the smaller the required in r to restore the equil. and the smaller the crowding out effect. The more effective the FP Y Interest elasticity of investment (rEI ) r IS*0 (I is less income elastic) IS*1 IS1 IS0 0 Y0 Y1 Y*1 © Pilot Publishing Company Ltd. 2005 LM The smaller the rEI , the smaller the drop in I and the smaller the crowding out effect. The more effective the FP Y Income elasticity of saving (YES) r LM IS*1 IS1 IS0 0 Y0 Y1Y*1 © Pilot Publishing Company Ltd. 2005 The smaller the YES , the larger the required in Y to raise enough W to restore the equil. The more effective the FP IS*0 (S is less income elastic) Y Effectiveness of the policies in extreme cases Extreme case Effectiveness of MP Horizontal IS Most effective Vertical IS Totally ineffective Horizontal rEMa= totally ineffective LM YEMt = 0 most effective Vertical rEMa = 0 most effective © Pilot Publishing Company Ltd. 2005 LM YEMt= totally Effectiveness of FP = totally ineffective YES = 0 most effective rEI = 0 most effective YES= totally ineffective Most effective rEI Totally ineffective Effectiveness of MP Horizontal IS r LM0 Cause of horizontal IS: rEI = or YEs = 0 LM1 IS0 Y0 Y1 © Pilot Publishing Company Ltd. 2005 E.g., an expansionary MP Y MP is most effective Effectiveness of FP Horizontal IS r Cause of horizontal IS: rEI = LM0 IS0 = IS1 E.g., an expansionary FP FP is completely ineffective Y0 = Y1 © Pilot Publishing Company Ltd. 2005 Y Effectiveness of FP Horizontal IS r Cause of horizontal IS: YEs = 0 LM0 IS1 IS0 Y0 Y1 © Pilot Publishing Company Ltd. 2005 E.g., an expansionary FP Y FP is most effective Vertical IS r IS0 Effectiveness of MP Cause of vertical IS: rEI =0 or YEs = LM0 LM1 E.g., an expansionary MP MP is completely ineffective Y0 = Y1 © Pilot Publishing Company Ltd. 2005 Y Effectiveness of FP Vertical IS r IS0 IS1 Cause of vertical IS: rEI = 0 LM0 E.g., an expansionary FP FP is most effective Y0 Y1 © Pilot Publishing Company Ltd. 2005 Y Effectiveness of FP Vertical IS r IS0 = IS1 Cause of vertical IS: Es = LM0 Y E.g., an expansionary FP FP is completely ineffective Y0= Y1 © Pilot Publishing Company Ltd. 2005 Y Effectiveness of MP Horizontal LM Cause of horizontal LM: rEMa = r LM0 = LM1 IS0 Y0 = Y1 © Pilot Publishing Company Ltd. 2005 E.g., an expansionary MP MP is completely ineffective Y Effectiveness of MP Horizontal LM Cause of horizontal LM: YEMt = 0 r LM0 E.g., an expansionary MP LM1 IS0 Y0 Y1 © Pilot Publishing Company Ltd. 2005 MP is most effective Y Effectiveness of FP Horizontal LM Cause of horizontal LM: YEMt = 0 or rEMa = r E.g., an expansionary FP LM0 IS0 IS1 Y0 Y1 © Pilot Publishing Company Ltd. 2005 Y FP is most effective Effectiveness of MP Vertical LM r Cause of vertical LM: rEMa = 0 LM0 LM1 E.g., an expansionary MP IS0 Y0 Y1 © Pilot Publishing Company Ltd. 2005 MP is most effective Y Effectiveness of MP Vertical LM r LM0= LM1 Cause of vertical LM: YEMt = E.g., an expansionary MP IS0 Y0= Y1 © Pilot Publishing Company Ltd. 2005 MP is completely ineffective Y Effectiveness of FP Vertical LM r Cause of vertical LM: YEMt = or rEMa = 0 LM0 E.g., an expansionary FP IS1 IS0 Y0= Y1 © Pilot Publishing Company Ltd. 2005 FP is completely ineffective Y Advanced Material 7.1 Interest rate versus money supply as an instrument of monetary policy Money supply as an instrument of MP Money supply is fixed & is adjusted deliberately. The LM curve is upward sloping. An expansionary MP shifts the LM curve rightward or downward. Ms is exogenous but interest rate is endogenous. © Pilot Publishing Company Ltd. 2005 Advanced Material 7.1 Interest rate versus money supply as an instrument of monetary policy Interest rate as an instrument of MP Interest rate is fixed & is adjusted deliberately. The LM curve is horizontal at that fixed rate. An expansionary MP lowers the interest rate & shifts the LM curve downward to the new rate. Interest rate is exogenous but Ms is endogenous. © Pilot Publishing Company Ltd. 2005 Advanced Material 7.2 Comparison between the IS-LM model and the Y-E Model Differences between the two models The Y-E model considers the goods market only, while the IS-LM model considers both the goods market & the money market. In the Y-E model, I is a constant independent of r, while in the IS-LM model, I is a variable negatively related to r. © Pilot Publishing Company Ltd. 2005 Advanced Material 7.2 Comparison between the IS-LM model and the Y-E Model Superiority of the IS-LM model can investigate the effects of monetary forces (changes in Md & Ms) can predict the value of the equil. interest rate can give a more accurate prediction on the value of the equil. Y © Pilot Publishing Company Ltd. 2005 The Y-E model is a special case of the IS-LM model When rEMa = (horizontal LM), YEMt = 0 (horizontal LM) or rEI = 0 (vertical IS) No crowding-out effect The Y-E model gives the same (& accurate) prediction as the IS-LM model on how real forces (in the goods market) affect the equil. Y. Notice that when rEI = 0 and rEMa, monetary forces are neutral, having no effect on Y. In other words, the goods market & the money market are separated. © Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 1. For the same amount of autonomous change in J or W causing J > W, the IS curve will shift rightward (upward) by the same amount. 2. For the same amount of autonomous change in Md or Ms causing Md < Ms, the LM curve will shift rightward (downward) by the same amount. © Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 3. The flatter the IS curve, the more effective the monetary policy but the less effective the fiscal policy. 4. The steeper the LM curve, the less effective the fiscal policy but the more effective the monetary policy. © Pilot Publishing Company Ltd. 2005