BLOCK 16 (BVFD Chap 20)

MONETARY AND FISCAL POLICY

(IS-LM Frame-work)
Monetary policies: Central bank’s policy of
changing money supply or interest rate.
• A given monetary policy refers to changes in the
interest rate through changes in money supply?
In old version it was monetary policy and now it is
defined as interest rate policy.

For the reasons given in the previous two

chapters,
we prefer to focus on the interest rate policy.

• Another part of the monetary policy is the

particular relationship defining how the interest rate is
chosen. This may reflect discretionary choices of
• In the heyday of monetarism, central banks used to adjust
interest rates to stop the money supply deviating from a given
target path of monetary growth.
• Most central banks have abandoned this policy, preferring to
target the inflation rate itself through changes in interest rate.
• Increasing money supply was called expansionary
monetary policy and reverse as contractionary
monetary policy. Now reducing interest rate is called
loose monetary policy and increasing interest rate
as tight monetary policy.
 The IS (investment-
saving )schedule:
• Theor Goods
goods market
market equilibrium
is in equilibrium when
aggregate demand (AD) and actual income
(Y) are equal or planned investment (I)
equals planned savings (S).
• The IS schedule shows the different
combinations of income and interest rates at
which the goods market is in equilibrium.
• IS schedule consists of combinations of real
interest (r) and level of output (Y) such that
goods market is in equilibrium
• Note: to derive IS curve we assume that
investment depends upon interest rate i.e.
I=I(r), for simplicity a linear relationship I=AI-
 The IS schedule
At a relatively high interest
AD

45o line
AD1(r1) rate r0, consumption and
investment are relatively
A’ _____(c(1-t) AD0(r0) low – so AD is also low.
Equilibrium is at Y0.
A _____(c(1-t)
At a lower interest rate r1
Y0 Y1 Income(Y) consumption, investment
r
and AD are higher.
r0 Equilibrium is at Y1.

r1
The IS schedule shows all
IS the combinations of real
incomes and interest rates
Y0 Y1 Income (Y) at which the goods market
is in equilibrium.
 Some mathematics
• We begin with the equilibrium condition,
that output equals desired spending in the goods
market.
• Y=C+I+G;
• C = Ac + c(Y – T); ------ Consumption Function
• I = AI – d*r; ------------- Investment Function
Y = Ac+c(Y – T)+AI – d*r + G
we write this equation as

Where A and b are defined as

 Rearranging this equation we get following equation

------this is equation of IS curve

Where A’=Ac- cT+AI+G

If we assume proportional income tax T=t*Y then equation of IS curve is
given as

--------equation of IS curve

Where A’=Ac+AI+G
 Shifts in the IS schedule
• Changes in aggregate demand shift the IS schedule. For a
given interest rate, more optimism about future profits raises
investment (I) demand.
• Higher expected future incomes raise consumption
(C)demand.
• Higher government spending (G) adds directly to aggregate
demand.
• Any of these, by raising aggregate demand at a given interest
rate, raise equilibrium output at any interest rate, and lead to
an upward shift in the IS schedule.
• Due to increase in G or decrease in T the IS schedule shift to
the right. It is defined as expansionary fiscal policy.
Decrease in G or increase in T is called contractionary fiscal
policy. Activity 16.1
 The slope of the IS
•
schedule
The IS schedule slopes down. Lower interest rates (r)
boost aggregate demand (through increase in
investment demand) and output (Y).
• The slope of the IS schedule reflects the sensitivity of
aggregate demand to interest rates.
• If demand is sensitive to interest rates, the IS
schedule is flat.
• Conversely, if output demand is insensitive to
interest rates, the IS schedule is steep.
• slope of Is= with lump-sum tax

• Slope of IS = with proportional tax

 The IS schedule
Due to increase in G, Ac, AI
r0 or decrease in T, IS curve
shifts to the right. Due to
IS(G1,T0) decrease in G, Ac, AI or
IS(G0,T0) increase in T, IS curve shifts
Y0 Y1 to the left.
Income(Y)

Due to increase in MPC (c),

decrease in tax rate (t)or
increase in interest sensitivity
of investment (d) IS curve
r0 becomes flatter and vice
versa.
IS(t1) Larger multiplier also means
IS(t0) flatter IS curve.
Y0 Y1 Income(Y)
 The LM (demand for liquid
asset(L)-supply of money(M))
schedule:
or money
• The money market
market equilibrium
is in equilibrium when
money demand (Md/LL) equals money supply
(M).
• The LM schedule shows the relationship between
interest rates and output implied by the monetary
policy in force.
• We interpret the LM schedule as monetary policy in
which the central bank deliberately sets higher
interest rates when output is higher and vice versa.
• This is consistent with a desire to stabilize output
around its full capacity level.
• The steeper the LM schedule, the more aggressively
the central bank ’leans into the wind’ in order to offset
When aggregate demand falls and output is below
potential output Y*, the central bank reduces interest
rates to r2, helping to mitigate the fall in aggregate
demand and ensure output falls only to Y2.
Conversely, when aggregate demand is higher than
potential output, the central bank raises interest rates
to r1, thereby restricting the increase in demand and
output
r
to Y1. LM’ Central Bank passively
supplies necessary
LM
amount of money to
maintain interest rate.
r1 An upward shift in LM
r* cure reflect tight
monetary policy. At every
r2 output level interest
rates are higher than
previous.
Downward shift means
 LM1
LM0
LM0
LM1
r1
r0
r0
r1

O Y O
Y0 Y0 Y

Due to loose monetary policy LM Due to tight monetary policy LM

curve shifts down to the right. At the curve shifts up to the left. At the
given level of output interest given level of output interest
decreases in the money market. increases in the money market.
 Simultaneous Equilibrium in
Goods & Money markets
Bringing together the
IS schedule (showing
goods market equilibrium)
r and the LM schedule
LM (showing money market
Equilibrium or central
bank’s interest rate
r* policy
We can) identify the
E
unique combination of
real income and interest
rate (r*, Y*) which ensures
overall equilibrium (in
IS goods and money
markets).
Y* Income
Note: Due to the fiscal policy IS curve shifts and due monetary policy LM
curve shifts.
 Fiscal policy in the IS-LM
Sources of financing G are model
1.Taxes Y0, r0 represents the initial
2.Selling Bonds
3.Printing new money
equilibrium.
A bond-financed increase in
government spending shifts the
r IS
LM schedule to IS1.
Equilibrium is now at r1, Y1.
E1
r1 At the same interest rate output
 would have increased multiplier
r0 E0   times up to Y’. As the central
bank increases the r according to
IS1 its policy some private spending
(Y1Y’) has been crowded out by
IS0
this increase in the rate of
interest. An increase in
Y0 Y1 Y’ Income government spending, G, leads to
an increase
in output and an increase in interest rates. However, this increase in
interest rates will lead to a fall in private spending – a fall in investment
and consumption. This means that the overall increase in output is less
than it otherwise would have been.
 Crowding out
Increase in government spending, G, leads to an increase in
output and an increase in interest rates.

Increase in interest rates will lead to a fall in private

spending – a fall in investment and consumption.

This means that to a certain extent, the increase in

government spending has merely replaced private spending
that would otherwise have taken place called crowing out.

Another way of thinking about this is that an increase in G,

unmatched by an increase in taxation reduces desired
national savings. At unchanged interest rates there will be
an excess of desired investment over desired savings so the
interest rate increases to eliminate this excess. The
investment does not fall by the same amount that G has
increased unless the LM curve is vertical,

Under what conditions there would be no crowding out at all.

 Monetary policy in the IS-LM
model

Y0, r0 represents the

r
initial equilibrium.
LM0
A loose monetary policy
LM1 shifts the LM schedule
r0  down to the right. At
initial output Y0 interest
r1  decreases to r’. Due to
r’ 
decreased r both C and I
IS0 increase. Equilibrium is
now at r1, Y1. Due to
Y0 Y1 Income loose monetary policy
interest decreases and
output increases.
 Combining policies in the IS-
LM model

Y0, r0 represents the

r initial equilibrium.
LM
A bond-financed
LM’ increase in
r1  government
r0   spending shifts the IS
schedule to IS1.
IS1 Equilibrium is now
at r1, Y1.
IS0
Loosening monetary
policy in order to keep
Y0 Y1 Y2 Income the rate of interest at
r0 allows output to
expand to Y2.
Activity 16.2
 The policy mix
Note that Fiscal and Monetary policies are defined as demand
management policies. Demand management is the use of
monetary and fiscal policy to stabilize the level of income around
a high average level.

r Income level Y* can

be attained by:
LM1
‘Tight’ fiscal policy (IS0)
LM0 with ‘easy’ monetary
r1  policy (LM0)
OR with ‘easy’ fiscal
r0  policy (IS1) with ‘tight’
IS1 monetary policy (LM1).
IS0
This affects the private:
Y* Income public balance of
spending in the
economy.
Activity 16.4
 Concluding comments
• The IS-LM model seems to offer
governments a range of options for
influencing equilibrium income.
• There are other issues to be
considered:
• the price level and inflation
• the supply-side of the economy
• the exchange rate
 Concluding comments (1)
• The IS schedule shows combinations of
interest rates and output compatible with
short-run equilibrium output in the goods
market
• The LM schedule shows combinations of
interest rates and output compatible with
money market equilibrium when the central
bank pursues a interest rate target.
• The intersection of IS and LM schedules
shows simultaneous equilibrium in both
goods and money markets, jointly
determining output and interest rates.
 Concluding comments (2)
• With a given monetary policy, a fiscal expansion
increases output, money demand and interest
rates, thus crowding out or partially displacing
private consumption and investment demand.

• For a given fiscal policy, a monetary expansion

leads to lower interest rates and higher output.

• The mix of monetary and fiscal policy affects

the equilibrium interest rate as well as the level of
output.
 Criticism on IS-LM Model

IS-LM is criticized due to the assumption regarding the

fixed price level. As in real life prices are flexible.

Other criticisms of the IS-LM model include the fact

that it is a static model, while interest rates are
meaningless unless time is a factor; and the fact that
the central bank no longer uses money supply targets
(most central banks now set inflation targets).

Nonetheless, it is a useful model for clarifying several

fundamental concepts and although it is sometimes
seen as being a little old-fashioned, in practice it is
often still used by policy-makers