Macroeconomics

Lecture 7

The IS-LM model

Monetary Policy

Outline

• Active monetary policy in the IS-LM model.

• Monetary rules: money versus interest rate control.

Monetary PolicyOpen market operation (OMO)

Central Bank

Buy bonds

Inject money

Sell bonds

Retire money

Y

0LM

0IS

A

R

0R

0Y

1LM

1Y

1R

P

M S

C

ESM R

R I Y

A’

EDM R

Non-neutrality of Money

0C0G

0I

I

C

The IS-LM model.

I C Y G

P

M S

The classical model

RLYLLP

M S210

),( KLFY

)()( RIYS

SM P

Money are neutral

Money are non-neutral

The Keynesian Transmission mechanism

P

M S R I

Y

L2

i1

L1

MP

Money market Goods market

feedback

smallL2

+ largei1

= effectivetransmission

If L2= or i1=0, thenthe transmissionmechanism fails.

R I

Y

The Monetary Policy Multiplier

The effect on Y when MS changes and the interest rateis allowed to adjust to its equilibrium level

2

11

2

1

)1(1 1LMIS

LiL

Li

MY

tcS

“The transmission mechanism”

simple multiplierfeedback

Active Monetary Policy

• An expansion of Ms can effectively stimulate the level of activity and employment if the Keynesian Transmission Mechanism is effective:– Real money demand is insensitive to R.– Investment demand is sensitive to R.

Caveats

• The IS-LM models shows that monetary policy is non-neutral in a closed economy if the price level can be taken as fixed and the Keynesian transmission mechanism works.

• The transmission mechanism may not work, e.g., if the interest rate is very close to zero (liquidity trap).

• The price level is unlikely to stay constant in response to a large and sustained expansion of MS and so inflation will eventually reduce the potency of monetary.

• Monetary rules versus active monetary policy.

Monetary policy instruments

OMO =The central bank increases/decreases cashin circulation by buying/selling government bonds in the financial markets.

The base rate =The base rate is the official rate atwhich banks can obtain cash fromthe central bank.

1. Money supply control:

For given MS, the interest rate is allowed to clear the money market.

2. Interest rate control

The central bank supplies money to the money marketsuch that the market clears at the chosen interest rate.

Money versus interest controlThe central bank is like a monopolistic firm facing adownwards sloping demand curve, so…it can either set the volume and let the market determinethe price orit can set the price and let the market determine the volume

MD

RP

M s0

),( 0YRM D

0R

Option 1: Set Ms

and let marketdetermine R

Money supply with fixed Ms

Money supply with fixed ROption 2: Set Rand let marketdetermine Ms

The choice of monetary policy instrument.

If there is no uncertainty about the location of the LM and theIS curves, the two instruments can achieve equivalent outcomes.

Uncertainty because of business cycle shocks:

Real demand shocks: RGRiiTYtccYIS 1010 )1( :

nRLYLLPLM )(M : 210SNominal demand shocks:

uncertainty about the location of the IS curve.

uncertainty about the location of the LM curve.

1. Reaction time => fix a target based on expectations about shocks.2. The central bank can either use a money target or an interest rate target.3. Which of these instruments would cause the least fluctuations in output?

Y

eLMeIS

R

0R

eY

LM

LM

Monetary control Interest control

Y

eLMeIS

R

0R

eY

LM

LM

No income fluctuation

Income fluctuation

0 sM

R I Y

0RsM

0I 0Y

No transmission.

Transmission.

Nominal demand shocks

Y

eLMeIS

R

0R

eY

Monetary control

Small income fluctuations

IS

IS

Y

eLMeIS

R

0R

eY

Interest control

Large income fluctuations

IS

IS

0 sM

R I Y

but counter cyclically!

0RsM

0I Y

No counter cyclical crowding out of I.

Real demand shocks

but

Summary

• The “optimal” choice of monetary policy instrument (rule) depends on the source of business cycle fluctuations.

• If the business cycle is mainly driven by real demand shock (IS), then money supply control is better at reducing fluctuations.

• If the business cycle is mainly driven by nominal demand shocks (LM), then interest rate control is better at reducing fluctuations.

What is next?

• The great depression and the IS-LM model.

Effectiveness of monetary policy

Transmissionmechanism

Keynesian multiplier

Slope of IS

Slope of LM

2

1

L

i

)1(1

1

1 tc

1

1 )1(1

i

tc

2

1

L

L

small

large small

shallow steep

steep shallow

Effect Effective IneffectiveParameters

large

Feedbackeffect 1L small large