Economics essay
ECON 1110 Lecture Notes 7
ECON 1110 Intermediate Macroeconomics
James R. Maloy
Spring 2020
Lecture Notes for Topic 7: Keynesian Macroeconomics (III)
Readings: Froyen Ch. 7 (8th Ed. Ch. 8)
In this section, we will discuss the role of demand management in the Keynesian system, i.e. the use of fiscal/monetary policies to adjust aggregate demand and output. The overall goal of such policies in the Keynesian system is to stabilize output, employment and prices—i.e. keep AD stable—by counterbalancing any AD shifts (due primarily to volatile investment), thus eradicating the business cycle. Note that this is IS/LM analysis, which assumes prices are fixed—more on price volatility in a later topic.
I. Monetary Policy in the IS-LM Model
In the last topic we discussed factors that cause a shift in the LM curve—changes in money supply or money demand. Monetary policy is the manipulation of the money supply to change equilibrium income. Suppose the central bank wants to increase equilibrium income. They will increase the money supply (the methods and tools of the central bank will be discussed in the spring term), thus shifting the LM curve to the right. At the new equilibrium, output has increased and the interest rate has fallen.
How does monetary policy work? Why does increasing the money supply increase output? There is some disagreement about how monetary policy actually works. In the Keynesian system, monetary policy works through what is known as the indirect transmission process. In economic terms, the increase in the money supply creates an excess supply of money at the current interest rate, which causes the interest rate to fall. (Remember the money market analysis from the last chapter.) As the interest rate falls, investment will increase, and thus income will rise. The rise in income will boost consumption through the multiplier effect. Both of these factors will then boost the quantity of money demanded, since money demand is a positive function of income. At the new equilibrium, income is higher and interest rates are lower. This is where the new LM curve intersects the IS curve. Hence the indirect transmission process—changes in money yield changes in interest rates, which in turn cause changes in consumption, investment, and output. Monetary policy works indirectly via the interest rate.
A monetary contraction is a decrease in the money supply, and has the opposite effects.
II. Fiscal Policy in the IS-LM Model
Fiscal policy is the manipulation of government spending and taxes to change the level of equilibrium income. An increase in government spending and/or a decrease in taxes will shift the IS curve to the right, and a decrease in government spending and/or an increase in taxes will shift the IS curve left. For an expansionary government policy (G up and/or T down), a new equilibrium will be attained with increased output and higher interest rates.
The economic reason for this occurrence is also straightforward. Since government spending adds to aggregate demand (Y= C + I + G), an increase in government spending will place upward pressure on output. Likewise, a decrease in taxes will boost consumption. If the interest rate remains unchanged, output will increase by the amount of the expansion times the multiplier, just as in the simple Keynesian model from Topic 4. However, the simple Keynesian model did not include the money market. The increase in income from the fiscal expansion will increase the quantity of money demanded. As the quantity of money demanded increases, the interest rate will rise. The increase in the interest rate will in turn cause a decrease in investment. The decrease in investment will partially offset the fiscal expansion. Therefore, the equilibrium output is at a lower level than in the simple Keynesian model—there is partial crowding out because the increase in government spending drives up interest rates. Note that this result is between the two extremes of the Classical model and the simple Keynesian model. In the Classical model there was complete crowding out and the fiscal policy was useless. In the simple Keynesian model without the money market there was no crowding out at all. In the complete Keynesian model the fiscal policy is partially effective. Again, the new equilibrium occurs where the new IS curve intersects the LM curve.
III. Policy Effectiveness and the Slope of the IS Schedule
Recall that we calculated the slope of the IS schedule to be
1
i
b
1
Y
r
-
-
=
¶
¶
. Therefore, the higher the value of (1 – b), which you should recall is the marginal propensity to save (MPS), the steeper the IS curve. (Alternatively, you could say that the lower the value of the marginal propensity to consume, b, the steeper the IS curve.) Also, the lower the absolute value of the interest elasticity of investment (i1), the steeper the IS curve. A low value of b (i.e. a high value of 1 – b) and/or a low value of i1 will make a steep IS curve, and vice versa. The interest rate sensitivity of investment demand (i1) is the more interesting case, and is the source of much disagreement among economists over the slope of the IS curve.So what are the policy effects of having a steep IS curve because of low interest rate sensitivity of investment? Assuming a “normal” upward-sloping LM curve, we can easily show that fiscal policy will be relatively more effective than monetary policy in changing output. What is the economic intuition for this result? If investment is not very sensitive to changes in the interest rate, it will take a large change in interest rates to change investment. An increase in G, for example, will cause a rise in the interest rate, but since investment is not sensitive to this change, the increase in interest rates will not cause a large fall in investment—there is very little crowding out. Therefore, fiscal policy is very effective. Monetary policy, remember, works by influencing investment via the interest rate, but since investment is not very sensitive to the interest rate, monetary policy will not work very well.
Conversely for a flat IS curve, due to high interest rate sensitivity of investment, monetary policy will be relatively more effective than fiscal policy, for the exact opposite reason as the low interest rate elasticity case. These results can easily be viewed graphically. It is also possible to demonstrate this mathematically. The homework will show some examples of economies with different values of i1 and b, and your assignment will be to calculate the effect of monetary and fiscal policies for these economies using the same procedures from the previous homework. Consult the appendix to chapter 7 if you need help on this before the seminars.
IV. Policy Effectiveness and the Slope of the LM Schedule
Recall that we calculated the slope of the LM schedule to be
2
1
c
c
Y
r
=
¶
¶
. Therefore, the higher the value of c1, (the increase in money demand from an increase in income, i.e. the percentage of income that is demanded as money), the steeper the LM curve. Likewise, the lower the value of c2, (the interest elasticity of money demand), the steeper the LM curve, and vice versa. Again, the more interesting case is the interest rate sensitivity of money demand, c2. Keynesians typically believe that c2 is relatively high and thus the LM curve is relatively flat.The policy implications for LM curves of different slopes can be seen graphically. For a flat LM curve, we can easily see that fiscal policy will be relatively more effective than monetary policy for changing equilibrium output. Why?
If there is an expansionary fiscal policy, for example an increase in G, output will increase, thus boosting transactions demand for money and throwing the money market out of equilibrium at the current interest rate (more money demanded, same quantity of money). Interest rates will therefore rise. If money demand is very sensitive to changes in the interest rate, it will not take much an increase in interest rates to restore equilibrium (very small change in interest rates will cause a big change in money demand and thus equilibrium quickly restored). Since interest rates only rise by a small amount, there is not much crowding out and the policy is very effective.
Monetary policy with a flat LM curve will not be very effective because the increase in the money supply will only yield a small fall in interest rates (again, it only takes a small change in interest rates to cause money demand to match the larger money supply). Since interest rates only fall a little, there will not be much increase in investment and thus only a small change in output.
Conversely, monetary policy will be relatively more effective than fiscal policy for a steep LM curve. Keynesians typically believe the previous case to be true, i.e. fiscal policy more effective.
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