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					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 Policy
      Open market operation (OMO)


  Sell bonds                Buy bonds
               Central
                Bank
Retire money               Inject money
   R                                LM 0    LM 1


                      A
      R0
      R1                        C

                 A’                  IS 0

                  Y0       Y1
                                            Y
MS
          ESM   R
P
                          EDM        R
 R        I    Y
            Non-neutrality of Money
   The IS-LM model.          The classical model
                                              S (Y )  I ( R)

                            MS
                                L0  L1Y  L2 R
  G0             C0         P
                                      Y  F (L , K )
       I0             C                               MS
                           MS       P                   
                                                       P
            I

I  C  Y  G               Money are neutral
Money are non-neutral
     The Keynesian Transmission
            mechanism
               Money market                 Goods market
       MS                              i1
                       R                       I
       P           L2
                                R          I      MP

If L2= or i1=0, then                       Y
the transmission                 L1
mechanism fails.                                 Y
                            feedback
       small            large             effective
        L2     +          i1     =      transmission
  The Monetary Policy Multiplier

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


                 “The transmission mechanism”
                                        i1
 Y
                   
                                        L2
M S   IS LM          1  c1 (1  t )               L1i1
                                                      L2
                            simple multiplier
                                                 feedback
     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 policy.
• Monetary rules versus active monetary policy.
                Monetary policy
 1. Money supply control:

      The central bank increases/decreases cash
OMO = in circulation by buying/selling government
      bonds in the financial markets.
          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 market
         such that the market clears at the chosen interest rate
         (or within a chosen band).
Money versus interest control
The central bank is like a monopolistic firm facing a
downwards sloping demand curve, so…
it can either set the volume and let the market determine
the price or
it can set the price and let the market determine the volume
    R                     M s0
                                      Money supply with fixed Ms
                          P

                                              Money supply with fixed R
        Option 2: Set R
   R0   and let market
         determine Ms

                   Option 1: Set Ms
                    and let market
                     determine R          M D ( R, Y0 )
                                                    MD
R    M s0   Ms1


     P      P
R1

R0

                       M D ( R, Y1 )
                  M D ( R, Y0 )
                           MD
       The choice of monetary policy targets.
     If there is no uncertainty about the location of the LM and the
     IS curves, the two can achieve equivalent outcomes.
      Uncertainty because of business cycle shocks:
     Real demand shocks: IS : Y  c0  c1 (1  t )Y  T   i0  i1 R  G   R
         uncertainty about the location of the IS curve.

     Nominal demand shocks: LM : M S  P( L0  L1Y  L2 R)   n
         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 targets would cause the least fluctuations in output?
                            Nominal demand shocks
            Monetary control                           Interest control
R                        LM               R                         LM 
     IS e                       LM e            IS e                        LM e
                                   LM                                        LM 

R0                                         R0


                 Y   e                 Y                         e                 Y
                                                             Y
                                                          No income
               Income
                                                          fluctuation
             fluctuation
M s  0 Transmission.                          R  0    I  0     Y  0
 R           I          Y                 M s  No transmission.
                              Real demand shocks
             Monetary control                         Interest control
R            IS                         R            IS 
                              LM e                                    LM e
      IS e                                     IS e
     IS                                      IS 
R0                                       R0


                         e           Y                           e           Y
                     Y                                       Y
          Small income                                Large income
M s    0 fluctuations                                fluctuations

  R               I      Y              R  0    I  0 but Y 
                                              M s  No counter cyclical
but counter cyclically!
                                                     crowding out of I.
                 Summary

• The “optimal” choice of monetary policy 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
   Effect      Parameters        Effective   Ineffective

Transmission         i1
                                 large       small
mechanism            L2
Keynesian            1
multiplier     1  c1 (1  t )   large       small

Feedback
                     L1          small       large
effect
               1  c1 (1  t )
Slope of IS                      shallow     steep
                     i1
                    L1
Slope of LM                      steep       shallow
                    L2

				
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posted:2/10/2012
language:English
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