The IS-LM model
• Active monetary policy in the IS-LM
• Monetary rules: money versus interest
Open market operation (OMO)
Sell bonds Buy bonds
Retire money Inject money
R LM 0 LM 1
A’ IS 0
R I Y
Non-neutrality of Money
The IS-LM model. The classical model
S (Y ) I ( R)
L0 L1Y L2 R
G0 C0 P
Y F (L , K )
I0 C MS
I C Y G Money are neutral
Money are non-neutral
The Keynesian Transmission
Money market Goods market
R I MP
If L2= or i1=0, then Y
the transmission L1
mechanism fails. Y
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”
M S IS LM 1 c1 (1 t ) L1i1
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.
• 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
• 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.
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
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
Money supply with fixed R
Option 2: Set R
R0 and let market
Option 1: Set Ms
and let market
determine R M D ( R, Y0 )
R M s0 Ms1
M D ( R, Y1 )
M D ( R, Y0 )
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
Y e Y e Y
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
e Y e 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.
• The “optimal” choice of monetary policy rule
depends on the source of business cycle
• 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
Effectiveness of monetary policy
Effect Parameters Effective Ineffective
multiplier 1 c1 (1 t ) large small
L1 small large
1 c1 (1 t )
Slope of IS shallow steep
Slope of LM steep shallow