Question

1. Using IS and LM graphs, explain

PLEASE USE GRAPHS!!!!

1. Monetary policy which targets the interest rate
2. Monetary policy which targets the money supply
3. When each of the two targeting strategies are the most effective in managing the business cycle

Answer 1

USING IS AND LM GRAPHS:

The IS-LM model, which stands for "investment-savings, liquidity-money," is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph in which the IS and LM curve intersect to show the short-run equilibrium between interest rates and output. The three critical exogenous variables in the IS-LM model are liquidity, investment, and consumption. According to the theory, liquidity is determined by the size and velocity of the money supply. The levels of investing and consumption are determined by the marginal decisions of individual actors. The IS-LM graph examines the relationship between real output, or GDP, and nominal interest rates. The entire economy is boiled down to just two markets, output and money, and their respective supply and demand characteristics push the economy towards an equilibrium point. This is sometimes referred to as "the Keynesian Cross."

Characteristics of the IS-LM Graph

In the IS-LM graph, the IS curve slopes downward and to the right. This assumes the level of investment and consumption is negatively correlated with the interest rate, but positively correlated with gross output. By contrast, the LM curve slopes upward suggesting the quantity of money demanded is positively correlated with an interest rate and with an increase in total spending or income. Gross domestic product (GDP), or (Y), is placed on the horizontal axis, increasing as it stretches to the right. The nominal interest rate, or (i or R), makes up the vertical axis. Multiple scenarios or points in time may be represented by adding additional IS and LM curves. In some versions of the graph, curves display limited convexity or concavity.

a) Using the IS-LM graph, a monetary policy which targets the interest rate:

Policy Makers (IMF, US Treasury) can use the IS-LM model to determine what happens to interest rates and output when they increase/decrease the money supply. Before we continue, we look at factors that cause the IS and LM curves to shift.

Factors that cause the IS curve to shift.

• A change in the interest rate or aggregate output will cause a movement along the IS curve. Changes that cause the expenditure function to shift cause the IS curve to shift.
• Changes in autonomous consumption e.g. increase in confidence about the economy, changes in wealth, etc.
• Changes in investment spending (unrelated to the interest rate) e.g. increase in business confidence, changes in technology, etc.
• Changes in government spending.
• Changes in taxes.
• Changes in Net Exports (unrelated to the interest rate) e.g. changes in taste, trade policy, etc.

An increase in G, I, NX, and a shifts the expenditure YAD function up. For a given interest rate, i1, the IS curve shifts
to the right Æ increase in equilibrium income.

Please see the graph.

An increase in T shifts the expenditure YAD function down. For a given interest rate, i1, the IS curve shifts to the leftÆ decrease in equilibrium income.

Please see the graph.

Factors that cause the LM curve to shift.

A change in the interest rate or aggregate output will cause a movement along the LM curve. Changes that cause the MD or MS curves to shift cause the LM curve to shift. When the money supply decreases, the LM curve shifts left for a given income,Y1. When the money supply falls, MS<MD. People sell bonds, price of bond falls, and interest rate increases. Since output does not change, the LM curve must shift to the left as the interest rate rises to satisfy money market equilibrium.

Please see graph.

Equilibrium in action:

Monetary Policy:

Suppose, MD increases or MS decreases, Æ LM curve shifts, left Æ XSD money, Æ sell bonds Æ interest rate increases. As i increases Æ I and NX falls Æ move along ISÆ fall in Y. Overall impact, interest rate rises and output
falls.

Monetary Policy in practice and the ISLM model

B) Targeting Interest Rates vs Targeting the Money Supply

Please see the graph.

When the government targets the money supply, interest rates fluctuate and when money demand fluctuates. When the government target interest rates, money supply shifts to accommodate fluctuations in money demand. The money supply fluctuates.

Interest rate targeting causes more dramatic fluctuations in output when the information about the IS curve is uncertain compared to Money Supply targeting.

If the IS curve shifts around due to uncertainty Æ the LM curve must shift to keep interest rates unchanged so output fluctuates from Y’i to Y”i. When the Fed target money, output fluctuates from Y’m to Y”m.

Please see the graph.

Interest rate targeting causes fewer fluctuations in output when the information about the LM curve is uncertain. Output fluctuates from Y3 to Y2 under money targeting.

Please see the graph.

C) Two targeting strategies are the most effective in managing the business cycle:

IS-LM in the LR and Money Neutrality:

As far, we have assumed that the price level is fixed so that nominal and real values are the same. Recall, Classical economists believe that output settles at the natural rate of output, Yn, which is that level of output when prices are neither rising nor falling. What happens to the effects of monetary policy in the LR?

Please see the graph.

When M increases, AD increases (Y>Yn) causing inflationary pressures, the price level increase. The real money supply gradually declines to the original value therefore the real money supply is unchanged. In the LR, money is neutralÆ, it has no real effects.

IS-LM and the AD Curve:

We saw earlier that the AD curve could be derived from the Keynesian cross. The AD curve can also be derived from the IS-LM model by allowing the price level to vary. As the price level increases from P0 to P2,the real money supply falls causing the LM curve to shift left. As the real money supply falls, output falls. Recall, the AD curve shows the relationship between output demanded and the price level. We can use this information to trace out the AD curve. The AD curve is downward sloping.

Please see the graph.

Therefore imagine a fixed IS curve and an LM curve shifting hard left due to increases in the price level. As prices increase, Y falls and i rises. Now plot that outcome on a new graph, where aggregate output Y remains on the horizontal axis, but the vertical axis is replaced by the price level P. The resulting curve, called the aggregate demand (AD) curve, will slope downward, as below. The AD curve is a very powerful tool because it indicates the points at which equilibrium is achieved in the markets for goods and money at a given price level. It slopes downward because a high price level, means a small real money supply, high interest rates, and a low level of output, while a low price level, all else constant, is consistent, with a larger real money supply, low interest rates, and kicking output.