Monetary and Fiscal Policy in the Very Short Run

CHAPTER 12

MONETARY AND FISCAL POLICY IN THE VERY SHORT RUN

Chapter Outline

Monetary Policy
Is There a Situation Where Monetary Policy Cannot Lower Interest Rates?

The Case of the Liquidity Trap

Can the LM Curve Be Vertical? Classical Economics Again
Fiscal Policy and Crowding Out
An Increase n Government Spending
Crowding Out
Is Crowding Out Important?
Monetary Policy and the Interest Rate Rule
Money Supply Rule and Interest Rate Rule:

When Would Policymakers Choose one over the Other?

Goods Market Shocks Only
Money Market Shocks Only
Working With Data

Changes from the Previous Edition

This chapter has been almost completely rewritten. We have introduced the liquidity trap in a modern perspective and related this to recent events in the United States and Japan. We have also modernized the section on the vertical LM curve and related it to the Classical model where it belongs. The fiscal policy section has been rewritten and now follows a much more logical order. There is a new section on conducting monetary policy according to an interest rate rule, and this policy stance is compared to the money supply rule, in what could be termed an accessible “Poole” exercise.

Learning Objectives

Students should understand the dynamics of adjustment in the IS-LM model following a fiscal or monetary policy change.
Students should understand that the U.S. and Japanese economies have been described as being in a liquidity trap in the recent past
Students should understand that a vertical LM curve implies a Classical model
Students should understand the concept of crowding out.
Students should be aware that crowding out is a matter of degree. In the IS-LM model, that degree depends on the slopes of the IS- and LM-curves.
Students should be aware of the limitations of the static, short-run nature of the IS-LM model.
Students should understand how monetary policy can be conducted according to an interest rate rule or according to a money supply rule, and the situations under which one may be superior to the other.

Accomplishing the Objectives

We begin by discussing monetary policy in both comparative statics and dynamic frameworks. The adjustment path of the economy after a money shock (see Figure 12-2) is that interest rates change while income and output remain constant, and subsequently both income and interest rates increase. Here, the money market is always in equilibrium, while the goods market can be out of equilibrium. These adjustment assumptions mimic real world observations.

Two extreme cases in the operation of monetary policy are given special attention. Monetary policy is powerless to affect interest rates (and thus the economy) in the liquidity trap (represented by a horizontal LM-curve). The polar opposite is the Classical case (represented by a vertical LM-curve), in which a given change in money supply cannot effect the level of real income.

The effectiveness of expansionary fiscal policy depends on the amount of crowding out that takes place, that is, on the reduction in private spending (most notably investment) caused by rising interest rates following fiscal expansion, and the extent of the crowding-out effect depends on the slopes of the IS- and LM-curves. The flatter the IS-curve and the steeper the LM-curve, the larger the crowding-out effect. The factors that determine the slopes of the IS- and LM-curves have already been discussed in the previous chapter. Of course, crowding out can be avoided by coordinating monetary and fiscal policy. This is illustrated in Figure 12-5.

Since different monetary and fiscal policy mixes vary in their effects on the different sectors of the economy, actual policy choices are often determined by political preferences. Liberals often favor increases in government spending on education, job training, or the environment, while conservatives tend to favor tax cuts. Those advocating rapid economic growth favor investment subsidies and lower interest rates.

We finish this chapter with a discussion of monetary policy conducted according to an interest rate rule. This is especially relevant in today’s policy environment in both Canada and the U.S. In Canada we now have fixed announcement dates for changes in the Bank rate, so monetary policy is well described as running an interest rate rule. Students will find the section on comparing an interest rate rule to a money supply rule very interesting, as this can be cast in terms of policy intervention (interest rate rule) vs. no policy intervention (money supply rule).

Suggestions and Pitfalls

Students should be asked to work out several examples of either fiscal or monetary policy changes, both graphically and with a written explanation of the adjustment processes that take place. In doing these exercises, students should ask themselves the following three questions:

Which sector is involved, the expenditure sector or the money sector? This will tell them which curve will shift, the IS-curve or the LM-curve.
Will the policy change lead to an increase or decrease in national income? This will tell them whether the respective curve will shift to the right or left.
Is it a parallel shift (caused by a change in autonomous spending or nominal money supply) or is it a change in the slope?The only policy change discussed here that could cause a change in slope is a change in the marginal income tax rate (t), which would change the size of the expenditure multiplier () and therefore the slope of the IS-curve.

The following simplified description of the adjustment process in response to an increase in government purchases (G) may be used:

G up ==> Y up ==> the IS-curve shifts right ==> md up ==> i up ==> I down ==> Y down.

Effect: Y goes up, i goes up.

IS2

i IS1 LM

Y1 Y2 Y

The following simplified description of the adjustment process following an increase in real money supply may be used:

ms up ==> i down ==> I up ==> Y up ==> the LM-curve shifts right ==> md up ==> i up.

Effect: Y goes up, i goes down.

i IS LM1

LM2

Y1 Y2 Y

When these simplified adjustment processes above are presented to students, they are often confused. In order to help students get over his confusion, you may want to explain the difference between comparative statics and dynamics. In terms of the above diagrams, the comparative statics are fairly simple:

An increase in government spending will increase booth the interest rate and income.
An increase in the money supply will lower the interest rate and increase income.

In order to discuss the dynamics, we need to impose an adjustment assumption: the money market always clears quickly while the goods market clears slowly. In terms of the above diagrams, for the fiscal policy adjustment, the movement is always along the LM curve. For the monetary adjustment, the economy follows the path given in Figure 12-2 in the text.

Discussing actual events with which students should be at least somewhat familiar always makes the theoretical material come to life and gets students to participate more actively in class. The IS/LM model is a perfect model for discussing the policy interventions surrounding the events of September, 2001. In both Canada and the U.S., monetary policy became quite expansionary, so interest rates went down. In Canada, this had the desired effect, as output went up. However, in the U.S. output did not immediately respond. Consumer confidence may have been so badly shaken, that this IS curve could have been (temporarily) vertical. In this case it would not matter how low interest rates were, output just would not respond. Of course, this also leads to a discussion of the possibility that the U.S. was in a liquidity trap at that time.

When discussing monetary accommodation of expansionary fiscal policy, the following point should be made: Within an IS-LM framework, that is, as long as prices are assumed to be fixed, the Bank of Canada can prevent crowding out fairly easily by expanding money supply. However, as soon as prices are allowed to vary, such policy may lead to a higher price level. In this case, crowding out cannot be avoided since a higher price level implies lower real money balances, which provide upward pressure on interest rates.

It is also important that students understand why fiscal policy has a much smaller multiplier effect in the IS-LM model than in the simple Keynesian model of income determination that was presented in Chapter 10. In the IS-LM framework, the extent of crowding out clearly depends on the slopes of the IS- and LM-curves. Even though the factors determining these slopes are covered in Chapter 11, it may be beneficial to mention them here again. Instructors also may want to assign both Chapter 11 and Chapter 12, simultaneously, since Chapter 11 lays the theoretical framework for the IS-LM model, while Chapter 12 provides its practical application.

Students will find that Section 12-3 on the interest rate rule is very relevant. Monetary policy in both Canada and the U.S. could be accurately described as following an interest rate rule. It is important to point out the meaning of two different horizontal LM curves: for a liquidity trap, monetary policy cannot affect the economy; for an interest rate rule, policy has chosen to make the LM curve horizontal, and could just as easily choose another interest rate. Therefore, in the case of a horizontal LM curve due to an interest rate rule, monetary policy is very effective.

Students will also find that the discussion of a money supply rule vs. an interest rate rule is very relevant. This discussion can always be cast in terms of a “no intervention policy” (money supply rule) vs. a “complete intervention policy” (interest rate rule). This could lead to interesting discussion concerning the role of monetary policy in the short run.

SolutionstotheProblemsintheTextbook:

Discussion Questions:

1.Technically, although it is difficult to show this at this level, the optimal policy will depend on the relative slopes of the IS and LM curves. However, the general results could be applied here: if the shocks to the goods market are relatively bigger, then a money supply rule is superior; if the shocks to the money market are larger then an inters rate rule is superior. The better students may point out that if you really do not know, then a policy where there is minimal intervention (money supply rule) is probably the safest policy.

2.The IS-curve is vertical, if investment spending is totally interest insensitive. This is called investment insufficiency; in this case the monetary multiplier is zero. Since the parameter b in the investment equation equals zero, the equation changes from

I = Io - bi to I = Io.

A horizontal LM-curve will also render monetary policy ineffective. This is called the liquidity trap. In this case, money demand is totally interest elastic, and the parameter h in the money demand equation is assumed to be infinitely large.

The fiscal policy multiplier is zero if the LM-curve is vertical. This case is called the classical case, and money demand (and money supply) is assumed to be totally interest insensitive. Since the parameter h in the money demand equation equals zero, the equation changes from

L = kY - hi to L = kY.

None of these three cases is very likely to occur. However, some economists assert that Japan in the late 1990’s and Canada in the Great Depression were in, or close to, the liquidity trap.

3. A liquidity trap is a situation in which the public is willing to hold, at a given interest rate, as much money as the Bank of Canada is willing to supply. In this case, the LM-curve is horizontal and monetary policy is totally ineffective. Fiscal policy (which will shift the IS-curve) is clearly the better choice to stimulate the economy in such a situation, since no crowding out will occur. This means that fiscal policy will have its maximum effect.

4.Crowding out occurs when an increase in government spending raises interest rates, which reduces private spending (especially investment). For example, an increase in government purchases (G) will increase income (Y) and therefore consumption (C); but because the interest rate (i) will increase, the level of investment spending (I), and most likely also net exports (NX), will decrease, changing the composition of GDP. Some degree of crowding out will always occur as long as the LM-curve is upward sloping, that is, in all cases except the liquidity trap. The steeper the LM-curve is, the greater the degree of crowding out. This implies that if the LM-curve is steep monetary policy will be more effective than fiscal policy in stimulating national income.

5.In this case, the LM-curve is vertical. Money demand and money supply would be completely interest inelastic. The Keynesian IS/LM model is probably inappropriate for discussing this case. It is hard to see how you can have a sensible equilibrium with two vertical curves. In a Classical model, fiscal policy would only change the allocation of income, and monetary policy would only change the price level.

Assume the government finances an increase in government spending by borrowing from the public (the Treasury sells government bonds to finance the increase in the budget deficit). The increase in the demand for credit by the government will lead to an increase in interest rates. If the Bank of Canada is worried about high interest rates, it may monetize the budget deficit, that is, buy the government bonds that the public now holds. This will inject money into the economy, and interest rates will drop again, so no crowding out of private spending may occur, at least in the short run.

In an IS-LM model, the expansionary fiscal policy will shift the IS-curve to the right, while the Bank of Canada’s action will shift the LM-curve to the right. This means that the AD-curve will shift further to the right than would have been the case if the Bank of Canada had not accommodated the expansionary fiscal policy. But this causes more upward pressure on the price level. In a recession, when there is little inflationary pressure, such a fiscal/monetary policy mix may be beneficial and cause only a small increase in the price level. However, if the economy is close to full employment, then we can expect a significant increase in the price level. In the long run, when the AS-curve is vertical, there will be total crowding out, whether the Bank of Canada monetizes the increase in the budget deficit or not.

7.A combination of restrictive fiscal policy and expansionary monetary policy will not significantly affect aggregate demand or income, and neither will expansionary fiscal policy combined with restrictive monetary policy. However, the first policy mix will decrease interest rates, while the latter will increase interest rates. Therefore the composition of output will be different in each case.

The first combination will shift the IS-curve to the left and the LM-curve to the right, in which case income will remain roughly the same while interest rates will be reduced. A tax increase will lower consumption while increasing investment spending due to lower interest rates. The second combination will shift the IS-curve to the right and the LM-curve to the left, leaving income roughly the same, while increasing interest rates. This will decrease the level of investment spending, while either government spending or consumption (through a tax cut) will increase.

Other considerations may involve the effect of a given policy mix on the budget surplus and the value of the dollar (and therefore net exports). The first policy mix will increase the budget surplus. Lower interest rates may also lead to an outflow of funds, which will lower the value of the dollar, leading to an increase in net exports. The second policy mix will decrease the budget surplus. Higher interest rates may lead to an inflow of funds, which will increase the value of the dollar, leading to a decrease in net exports.

Application Questions:

1.If the government wants to change the composition of GDP towards investment and away from consumption without changing the level of aggregate demand, it needs to implement a combination of restrictive fiscal policy and expansionary monetary policy. An increase in personal income taxes or a decrease in transfer payments will reduce consumption and thus aggregate demand. The IS-curve will shift to the left, leading to a decrease in the level of output and the interest rate. To increase output to its original level, the Bank of Canada can undertake expansionary monetary policy. This will shift the LM-curve to the right, leading to a further decrease in the interest rate, thus stimulating investment, and, in turn, aggregate demand. If the intersection of the new IS- and LM-curves is at the same income level as previously, then the decrease in the interest rate will have stimulated investment spending sufficiently to exactly offset the decrease in consumption. (Note: The tax increase can be combined with an investment subsidy. In this case, the IS-curve will not shift as far to the left as before.)

The following diagram shows the effect of a decrease in transfer payments (TR) that is combined with an increase in money supply (M/P). The adjustment process is as follows:

1-->2: TR ==> C  ==> Y == md ==> i  ==> I  ==> Y . Effect: Y  and i .

2-->3: (M/P) up ==> i  ==> I  ==> Y  ==> md ==> i  Effect: Y  and i .

Combined effect: Y about the same and i .