C H A P T E R

12
MONETARY AND FISCAL
POLICY IN THE VERY
SHORT RUN
LEARNING OBJECTIVES
After reading and studying this chapter, you should be able to:
 Understand that both fiscal and monetary policy can be used
to stabilize the economy in the short run.
 Understand that the output effect of expansionary fiscal policy
is reduced by crowding out: Increased government spending
increases interest rates, reducing investment and partially
offsetting the initial expansion in aggregate demand.
 Understand that the slope of the LM curve has an important
bearing on the effectiveness of fiscal and monetary policy.

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here are many interesting examples of the effects of monetary and fiscal
policy on the economy. For example, the long period of deficit-financed
expansionary fiscal policy that started in the early 1970s contributed to
strong GDP growth. We have previously discussed the severe recessions of
the early 1980s and 1990s, when monetary policy makers chose to raise interest rates
and the economy went into a downturn.
Figure 12-1 illustrates one of the most recent responses of the economy to monetary policy intervention. In 1997 and 1998, real GDP was growing at an average
annual rate of approximately 4 percent. The governor of the Bank of Canada considered this growth to be to be excessively strong and, therefore, began to slowly raise
interest rates. Notice in Figure 12-1 how, by the beginning of 2001, output growth
began to slow in response to these interest rate increases. However, after the events of
September 11, 2001, output fell dramatically. In response to this, interest rates were
lowered in an equally dramatic fashion. The result was a strong rebound in output
growth in early 2002.
In this chapter we use the IS-LM model developed in Chapter 11 to show how
monetary policy and fiscal policy work. These are the two main macroeconomic
policy tools the government can call on to try to keep the economy growing at a reasonable rate, with low inflation. They are also the policy tools the government uses
to try to shorten recessions, as in 1991, and to prevent booms from getting out of
hand. Generally speaking, fiscal policy has its initial impact in the goods market, and
monetary policy has its initial impact mainly in the assets markets. However, because
the goods and assets markets are closely interconnected, both monetary and fiscal
policies have effects on both the level of output and interest rates.
Figure 12-2 will refresh your memory about our basic framework. The IS curve
represents equilibrium in the goods market. The LM curve represents equilibrium in
the money market. The intersection of the two curves determines output and interest
rates in the very short run, that is, for a given price level. Expansionary monetary
policy moves the LM curve to the right, raising income and lowering interest rates.

FIGURE 12-1

90-DAY TREASURY BILL RATE AND REAL GDP GROWTH, QUARTERLY, 19972002

Between 1997 and

2001, monetary policy
raised interest rates in
order to slow output
growth. However, after
the events of September
11, 2001, monetary
policy was forced to
lower interest rates to
prevent output from
falling further.

SOURCE: Treasury bill: CANSIM II V122484; real GDP: CANSIM II V1992259..

CHAPTER 12

Monetary and Fiscal Policy in the Very Short Run

235

Contractionary monetary policy moves the LM curve to the left, lowering income
and raising interest rates. Expansionary fiscal policy moves the IS curve to the right,
raising both income and interest rates. Contractionary fiscal policy moves the IS
curve to the left, lowering both income and interest rates.

12-1 MONETARY POLICY

monetary policy
Any choice made by the
Bank of Canada
concerning the level of the
nominal money stock.

www.bankofcanada.ca/en/
monetary/index.htm

FIGURE 12-2
An increase in the real
money stock shifts the
LM curve to the right.

For the purposes of this chapter, monetary policy will be defined as any choice made
by the Bank of Canada concerning the level of the nominal money stock. Figure 12-2
describes the case of expansionary monetary policy, which is defined as an increase
in the nominal money stock.
The initial equilibrium is at point E, which corresponds to a real money supply

of M /P . Expansionary monetary policy, which increases the nominal money stock,
also increases the real money stock, as we assume that the price level is fixed, and
shifts the LM curve outward to LM. The new equilibrium is at point E, with a
lower interest rate and a higher level of income. This is exactly the result shown in
Figure 11-10(b) in Chapter 11.
Simply comparing the new equilibrium to the old (which is technically
called comparative statics) hides the more interesting story concerning the adjustment path of the economy while it is in transition to the new equilibrium. In order
to understand the dynamic adjustment, we make an important assumption: The
money market adjusts very rapidly, while the goods market adjusts less quickly. This
assumption actually is consistent with observed behaviour of the economy over the
very short run. We often observe a change of interest rates engineered by the Bank of

MONETARY POLICY

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PART 4

The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity

Canada, which is followed, after some time lag, by a change in real economic activity.
Now consider the adjustment path to the new equilibrium in Figure 12-2.
Because the money market is assumed to adjust rapidly, the initial response of the
economy is to move to point E1, where the interest rate is lower but output has not
yet changed. At point E1, the money market is in equilibrium (the economy is on the
new LM curve) but the goods market is not in equilibrium. In the goods market, the
new interest rate, given the existing level of income, Y0, is too low for equilibrium, so
the economy is not on the IS curve. Given the decrease in the interest rate, there is
now excess demand for goods, so output starts to increase.
In this very short run model, whenever there is adjustment, there will be feedback between the goods and money markets. Notice that as income and output
increase, the demand for money increases, which causes interest rates to increase, so
the economy moves along the LM curve toward the new equilibrium at E.
Therefore, the adjustment path of the economy in response to an increase in
the money stock is for interest rates to first decrease, while income and output
remain constant. After the interest rate decreases, output begins to increase in
response to the interest rate change. While on the path from E1 to E, output is
increasing and interest rates must also increase.
It is important to understand that the adjustment of the economy as a result of
this monetary policy change is dependent on two general responses. First, monetary
policy must have the ability to lower interest rates. The fact that the interest rate
decreases to i initially is one measure of the effectiveness of monetary policy in the
very short run. Remember from Chapter 11 that (ceteris peribus) the flatter the LM
curve, the smaller the interest rate change will be. Second, the ability of monetary
policy to change real output in the very short run depends on the interest rate
response in the IS curve. It is fairly easy to see from Figure 12-2 that for any given LM
shift, output will change more if the IS curve is flatter and less if the IS curve is
steeper.

Is There a Situation When Monetary Policy Cannot Lower

Interest Rates? The Case of the Liquidity Trap

liquidity trap
A situation that arises
when the LM curve is
horizontal because the
interest elasticity of
money demand is infinite.

Consider the situation where the interest elasticity of money demand, h, is infinite.
Given that we know that the slope of the LM curve is given by the ratio k/h, when h
is infinite, the LM curve is horizontal. Remember that the slope of the money
demand curve is given by 1/h, so in this situation, the money demand curve is also
horizontal. Therefore, when h is infinite, monetary policy cannot shift the LM curve.
Put another way, monetary policy has no ability to lower interest rates.
The situation described above is the famous liquidity trap. The idea of a liquidity trap arose from the theories of John Maynard Keynes. Keynes himself stated
that he was not aware of any practical situation in which the economy would be in a
liquidity trap. Technically, a liquidity trap would exist at zero nominal interest rate,
and this is something that we do not observe.
Given the above discussion, the liquidity trap remained a theoretical curiosity
for many years, and was included in textbooks only as a technical exercise, without
much real-world appeal. However, a series of events over the past several years has
led economists to revive a form of the liquidity trap. In the 1990s, the Japanese
economy, which was once one of the most powerful in the world, began to show signs
of serious trouble. There were many policy responses to this slowdown, but one of

CHAPTER 12

Monetary and Fiscal Policy in the Very Short Run

237

the most interesting was the intervention on the part of the Japanese central bank,
which aggressively lowered Japanese interest rates in an attempt to stimulate the
economy, much along the lines depicted in Figure 12-2.
However, the intervention did not produce the desired result because, even
though the Japanese central bank was successful in lowering interest rates, output did
not respond. In Figure 12-2, we would explain this as a very steep, or vertical, IS
curve. In spite of this lack of success, the Japanese central bank continued to put
downward pressure on interest rates. The failure of this policy promoted The
Economist to publish an article entitled Is Japan in a Liquidity Trap?
After this series of events, the concept of a liquidity trap took on a new realworld meaning: An economy is sometimes said to be in a liquidity trap when interest
rates are so low that a central bank has no scope to lower them further. Notice that
this is somewhat different than the technical condition for a liquidity trap outlined
above. One important difference is that in the modern version of a liquidity trap, the
central bank can raise interest rates, something that cannot be done in the earlier
technical version of a liquidity trap. For another important event that gave rise to the
question of a liquidity trap, see the following Policy in Action feature.

The level of aggregate supply is the amount of output the economy can
produce given the resources and technology available.

The Liquidity
Trapsupply
in Canada
and theprice
United
States
The aggregate
tradeoff between
and output
represents
firms
In this
chapter,to we
discussed
how the
liquidity
trap
taken
decisions
raise
or lower prices
when
demand
for has
output
riseson
or new
falls.
meaning in modern macroeconomics, describing a situation in which mone policy
The level
of like
aggregate
demand
the total
demand
tary
would
to lower
interestisrates
but may
havefor
no goods
scope to
to condo so.
After the events of September 11, 2001, there was a general fear that the
economies of Canada and the United States would slip into a severe recession. In response to this, the Bank of Canada and the Federal Reserve Board
very quickly began lowering interest rates. In a short period of time, interest
rates in each country were at a 40-year low. The hope was that this sudden
large drop in interest rates would stimulate output. This immediately gave
rise to the question of whether interest rates were low enough to generate
some growth on the output side, and if not, could monetary policy lower
interest rates any further. That is, were the two economies each in a liquidity
trap?
In Canada, the lowering of interest rates had the desired effect, as output
growth rebounded strongly in the first quarter of 2002. However, in the
United States, output growth remained sluggish and there was talk of the
U.S. economy entering a period of deflation, when prices would be falling. Of
course, this led to more calls for a lowering of interest rates in the United
States and more talk of the U.S. economy experiencing a liquidity trap.

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The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity

Can the LM Curve Be Vertical? Classical Economics Again

Can the LM curve be vertical? The answer to this question is that, technically, the LM
curve could be vertical if either the interest elasticity of money demand is zero or the
income elasticity of money demand is infinite. We can dismiss the latter of these two
possibilities immediately.1 The interest elasticity of money demand could possibly be
zero but, in this case, the money demand curve would be vertical and the money
supply curve would also be vertical, as depicted in Figure 12-3. Therefore, there would
either be no equilibrium, as shown in Figure 12-3, or an infinite number of equilibria
in the special case where the money demand and money supply curves coincide.
Neither of these cases is very appealing from an economic modelling point of view.
That is, if the interest elasticity of money demand is zero, then there is no manner in
which to determine the equilibrium interest rate in the money market, which leaves
the model with no sensible role for the interest rate in the very short run.

FIGURE 12-3

THE MONEY MARKET WHEN h = 0

When the interest elasticity of money demand

(h) is zero, the money
demand curve is vertical.
Since the money supply
curve is also vertical,
there is either no equilibrium (as shown here)
or an infinite number of
equilibria if the money
demand and money
supply are superimposed.

It is helpful to think of this problem in terms of markets and prices. The money
market, like any other market, has a price that coordinates supply and demand. In the
long run Classical model studied in Chapter 3, the quantity theory of money was
assumed to hold. In that model, if there was, for instance, an increase in the nominal
money stock, then the price level would increase. Therefore, the price of money was
assumed to be (the inverse of) the general price level.2 When we moved to the
Keynesian IS-LM model in this chapter, we assumed that the price level was fixed
and, therefore, the quantity theory of money could not hold. In the Keynesian IS-LM
income elasticity of money demand is relevant only over a range of 0 < k 1. See Chapter 16 for a
discussion of this point.

1 The

2 It

may be helpful to have another look at Box 11-3 in Chapter 11.

CHAPTER 12

Monetary and Fiscal Policy in the Very Short Run

239

model, the price of money is assumed to be the nominal interest rate. Now, if we
assume that the interest elasticity of money demand is zero, then the interest rate is
no longer the price of money.
In any event, the above theoretical discussion notwithstanding, it is fairly clear
that, empirically, the nominal interest rate plays a prominent role in money market
adjustment in the very short run, and removing it by assuming that the interest elasticity of money demand is zero would remove our ability to explain very short run
movements in the economy.

BOX

12-1

A Classical IS-LM Model

In this chapter, we have discussed the situation in which the interest elasticity of
money demand is zero. In this situation, monetary policy can no longer work through
the interest rate channel to affect output in the usual manner described in this chapter.
Instead, the money market is actually a Classical money market, which behaves
according to the quantity theory of money. This situation gives rise to the Classical ISLM model shown in the figure below.

Notice that in the Classical IS-LM model, the price level is on the horizontal axis,
not real income. This is because in a Classical world, the money market determines the
price level. On the vertical axis is the real interest rate, which is the important interest
rate in a Classical model. In the Classical model, the real interest rate is determined
by the interaction of savings and investment, and this is exogenous to the money
market. Therefore, the Classical IS-LM model, although logically correct, does not really
tell us much. We are asking about the relationship between the real rate of interest and
the nominal price level, and in a Classical model, these two variables are not related to
each other.

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The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity

12-2 FISCAL POLICY AND CROWDING OUT

www.fin.gc.ca/access/
ecfisce.html

This section shows how changes in fiscal policy shift the IS curve, the curve that
describes equilibrium in the goods market. Recall that the IS curve slopes downward
because a decrease in the interest rate increases investment spending, thereby
increasing aggregate demand and the level of output at which the goods market is in
equilibrium. Recall also that changes in fiscal policy shift the IS curve. Specifically, a
fiscal expansion shifts the IS curve to the right.
The equation of the IS curve, derived in Chapter 11, is repeated here for convenience:
1
Y  G(A1 bi)
G  
(1)
1  c (1  t)
Note that G
, the level of government spending, is a component of autonomous
spending, A1, in equation (1). The income tax rate, t, is part of the multiplier. Thus,
both government spending and the tax rate affect the IS schedule.

An Increase in Government Spending

We now show, in Figure 12-4, how a fiscal expansion raises equilibrium income and
the interest rate. At unchanged interest rates, higher levels of government spending
increase the level of aggregate demand. To meet the increased demand for goods,
output must rise. In Figure 12-4, we show the effect of a shift in the IS schedule. At
each level of the interest rate, equilibrium income must rise by G times the increase
in government spending. For example, if government spending rises by 100 and the
multiplier is 2, equilibrium income must increase by 200 at each level of the interest
rate. Thus, the IS schedule shifts to the right by 200.
If the economy is initially in equilibrium at point E and government spending
rises by 100, we would move to point E if the interest rate stayed constant. At E, the
goods market is in equilibrium in that planned spending equals output. However, the
money market is no longer in equilibrium. Income has increased, and therefore the
quantity of money demanded is higher. Because there is an excess demand for real
balances, the interest rate rises. Firms planned investment spending declines at
higher interest rates, and thus aggregate demand falls off.
What is the complete adjustment, taking into account the expansionary effect of
higher government spending and the dampening effects of the higher interest rate on
private spending? Figure 12-4 shows that only at point E do the goods and money
markets both clear. Only at point E is planned spending equal to income and, at the
same time, the quantity of real balances demanded equal to the given real money
stock. Point E is therefore the new equilibrium point.

Crowding Out
Comparing E to the initial equilibrium at E, we see that increased government
spending raises both income and the interest rate. But another important comparison is between points E and E, the equilibrium in the goods market at unchanged
interest rates. Point E corresponds to the equilibrium we studied in Chapter 11,
when we neglected the impact of interest rates on the economy. In comparing E and
E, it becomes clear that the adjustment of interest rates and their impact on aggregate demand dampen the expansionary effect of increased government spending.
Income, instead of increasing to level Y, rises only to Y.

CHAPTER 12

FIGURE 12-4

Monetary and Fiscal Policy in the Very Short Run

241

EFFECTS OF AN INCREASE IN GOVERNMENT SPENDING

Increased government
spending increases
aggregate demand,
shifting the IS curve to
the right.

crowding out
Occurs when expansionary
fiscal policy causes
interest rates to rise,
thereby reducing private
spending, particularly
investment.

The reason that income rises only to Y rather than to Y is that the rise in the
interest rate from i0 to i reduces the level of investment spending. We say that the
increase in government spending crowds out investment spending. Crowding out
occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing
private spending, particularly investment.
What factors determine how much crowding out takes place? In other words,
what determines the extent to which interest rate adjustments dampen the output
expansion induced by increased government spending? By drawing for yourself different IS and LM schedules, you will be able to show the following:


Income increases more and interest rates increase less, the flatter the LM
schedule.

Income increases less and interest rates increase less, the flatter the IS schedule.

Income and interest rates increase more the larger the multiplier, G, and thus
the larger the horizontal shift of the IS schedule.

In each case, the extent of crowding out is greater the more the interest rate increases
when government spending rises.

Is Crowding Out Important?

How seriously must we take the possibility of crowding out? Here, three points must be
made. The first point is also an important warning. In this chapter, as in the two preceding chapters, we are assuming an economy with prices given, in which output is

242

PART 4

monetary
accommodation
The central bank prints
money to buy the bonds
with which the
government pays for its
deficit.

FIGURE 12-5
If the Bank of Canada
increases the money
supply when there is a
fiscal expansion, both
the IS and the LM
curves shift to the right.
Because interest rates
do not rise, there is no
crowding out.

The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity

below the full employment level. In these conditions, when fiscal expansion increases
demand, firms can increase the level of output by hiring more workers. But in fully
employed economies, crowding out occurs through a different mechanism. In such
conditions, an increase in demand will lead to an increase in the price level. The
increase in price reduces real balances. (An increase in P reduces the ratio M
/P.) This
reduction in the real money supply moves the LM curve to the left, raising interest
rates until the initial increase in aggregate demand is fully crowded out.
The second point, however, is that in an economy with unemployed resources,
there will not be full crowding out because the LM schedule is not, in fact, vertical. A
fiscal expansion will raise interest rates, but income will also rise. Crowding out is
therefore a matter of degree. The increase in aggregate demand raises income, and
with the rise in income, the level of saving rises. This expansion in saving, in turn,
makes it possible to finance a larger budget deficit without completely displacing private spending.
The third point is that with unemployment and, thus, a possibility for output to
expand, interest rates need not rise at all when government spending rises, and there
need not be any crowding out. This is true because the monetary authorities can
accommodate the fiscal expansion by an increase in the money supply. Monetary
policy is accommodating when, in the course of a fiscal expansion, the money supply is
increased in order to prevent interest rates from increasing. Monetary accommodation
is also referred to as monetizing budget deficits, meaning that the Bank of Canada prints
money to buy the bonds with which the government pays for its deficit. When the
Bank of Canada accommodates a fiscal expansion, both the IS and the LM schedules
shift to the right, as in Figure 12-5. Output will clearly increase, but interest rates
need not rise. Accordingly, there need not be any adverse effects on investment.

MONETARY ACCOMMODATION OF A FISCAL EXPANSION

CHAPTER 12

BOX

12-2

Monetary and Fiscal Policy in the Very Short Run

243

The Policy Mix

In the Policy in Action feature in Chapter 11, we discussed how tight monetary policy
and loose fiscal policy could lead to high interest rates. This is generally called the
policy mix.
The policy mix of the early 1980s featured highly expansionary fiscal policy and
tight money. The tight money succeeded in reducing the inflation rate at the expense
of a serious recession. The continued expansionary fiscal policy then drove a recovery
during which real interest rates increased.
This recovery continued until mid-1988, when both the Bank of Canada and the
U.S. Federal Reserve Board, fearing that inflation was rising again, began to tighten
monetary policy again, and interest rates began rising. The table below shows that the
real interest rate reached 7 percent in 1989 and 8.1 percent in 1990, which forced
the economy into a recession in 1990 and 1991. In 1992, inflation fell dramatically
from 5.6 percent to 1.5 percent. Also, in 1992, the Bank of Canada allowed interest
rates to drop and a modest recovery began. This recovery was aided by the continuation of full employment deficits throughout the 1990s.
An interesting feature of this recession and recovery is the behaviour of the unemployment rate. You can see from the table below that the unemployment rate increased
from 1988 to 1992. After 1992, the unemployment rate remained above 10 percent
until the late 1990s.

THE RECESSION OF THE EARLY 1990S

Nominal interest rate

Real interest rate
Full-employment deficit
Unemployment rate
GDP growth
Inflation

1988
9.4
5.4
4.0
7.7
4.9
4.0

1989
12.0
7.0
3.9
7.5
2.4
5.0

(PERCENT)
1990
12.8
8.1
3.9
8.1
0.2
4.7

1991
8.8
3.2
3.6
10.4
1.9
5.6

1992
6.5
5.0
3.0
11.3
0.76
1.5

12-3 MONETARY POLICY AND THE INTEREST RATE RULE

Until now, we have made the assumption that monetary policy is conducted by
making discrete changes in the money supply, so that the nominal money supply was
an exogenous variable. In this case, we specified the behaviour of monetary policy as
Ms = M

(2)

244

PART 4

money supply rule

A policy stance where the
central bank holds the
level (or growth rate) of
the money supply
constant.

FIGURE 12-6

The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity

This type of policy stance is technically known as a money supply rule.

Now imagine a situation where the money demand curve is subject to random
shocks. As an example, suppose there was a major world event that caused people to
hold a great deal of moneyperhaps because they felt that they would not be able to
liquidate other forms of wealth fast enough. This type of event would suddenly
increase the demand for money, as illustrated in Figure 12-6.

CHANGING THE MONEY SUPPLY WHEN THE DEMAND FOR MONEY SHIFTS

If the money supply is

increased when the
demand for money shifts
outward, then the
interest rate would not
rise as it would if the
money supply was not
changed.

The initial equilibrium is at point E, with an interest rate of i1. The shock to
money demand shifts the money demand curve to L. If the Bank of Canada continues to run policy according to a money supply rule, the interest rate will rise to i2.
Suppose that the Bank of Canada, for whatever reason, felt that the economy
should not be subject to as large of an interest rate change as given by the movement
from i1 to i2. In response to this shock, the Bank of Canada could increase the money
supply when the interest rate goes up, which would make the interest rate increase
smaller than in the absence of the money supply increase. For instance, in Figure 12-6,

the Bank of Canada could change the money supply to M, and the interest rate would
increase to only i3.
If the Bank of Canada did this every time there was a shock to money demand
(of course, the shocks could be both positive and negative), the money supply would
no longer be completely exogenous but would now have an endogenous component.
We could write the money supply equation that describes this stance on monetary
policy as
Ms = M  i ;  > 0

(3)

CHAPTER 12

interest elasticity of the

money supply
A parameter that
measures how much the
central bank changes the
money supply in response
to an interest rate change.

Monetary and Fiscal Policy in the Very Short Run

245

The parameter  measures the amount that the central bank increases the money
supply in response to an interest rate change. We call  the interest elasticity of the
money supply. The more that the Bank of Canada reacts to changes in the interest
rate, the larger  will be.
If we want to graph the money supply curve, we can rearrange equation (3).
1
i =  (M s M )

(4)

where the slope of the money supply curve is given by 1/. Therefore, the more the
Bank of Canada reacts, the larger  is and the flatter the money supply curve is. (Of
course, the reverse is also true.) The effects of running policy in this manner are
shown in Figure 12-7, where you can see that the interest rate change under a money
supply rule (i0 i2) is greater than the interest rate change if the central bank conducts policy according to equation (4) (i0 i1).

FIGURE 12-7

MONETARY POLICY REACTS TO INTEREST RATE CHANGES

If monetary policy
changes the money
supply every time that
interest rates change, as
given by equation (4),
then the money supply
curve is upward sloping,
rather than vertical. In
this situation, there is
less interest rate change
for any given money
demand shift.

interest rate rule

Monetary policy is
conducted according to an
interest rate rule whenever
the money supply is
changed in response to a
change in the demand for
money in order to keep
interest rates constant.

Now consider the extreme case where  = . In this case, the Bank of Canada
changes the money supply by any amount that is needed, as soon as there is any small
change in the interest rate. In this case, the money supply curve is horizontal and the
shifts in money demand do not cause any change in the interest rate. This is known
as conducting monetary policy according to an interest rate rule. Notice that, under
an interest rate rule, the money supply is endogenous and the interest rate is exogenous.
Now consider deriving an LM curve under the monetary policy of an interest
rate rule. For an LM curve, money supply equals money demand. Our money
demand equation is assumed to be the same as before, and we put this together with
our new money supply curve in Figure 12-8.

246

PART 4

FIGURE 12-8

The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity

DERIVING THE LM CURVE UNDER AN INTEREST RATE RULE

If monetary policy is
conducted according to
an interest rate rule,
then the money supply
is changed any time
there is a small change
in the interest rate, and
the LM curve is horizontal.

www.bankofcanada.ca/en/
res/r03-1-ec.htm

Figure 12-8 shows that, when monetary policy is conducted according to an

interest rate rule, the LM curve is horizontal. It is important to understand that, in
this case, the LM curve is horizontal by policy design. To make sure that you understand this, contrast the LM curve shown in Figure 12-8 with the liquidity trap discussed earlier. Remember that, theoretically, the liquidity trap would occur when the
interest elasticity of money demand is infinite. There is nothing that policy can do
about this situation. However, in the case of an interest rate rule, the LM curve is horizontal because monetary policy makers have chosen to make the interest elasticity
of money supply infinite; that is, they are continually intervening in the money
market. Therefore, in the case of an interest rate rule, monetary policy is capable of
doing something: It acts to hold the interest rate constant. Theoretically, the Bank of
Canada could choose any interest rate it wanted, so the LM curve under an interest
rate rule, even though it is horizontal, can be shifted by policy.
You can think of conducting monetary policy according to a money supply rule
as a special case where  = 0, and the LM curve will be the familiar upward-sloping
curve. When policy is conducted according to an interest rate rule,  = and the LM
curve is horizontal. These two LM curves are shown in Figure 12-9.

Money Supply Rule and Interest Rate Rule:

When Would Policy Makers Choose One Over the Other?
The difference between a money supply rule and an interest rate rule is more than
just a textbook exercise. Under a money supply rule, the central bank sets the money
supply and then does nothing else.3 This is a policy of minimal intervention in the
3 For

this section, we rule out discrete, one-time changes in the money supply under a money supply rule.

CHAPTER 12

FIGURE 12-9

Monetary and Fiscal Policy in the Very Short Run

247

LM CURVE FOR A MONEY SUPPLY RULE AND FOR AN INTEREST RATE RULE

If monetary policy is
conducted according to
a money supply rule,
then the LM curve has
the familiar upward
slope. If monetary policy
is conducted according
to an interest rate rule,
then the LM curve is
horizontal.

money market. Under an interest rate rule, the central bank must be intervening in
the money market at all times. This is an activist monetary policy. (We will discuss
activist policy in detail in Chapter 17.) Therefore, the choice of conducting monetary
policy using a money supply rule or an interest rate rule is a choice of activist stabilization policy (interest rate rule) versus conducting policy by a fixed rule with a minimum of interference (money supply rule).
In order to compare the two policy stances, we assume that the goal of the central bank is to minimize the fluctuations in income, and we ask the question: Within
the framework of the IS-LM model, will fluctuations in income be smaller under a
money supply rule or under an interest rate rule? In the IS-LM model, fluctuations
in income can arise from shocks in the goods market (the IS curve fluctuates) or
from shocks in the money market (the LM curve fluctuates). We know that, at any
point in time, the economy is subject to both goods market and money market
shocks. However, this makes analysis very difficult. In order to make this exercise
simple and understandable, we will look first at a situation where there are only
goods market shocks, and then we will look at a situation where there are only money
market shocks.

Goods Market Shocks Only

In this section, we consider the situation where the goods market is subject to shocks,
while the money market is not. Therefore, in this situation, the IS curve is subject to
fluctuations, while the LM curve is not. This is depicted in Figure 12-10.

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PART 4

FIGURE 12-10

The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity

MONETARY POLICY WITH SHOCKS TO THE GOODS MARKET

If monetary policy is
conducted according to
a money supply rule,
income varies between
Y2 and Y1, and if it is
conducted according to
an interest rate rule,
income varies between
Y3 and Y4. In this case,
the variance of income
is minimized by a money
supply rule.

In Figure 12-10, when the IS curve is not subject to a shock, income is at Y0,
where either of the LM curves intersects the IS curve marked IS0. The IS curve
marked IS1 pertains to a negative goods market shock, and the curve marked IS2 pertains to a positive goods market shock.
Consider first conducting monetary policy using a money supply rule. In this
case, the IS-LM equilibrium varies between Y1 and Y2. These are the equilibrium
points where the LM (money supply rule) curve intersects the IS1 and the IS2 curves.
Now consider conducting monetary policy using an interest rate rule. In this case, the
IS-LM equilibrium varies between Y3 andY4. These are the equilibrium points where
the LM (interest rate rule) curve intersects the IS1 and the IS2 curves. Clearly, in this
case, the variance in output is minimized under a money supply rule.

Money Market Shocks Only

The situation of money market shocks only is depicted in Figure 12-11. Notice
immediately from this figure that if the money market is subject to shocks, these do
not affect the LM (interest rate rule), as the interest rate rule was designed to remove
shocks from the money market. Therefore, in a situation of money market shocks
only, and conducting monetary policy according to an interest rate rule, there is no
variance in output. Alternatively, if the money market is fluctuating and the monetary authorities use a money supply rule, income will vary between Y1 and Y2.
Clearly, in this situation, an interest rate rule has the minimum variance in output.

CHAPTER 12

FIGURE 12-11

Monetary and Fiscal Policy in the Very Short Run

249

MONETARY POLICY WITH SHOCKS TO THE MONEY MARKET

If monetary policy is
conducted according to
a money supply rule,
income varies between
Y2 and Y1, and if it is
conducted according to
an interest rate rule,
income does not change.
In this case, the variance of income is minimized by an interest
rule.

Working with Data

In the introduction to this chapter, we discussed the relationship between the interest
rate and growth in real GDP over the cycle. In Figure 12-1, we graphed the nominal
Treasury bill rate with the growth rate of GDP. Go to CANSIM II and retrieve the
Consumer Price Index (V735319), as well as the other data referred to in Figure 12-1.
Construct the annual inflation rate, quarterly, and then the real rate of interest, quarterly. Plot the real rate of interest with the growth rate of GDP over the period
19752002. You should be able to identify the negative relationship between these
two variables, especially during recessions.

R Y

Monetary policy affects the economy, first by affecting the interest rate and then
by affecting aggregate demand. An increase in the money supply reduces the
interest rate, increases investment spending and aggregate demand, and thus
increases equilibrium output.

There are two extreme cases in the operation of monetary policy. In the Classical
case, the demand for real balances is independent of the rate of interest. In that
case, monetary policy is highly effective. The other extreme is the liquidity trap, the
case in which the public is willing to hold any amount of real balances at the going
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The Economy in the Very Short Run: Spending and the IS-LM Model of Economic Activity

PART 4

interest rate. In that case, changes in the supply of real balances have no impact on
interest rates and therefore do not affect aggregate demand and output.


Taking into account the effects of fiscal policy on the interest rate modifies the
multiplier results of Chapter 8. Fiscal expansion, except in extreme circumstances, still leads to an income expansion. However, the rise in interest rates that
comes about through the increase in money demand caused by higher income
dampens the expansion.

Fiscal policy is more effective the smaller the induced changes in interest rates and
the smaller the response of investment to these interest rate changes.

The two extreme cases, the liquidity trap and the Classical case, are useful to
show what determines the magnitude of monetary and fiscal policy multipliers.
In the liquidity trap, monetary policy has no effect on the economy, whereas
fiscal policy has its full multiplier effect on output and no effect on interest rates.
In the Classical case, changes in the money stock change income, but fiscal policy
has no effect on incomeit affects only the interest rate. In this case, there is
complete crowding out of private spending by government spending.

A fiscal expansion, because it leads to higher interest rates, displaces, or crowds out,
some private investment. The extent of crowding out is a sensitive issue in assessing
the usefulness and desirability of fiscal policy as a tool of stabilization policy.

If the central bank wants to minimize fluctuations in the interest rate, it can conduct policy according to an interest rate rule, manipulating the money supply
every time interest rates change.

If all of the variation in income arises from fluctuations in the goods market,
then a money supply rule reduces the variance of income. If all of the variation
in income arises from fluctuations in the money market, then an interest rate
rule reduces the variance of income.

K
monetary policy, 235
liquidity trap, 236
crowding out, 241

monetary accommodation, 242

money supply rule, 244

C
1.

2.

interest elasticity of the money

supply, 245
interest rate rule, 245

Most of the time, both the goods market and the money market are subject to shocks
at the same time. How would you think about choosing between an interest rate rule
and a money supply rule in this real-world situation?
Discuss the circumstances under which the monetary and fiscal policy multipliers are
each, in turn, equal to zero. Explain in words why this can happen and how likely you
think this is.

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Monetary and Fiscal Policy in the Very Short Run

CHAPTER 12

3.
4.
5.

6.
7.

L
1.

2.

3.

251

What is a liquidity trap? If the economy was stuck in one, would you advise the use of
monetary or fiscal policy?
What is crowding out, and when would you expect it to occur? In the face of substantial crowding out, which will be more successfulfiscal or monetary policy?
What would the LM curve look like in a Classical world? If this really was the LM curve
that we thought best characterized the economy, would we lean toward the use of fiscal
policy or monetary policy? (You may assume that your goal is to affect output.)
What happens when the Bank of Canada monetizes a budget deficit? Is this something it
should always try to do? (Hint: Outline the benefits and costs of such a policy, over time.)
We can have the GDP path we want equally well with a tight fiscal policy and an easier
monetary policy, or the reverse, within fairly broad limits. The real basis for choice lies
in many subsidiary targets, besides real GDP and inflation, that are differentially affected
by fiscal and monetary policies. What are some of the subsidiary targets referred to in
this quote? How would they be affected by alternative policy combinations?

A T

The economy is at full employment. Now the government wants to change the composition of demand toward investment and away from consumption without, however,
allowing aggregate demand to go beyond full employment. What is the required policy
mix? Use an IS-LM diagram to show your policy proposal.
Suppose the government cuts income taxes. Show in the IS-LM model the impact of the
tax cut under two assumptions: (1) The government keeps interest rates constant
through an accommodating monetary policy, (2) the money stock remains unchanged.
Explain the difference in results.
Go to CANSIM and retrieve data on the money stock, M1B, and the 90-day Treasury
bill rate. Calculate the rate of growth of money and plot this with the Treasury bill rate.
Can you relate this graph to any of the monetary policy discussions in this chapter?

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