Example (5.5): Continuation of Example (5.

4)

Let increases to 400. What happens to , , , and ?

(Ans.)
relation: = 1100 2000 = 0.55 0.0005

1
relation: = 0.2 +
= 800 + 4000
4000
1
1
=
=
150 = 2 150 =
1 1 +1
1(0.25+0.25)

300

curve will shift to the right by 300 at initial interest rate:

Thus, new (1 ): = 1100 + 2000 = 1400 2000
= 0.7 0.0005
In new equilibrium, 1 = .

Example (5.5): Continuation of Example (5.4)

1400 2000 = 800 + 4000
6000 = 600
=

600
6000

= . ( )

= 800 + 4000 0.1 =

= 200 + 0.25 1200 200 =
= 150 + 0.25 1200 1000 0.1 =
Expansionary fiscal policy increases , , and , but remains
constant.

Example (5.5): Continuation of Example (5.4)

Q: Why is the net effect on investment equal to zero?

A: = 150 + 0.25 1000
Totally differentiate the investment function:
= 0.25 1000 ( )
increase in
due to

fall in
due to
=

= 0.25 200 1000 0.05

= 50 50 = 0
An increase in investment due to higher output is completely
offset by a fall in investment due to higher interest rate, so no
change in investment.

Crowding Out
Q: Is there any crowding out of investment if the economy is in the
liquidity trap, and thus the LM curve is horizontal?
A: There is no change in the interest rate associated with the change
in government purchases, and thus no investment is cut off.
There is no dampening of the effects of increased government
purchases on income an increase in government purchases has its
full multiplier effect on equilibrium income.
Therefore, monetary policy has no impact on the equilibrium of the
economy and fiscal policy has a maximal effect.

Crowding Out in the Classical Economics

If the LM curve is vertical, an increase in G has no effect on Y and
increases only the interest rate.
In this case, the increase in the interest rate crowds out an amount of
private (particularly investment) spending equal to the increase in G.
Thus, there is complete crowding out if the LM curve is vertical.

Caution on Budget Deficit and Investment!

A reduction in the budget deficit does not necessarily lead to an
increase in investment.
= + = +
"Given , " .

The crucial part of this statement is given private saving.

The point is that a fiscal contraction affects private saving, too:
.

Caution on Budget Deficit and Investment!

Private saving may go down by more than the reduction in the
budget deficit, leading to a decrease rather than an increase in
investment: > .

Summary: A fiscal contraction may reduce investment.

Or a fiscal expansion may actually increase investment.

Tight (or Contractionary) Fiscal Policy

Suppose the government decides to reduce the budget deficit by
increasing taxes while keeping government spending unchanged.
Step 1: At any interest rate, higher
taxes lead to lower output.
Consequently, the IS curve shifts to the left at any interest rate from
to .
Because taxes do not appear in the LM relation, they do not affect the
LM curve: Taxes do not shift the curve.

Figure 5.14: The Effects of an Increase in Taxes

Tight (or Contractionary) Fiscal Policy

Step 2:
As the curve shifts, the economy moves along the curve.

Step 3: The new equilibrium is at the intersection of the new IS curve

and the unchanged LM curve, or at point .
Note that the fall in i reduces the effect of higher on the demand
for goods but does not completely offset it.
Q: What happens to other components of demand?
A: ( ) but
The effect of higher on is ambiguous

Tight (or Contractionary) Fiscal Policy

Q: Why is the change in income = is clearly less than
1
?
11 1

A: An increase in taxes leads to a fall in income.

A fall in income tends to decrease the demand for money
With the money supply fixed, the interest rate has to fall to ensure
that the demand for money equals the fixed money supply
When the interest rate falls, investment increases and so output
rises
Accordingly, the equilibrium change in income is less than the
horizontal shift of the IS curve

Tight (or Contractionary) Fiscal Policy: Increases in Taxes

Note that at D the goods market is in equilibrium in that aggregate
demand equals output.
But the financial (or money) market is no longer in equilibrium.
Income has decreased, and so the quantity of money demanded is
lower.
Because there is an excess supply of money, the interest rate falls.
Investment increases at a lower interest rate, and thus aggregate
demand and output rise.

Decrease in Proportional Income Tax Rate

Q: Suppose that the government decides to cut proportional income
tax rate . Analyze the effects of this expansionary fiscal policy using
a diagram.
A:

Decrease in Proportional Income Tax Rate

Smaller increases C.
Note that the IS curve does not shift out in a parallel fashion in this
case because enters into the slope of the IS equation.
IS relation: =

1
2

0 + 0 + 1 +

A smaller makes the IS curve flatter.

11 1 1

Monetary Policy and the Interest Rate

Monetary expansion
An increase in money supply by open market purchases of
government securities
Monetary contraction (or monetary tightening)
A decrease in the money supply by open market sales of
government securities

Expansionary (or Loose) Monetary Policy

Suppose that the central bank increase nominal money , given
that the price level is fixed in the short run.
Step 1: An increase in nominal money leads to one-for-one
increase in real money supply

The LM curve shifts down to .

The money supply does not directly affect either the supply of or
the demand for goods.
In other words, does not appear in the relation.
Thus, a change in does not shift the curve.

Expansionary (or Loose) Monetary Policy

Step 2: At a given level of income, an increase in money leads to a fall
in the interest rate to .
Step 3: . The economy moves along the IS
curve, and the equilibrium moves to .
Output increases to and the interest rate falls to .
Q: What happens to other components of aggregate demand?
A: ( fixed) : and
Thus, monetary expansion is more investment friendly that fiscal
expansion.

Figure 5.15: The Effects of an Expansionary Monetary Policy

Process of Adjustment to the Monetary Expansion

At the initial equilibrium point , the increase in the money supply
creates an excess supply of money.
At the initial interest rate 0 and income 0 , people are holding
more money than they want.
This causes the public to attempt to reduce their money holdings
by buying other assets, thereby asset prices increase and yields fall.
Because money and asset markets adjust rapidly, it moves
immediately to point 1 .
At point 1 , there is an excess demand for goods.

Process of Adjustment to the Monetary Expansion

Given the initial income level 0 , a fall in the interest rate leads
to an increase in aggregate demand.
Because the increase in output raises the demand for money, the
greater demand for money leads to higher interest rate moving up
along the curve.

Thus, the increase in the money stock first causes interest rate fall
as the public adjusts its portfolio and then as a result of the decline
in interest rates increases aggregate demand.

Example (5.6): Continuation of Example (5.4)

Let (real money supply) increases to 1840. What happens to
, , and when the Fed increases money supply through open
market purchase?
(Ans.)
relation: = 1100 2000 = 0.55 0.0005

1
relation: = 0.2 +

4000
1

( ) =

= 800 + 4000
=

8000

240 =

100

curve will shift down by 3100 at any given output.

Example (5.6): Continuation of Example (5.4)

Thus, new ( ): =

= 920 + 4000
In new equilibrium, = .
1100 2000 = 920 + 4000
6000 = 180 =

180
6000

4000

= . ( )

23

100

4000

= 920 + 4000 0.03 =

= 200 + 0.25 1040 200 =
= 150 + 0.25 1040 1000 0.03 =
Expansionary monetary policy reduces , but increases , , and .