Chapter 5 Monetary and Fiscal Policy Monetary policy

Chapter 5 Monetary and Fiscal Policy

Monetary policy

Monetary policy An increase in the real money stock shifts the LM curve to the right; n The assets market adjusts quickly: E E 1; n Excess demand in the good market at E 1; n Output increases in response to excess demand; n ¨ The n interest rate rises because of higher income. The monetary policy is more effective when: ¨ The LM curve is steeper; ¨ The IS curve is flatter.

Monetary policy n The liquidity trap: ¨ At low interest rates, the public is willing to hold whatever amount of money supplied; n The cost of holding money is virtually zero, while money has the advantage in liquidity. ¨ Supplying more money no longer changes the interest rate; ¨ The LM curve is flat; ¨ The monetary policy becomes ineffective.

Monetary policy n The classical case: ¨ The demand for real money is irresponsive to the interest rate; ¨ The LM curve is vertical for given price level; ¨ The monetary policy is most effective while the fiscal policy is ineffective.

Fiscal policy and crowding out

Fiscal policy and crowding out An increase in government purchase shifts the IS curve to the right; n Excess demand in the goods market at E; n Output increases in response to excess demand; n ¨ The n interest rate rises because of higher income. The fiscal policy is more effective when: ¨ The LM curve is flatter; ¨ The IS curve is steeper.

Fiscal policy and crowding out n Crowding out: ¨ The interest rate rises because of higher income; ¨ Higher interest rate discourages private investment; ¨ The increase in output would be higher if the interest rate remained fixed at i 0; ¨ Government purchase crowds out more private investment if: The LM curve is steeper; n The IS curve is flatter. n

Fiscal policy and crowding out n The liquidity trap: ¨ No change in the interest rate; ¨ Government purchase has its full multiplier effect. n The classical case and crowd out: ¨ The LM curve is vertical; ¨ The interest rate increases so that the increase in government purchase is completely offset by the decrease in private investment.

The composition of output and the policy mix n The monetary policy: ¨ Stimulates n private investment. The fiscal policy: ¨ Income tax cut: stimulates consumption; ¨ Government purchase: stimulates itself; ¨ Investment subsidy: stimulates private investment.

The composition of output and the policy mix n An investment subsidy.