Stabilization Policy in a Closed

Economy: Monetary and Fiscal Policy

Macroeconomics
Session 10 & 11
 IS-LM Model: How Monetary and Fiscal
Policy Work
• Fiscal policy has its initial impact in the goods market
• Monetary policy has its initial impact mainly in the assets
markets

®Because the goods and assets markets are

interconnected, both fiscal and monetary policies have
effects on both the level of output and interest rates
®Expansionary/contractionary monetary policy moves the
LM curve to the right/left
®Expansionary/contractionary fiscal policy moves the IS
curve to the right/left
 Fiscal and Monetary Policy
• Main tools that the government can use to try
to:
– Keep the economy growing at a reasonable rate
with low inflation
– Shorten the recession
– To prevent booms going out of hand
 Repo Rate (India)
10
9
8
7
6
5
4
Difference between India and the US interest rate
3
2 Real interest rate = nominal - inflation
1
0
0 20 0 20 01 9 01 9 01 8 01 7 0 16 0 15 0 15 013 01 3 0 12 012 0 11 0 11 0 10 0 10 0 09 0 09 008 0 08 0 08 007 0 07 0 07
2 /2 7/2 7/2 4/2 6/2 6/2 9/2 7/2 5/2 9/2 3/2 3/2 0/2 6/2 7/2 6/2 0/2 7/2 5/2 5/2 0/2 2/2 0/2 1/2 6/2
2 2 8/ 4/ 6/ 4/ 7/ /2 /1 /2 5/ 1/ /1 /1 /1 /1 /2 1/ 1/ /2 /3 /1 /1 /3 1/
5/ 3/ 6 1 10 1 3 9 3 9 4 1 10 7 6 11 3

Source: RBI, https://dbie.rbi.org.in/DBIE/dbie.rbi?site=home

 Monetary Policy through OMOs
• Fed’s selling of the bonds reduces the money supply, increases the
bond supply, and raises the interest rate, and reduces the bond prices
– Only at a higher interest rate (and lower bond prices), public would be willing
to keep a larger fraction of their wealth in form of bonds
– At higher interest rate, the public will be willing to keep a smaller fraction of
their wealth in form of money

• Or think in reverse direction: Fed’s purchase of bonds increases money

supply, reduces the bonds supply, increasing their prices, or reducing
the interest rate
– Only at lower interest rate (and higher bond prices), public will be willing to
hold a smaller fraction of their wealth in bonds
– At lower interest rate, the public will be willing to keep a higher fraction of
their wealth in form of money
 i i
𝑀
∆
𝑃 LM
L2=kY2-bi
E2 LM’
i2 i2
E2
L1=kY1-bi E4
E4
∆𝑌
Interest rate

Interest rate
i1
E1 i1
E1
E3 E3

Y1 Y2 Y
𝑀 𝑀′ L
𝑃 𝑃
Income, output
Real balances

Shift OF THE LM CURVE

How to define the impact of

𝑀 1 𝑀
∆ =𝑘 ∆ 𝑌 ∆𝑌= ∆
𝑃 𝑘 𝑃
 • Open market operations:
Monetary Policy buying and selling of
government bonds
─ Fed buys bonds in
exchange for money
 increases the stock
of money
─ Fed sells bonds in
exchange for money
paid by purchasers of
the bonds  reducing
the money stock
 • Adjustment to the
Monetary Policy monetary expansion:
– Increase in money
supply creates excess
supply of money
– Asset prices increase,
yields decrease 
move to point E1
– Decline in interest
rate results in excess
demand for goods
– Output expands and
move up LM’
schedule
 Monetary Transition Mechanism
• Two steps in the transmission mechanism (the process by which
changes in monetary policy affect AD):
1. An increase in real balances generates a portfolio disequilibrium
– At the prevailing interest rate and level of income, people are holding more
money than they want
– Portfolio holders attempt to reduce their money holdings by buying other
assets  changes asset prices and yields
– The change in money supply changes interest rates
2. A change in interest rates affects AD
 When Can the Monetary Transmission
Mechanism Become Ineffective
• If change in the money supply does not
translate into change in interest rate

• If change in interest rate does not translate

into the rise in investment demand
 The Liquidity Trap
“There is the possibility...that, after the rate of interest has fallen
to a certain level, liquidity-preference may become virtually
absolute in the sense that almost everyone prefers cash to
holding a debt which yields so low a rate of interest. In this
event the monetary authority would have lost effective control
over the rate of interest. But whilst this limiting case might
become practically important in future, I know of no example of
it hitherto.”

John Maynard Keynes, General Theory, 1936

 The Liquidity Trap
• Liquidity trap = a situation in which the public is
prepared, at a given interest rate, to hold whatever
amount of money is supplied
– Implies the LM curve is horizontal  changes in the quantity
of money do not shift it
• Monetary policy has no impact on either the interest rate or the level
of income  monetary policy is powerless
• Possibility of a liquidity trap at low interest rates is a notion that grew
out of the theories of English economist John Maynard Keynes

• h is very high
When the Interest Rate Hits Zero: Japan
 When there is deflation
• Nominal interest rate = real interest rate + inflation

• If the inflation is negative, then even when the nominal

interest rate is zero, the real interest rate is greater than zero

• Better to keep cash rather than buy goods who will lose
value over time
• Better to keep cash rather than invest in physical assets
whose values and the value of their output will reduce over
time
 Demography and Aggregate Demand (may
be)
• Replacement demand for capital stock

• Declining young population lead to decline in

demand for capital stock

• Decline in investment demand

• Higher savings with ‘Asian characteristics’

 Banks’ Reluctance to Lend
• Another situation in which monetary policy is powerless to alter the
economy  break down in the transmission mechanism
• Despite lower interest rates and increased demand for investment,
banks may be unwilling to make the loans necessary for the
investment purchases
– If banks made prior bad loans that are not repaid, may become
reluctant to make more, despite demand  prefer instead to lend to
the government (safer)

• Indian banks parking their surplus liquidity with the RBI

through reverse repo
When the Interest Rate Hits Zero: The US
Interest rate came down from 4
percent in January 2008 to 0.16
percent in December 2008
 Yield Curve for the US G-Sec
6
Despite the fall in short-run interest rate, long-run
interest rates remained high
5.11
5 4.93
5.07 5
4.87
4.79 4.8 4.79
4.71 4.68 4.68 4.68

4.25 4.28
4
• Supply of long-term financial assets is
very large (high powered money is usually 3.29
3 10-15% of GDP, while public debt can be
2.78
more 60 or even 100 % of GDP
• At the zero bound, lowering the interest 2.15
2 rate by 1 percentage point will require the Real interest rate = nominal -
fed to buy $ 3 trillion in long term assets 1.44 inflation
1 1
02-01-2007 08-05-2009
0.55
0.31
0.15 0.17 0.19
0
1 Mo 2 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr

https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2009
Banks’ Reluctance to Lend Reduces the Money
Multiplier and Limits the Rise in Broad Money

• Fed printed massive amount of notes,

which were not loaned out by the bank
• Fed was explicit that the it expected to
‘unwind’ the monetary tsunami once the
danger had passed. Thus, the increase in
monetary base was seen temporary
 Yield Curve for the US G-Sec
3.5
03-01-2017 02-01-2020 30-11-2020

3 Higher long run interest rate than short run suggests bond market 3

(or lenders) expect interest rate to rise in future 2.78

2.5 2.45
2.33
2.26
2.19

2 1.94
1.88
1.79
1.67
1.57 1.56 1.58 1.59 1.58
1.55
1.5 1.53 1.54
1.5
1.37
1.22

1
0.89
0.84

0.65 0.62
0.5 0.52 0.52 0.53

0.36

0.16 0.19
0.08 0.08 0.08 0.09 0.11
0
1 Mo 2 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2020
 Yield of SGL Transactions In Government
Dated Securities for Various Maturities
8.5

8.0

7.5

7.0

6.5
the short-term interest rate in 2010 still remained
6.0 1.5 percent less than the level in 2007

5.5
The long term interest rate in both periods were quite close,
5.0 suggesting bond market expected higher inflation in future

4.5 2007 2008 2009 Jul-10

4.0
Source: Handbook of Statistics on Indian Economy
3.5
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
 Yield of SGL Transactions In Government Dated
9.0 Securities for Various Maturities
8.5

8.0

7.5

7.0

6.5

6.0

5.5

5.0

4.5
2017 2018 2019 2020 Jul-20
4.0

3.5
Source: Handbook of Statistics on Indian Economy
3.0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
 Control of the Money Stock and Control of
the Interest Rate
• The Fed cannot simultaneously
set the interest rate AND the
stock of money at any given
target levels that it may choose

• Suppose that the Fed wants to

set the interest rate at i* and
the money stock at M*, with
the demand for money at LL
• The Fed can move the money
supply around, but not LL
• It can only set combinations of
i and M that lie along LL
• At interest rate i*, can have
M0/P
• At the target money supply,
M*/P, can have interest rate of
i0
 i

i E1 E2
E1 E2 i

Interest rate
Interest rate

L2=kY2-bi

L1=kY1-bi
IS IS’

𝑀 Y1 Y2 Y
Real balances
𝑃 Income, output

Interest rate targeting by the Central Bank

 The Classical Case
• The opposite of the horizontal LM curve is the vertical LM curve
– Demand for money arises solely from transaction demand
– Demand for money is entirely unresponsive to the interest rate (speculative demand may
not be there)
– Recall, the equation for the LM curve is

• If h is zero, then there is a unique level of income corresponding to a given real money supply 
• VERTICAL LM CURVE

• Why the vertical LM curve is called the classical case

– Rewrite equation (1), with h = 0:

¯ × 1 =𝑃 ×𝑌
𝑀
𝑘

• Implies that Nominal GDP depends only on the quantity of money  quantity theory of money
• When the LM curve is vertical, shifts in the IS curve do not affect the level of income
 Fiscal Policy in the IS Curve
• The equation for the IS curve is:
𝑌=𝛼 𝐺 ( 𝐴¯ −𝑏𝑖)
– The fiscal policy variables (G, TR, and t) are within this definition
• G and TR are parts of A
• t is a part of the multiplier
®Fiscal policy actions, changes in G, TR, and t affect the IS curve

1
𝛼 𝐺=
1−𝑐(1−𝑡)
𝐴 − 𝑏𝑖= [ 𝐶 +𝑐 𝑇 𝑅+ 𝑐(1 −𝑡 )𝑌 ] +( ¯𝐼 −𝑏𝑖 )+ 𝐺+
¯ ¯ ¯ ¯ ¯ 𝑁¯ 𝑋
¯
 Fiscal Policy and Crowding Out
• If government
expenditures increase,
equilibrium moves from
E to E”
• The goods market is in
equilibrium at E”, but
the money market is not:
– Because Y has
increased, the demand
for money also
increases  interest
rate increases
– Firms’ planned
investment spending
declines and AD falls 
move up the LM curve
to E’ Suppose G increases
At unchanged interest rates, AD increases
To meet increased demand, output must increase
At each level of the interest rate, equilibrium
income must rise by
 Fiscal Policy and Crowding Out
• Comparing E to E’:
increased government
spending increases
income and the
interest rate
• Comparing E’ to E”:
adjustment of interest
rates and their impact
on AD dampen
expansionary effect
of increased G
– Income increases to
Y’0 instead of Y”
Consequences of Liquidity Trap on Fiscal Policy

• Liquidity trap implies horizontal LM curve (h is very-very large)

• Shift of IS curve does not lead to a change in interest rate

• Thus, there is no crowding out

• Fiscal policy has a full multiplier effect

Consequences of Vertical LM Curve on Fiscal Policy

• Fiscal expansion leads to rise in interest rate with no

multiplier effect

• Rise in government expenditure is completely offset by the

reduction in investment demand due to higher interest rate

• Thus, there is a full crowding out

 Is Crowding Out Really Important
• We have assumed that prices are fixed, which
implied presence of unemployed resources in the
economy available for production at current prices

• However, if the economy is at full employment, what

would be the channel of crowding out
– Workers from one sector (investment) are shifted towards
another sector (government)
– Prices will increase, reducing the real money supply and
raising the interest rate
 Is Crowding Out Really Important
• In economies below full employment (having
unemployed resources), LM curve will be upward
sloping but not vertical

• Thus, fiscal expansion will raise both interest rate and

output with partial crowding out
 Can Crowding Out be Avoided
• If there are unemployed resources and government raise G, the
interest rate tends to rise

• The monetary authority can increase money supply.

• Thus both IS and LM curve shift rightward, without rise in interest

rate and fall in investment

• This is termed as the monetary accommodation of fiscal

expansion
– Monetizing fiscal deficit: Central bank prints notes to fund the government
borrowings (buy new government bonds)
 The Composition of Output and the Policy Mix
• Monetary policy operates by stimulating interest-responsive components of
AD (investment)
• Fiscal policy operates through G and t  impact depends upon what goods
the government buys and what taxes and transfers it changes
• Impact of fiscal and monetary policy on output and interest rate
• Government guarantees for private loans (corporates, small scale industries, household –mortgage
loans/education loans) can shift the IS curve
• These are interesting tools as the expansion through fiscal policy is carried out without
outright/immediate rise in the fiscal deficit
• Credit agencies are some how fine with such expansions, as they do not enter in their excel sheets !!
• Companies rather than bureaucrats to decide where to spend and invest
 The Composition of Output
and the Policy Mix
• Policy problem of reaching
full employment output, Y*,
for an economy that is
initially at point E, with
unemployment
Choices:
1. Fiscal policy expansion,
moving to point E1, with
higher income and higher
interest rates
2. Monetary policy
expansion, resulting in full
employment with lower
interest rates at point E2
3. A mix of fiscal expansion
and accommodating
monetary policy resulting
in an intermediate position
 The Composition of Output
and the Policy Mix
• Policies all increase output,
but significantly different
impact on sectors of the
economy  problem of
political economy
• Who should be the primary
beneficiary of expansion?
– An expansion through a
decline in interest rates and
increased investment
spending?
– An expansion through a tax
cut and increased personal
consumption?
– An expansion in the form of
an increase in the size of the
government?
 Debate between Democrats and Republicans
(Large vs Small Govt)
• In a recession, democrats will call for larger government (G),
while republicans will call for tax-cut

• In a boom, democrats will call for higher taxes, while

republicans will call for cut in G

• Both achieve same purpose in the IS-LM framework, but are

drastically different in their long-run implications

• A construction lobby will call for investment subsidy and a

lower interest rate
• Initial response to the great depression was a pro-cyclical
policy where the government raised tax-rates and curtailed
expenditure during recession to contain fiscal deficit
Business Cycle under Various Fiscal Policy
Stance

Higher Fiscal Multipliers

During Economic Slowdown
United Kingdom (1987 – 2019)
Source: UK
Economic Accounts
(ONS) & OBR (UK)
Public Sector net
Balance = Net
lending by General
Govt and Public
Corporations
Private Sector Net
Balance = Net
lending by
Households,
Non Profit
Institutions serving
the Households and
private Non
Financial
Corporations
United States (1987 – 2019)
Source: BEA (US)
Government net
Balance =Total
Government
Receipts Total -
Government
Expenditure
Private Sector
Net Balance=
Gross Private
Domestic
Investment -
Gross Private
Savings
(Domestic
business,
households &
institutions)
 Trends in Government and Private sector
balances India (FY 1987 – FY 2019)

Source: RBI, MoSPI

Note: Govt net balance = (Public Sector Financial & Non-Financial Corporations and General Govt Gross
Domestic Saving) – (Public Sector Financial &Non-Financial Corporations and General Govt Gross Capital
formation)
Private sector net balance = Private sector Gross Domestic Saving – Private sector Gross Capital formation
For Households, total savings does not include gold and silver (to make it comparable).