#### Transcript Simple Keynesian Model

```IS-LM Model
Fiscal Policy
&
Monetary Policy
1
Outline


Introduction
Revision
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Slope & Shift of IS curve
Slope & Shift of LM curve
Fiscal Policy
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Expansionary & Contrationary Fiscal Policy
Crowding-Out Effect
Effectiveness of Fiscal Policy
2
Outline
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Monetary Policy
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Expansionary & Contractionary Monetary Policy
Effectiveness of Monetary Policy
Deflationary & Inflationary Income Gap
IS-LM model versus Simple Keynesian
Model
3
Introduction
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
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Unemployment (when Y < Yf) is one of
the major economic problems
The government always tries to attain full
employment Yf
In the simple Keynesian model, the
policy (G’ T’) when there is a
deflationary / recessionary gap (Yf - Y)
4
Introduction
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Y will then increase by the amount of k EG’
OR k TT’
Since in a three-sector Keynesian model
Y=
Y =
OR Y =
5
Introduction

Will income increase by the same
amount as in the elementary Keynesian
model when the government adopt a
discretionary (fiscal / monetary) policy,
when both interest rate and income are
endogenous variables in the IS-LM
model?
6
Revision - IS Curve
C = C’ + cYd = C’ - cT’ + cY
T = T’
I = I’ - br
r=
G = G’
slope = r/Y =
Y=
x-intercept =
when r = 0
7
Revision - IS Curve
When b is smaller, the IS curve will be
r
When s is larger, the IS curve will be
But k E will be
Construct IS2
IS1
Y
8
Revision - IS Curve
b=
r
b=
s=
r
kE=
s=
kE=
Y
Y
9
Revision - IS Curve
r
Y=
Y/G’ =
Y/T’ =
x-intercept =
Y
when r = 0
10
Revision - LM Curve
Ms = Ms’
Mt = dY
Ma = Ma’ - er
r=
slope = r/Y =
Y=
x-intercept =
when r = 0
11
Revision - LM Curve
r
When e is larger, the LM curve will be
When d is smaller, the LM curve will be
But 1/d will be
Construct LM2
LM1
Y
12
Revision - LM Curve
e=
r
r
d=
1/d =
e=
d=
1/d =
Y
Y
13
Revision - LM Curve
r
Y=
Y/Ms’ =
x-intercept =
when r = 0
Y
14
Expansionary Fiscal Policy
+ve G’ OR -ve T’
r
IS
LM
Y
15
Contractionary Fiscal Policy
-ve G’ OR +ve T’
r
IS
LM
Y
16
Crowding-Out Effect
Expansionary Fiscal Policy G’
r
IS1
IS2
LM
*
r1
Y1
Y2
When r = r1, there is
excess money _____ as
Y rises and _____ rises
_____ has to decrease in
order to restore
equilibrium in the money
market Ms = Mt + Ma
Y
17
Crowding-Out Effect
Expansionary Fiscal Policy G’
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When government expenditure increases, G’, IS
curve will shift outward by k EG’.
If interest rate remains constant, when Y  ,
there will be excess money demand, as
transactions demand for money has increased
Mt  = dY 
In order to restore equilibrium in the money
market Ms’ = Mt  + Ma 
Interest rate has to increase r  in order to
reduce the asset demand for money
Ma  = Ma’ - er 
18
Crowding-Out Effect
Expansionary Fiscal Policy G’
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But when r  investment will decrease I 
I = I’ - br 
Income will decrease Y  through the
multiplier effect Y = k E I
As a result, Y is less than that as in the
simple Keynesian model
19
Crowding-Out Effect
Expansionary Fiscal Policy G’


If interest rate will increase (How about e=?)
and investment will decrease (How about
b=0?), the effectiveness of an expansionary
fiscal policy on income is reduced.
Crowding-out effect refers to the situation in
which a rise in government expenditure raises
interest rate, causing interest sensitive
investment to fall.
20
Zero Crowding Out
Expansionary Fiscal Policy G’
r
Horizontal LM
IS1
IS2
slope = r/Y = d/e =
e = Ma/r =
LM
When Y by k E G
Mt  Ma  to restore equilibrium
Since e = , r = 0 and I= 0.
Thus, NO Crowding-out Effect
Y
21
Zero Crowding Out
Expansionary Fiscal Policy G’
r
Horizontal LM
IS1
IS2
slope = r/Y = d/e =
d = Mt/Y =
LM
When Y by k E G
Since d=0, Mt=0 and Ma=0,
in order to maintain equilibrium
Thus, r = 0 and I = 0.
Thus, NO Crowding-out Effect
Y
22
Zero Crowding Out ???
Expansionary Fiscal Policy G’
r
IS
LM
Vertical IS
slope = r/Y = -s/b =
s =  = 1/k E  k E =
Y = k E G’ =
Y
23
Zero Crowding Out
Expansionary Fiscal Policy G’
r
IS1
IS2
LM
Vertical IS
slope = r/Y = -s/b =
b =I/r =
When Y by k E G
Mt  Ma, in order to
maintain money mkt equilibrium
r  but I = 0 since b = 0
Thus, NO Crowding-out Effect
Y
24
Full Crowding Out
Expansionary Fiscal Policy G’
r
Vertical LM
IS1
IS2
LM
slope = r/Y = d/e =
e = Ma/r =0
 Mt but as  Ma= 0
 r  I   Y  in order
to reduce Mt to the
original level
Y
25
Full Crowding Out
Expansionary Fiscal Policy G’
r
Vertical LM
IS1
IS2
LM
slope = r/Y = d/e =
d = Mt/Y =
 Mt   Ma 
 r  I   Y  in order
to reduce Mt to the
original level
Y
26
Full Crowding Out
Expansionary Fiscal Policy G’
r
Horizontal IS
LM
slope = r/Y = -s/b =
s = 0 = 1/k E  k E =
b =
IS
Y
27
Crowding-Out Effect
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Zero crowding-out effect occurs when
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IS curve is vertical with b = 0
LM curve is horizontal with e =  or d = 0

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How about the case when IS curve is vertical with s=?
Full crowding-out effect occurs when
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IS curve is horizontal with b = 
LM curve is vertical with e = 0 or d = 

How about the case when IS curve is vertical with s=0?
28
1999 A#7
If consumption expenditure does not only depend
positively on income but also negatively on interest
rate, the IS curve will become ___ and the
crowding out effect of fiscal policy will be ___
(assuming that the LM curve is upward sloping)
A. flatter… smaller
B. flatter… bigger
C. steeper… smaller
D. steeper… bigger

29
1997 C#6
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Use the IS-LM model to explain the meaning
of the crowding-out effect and how it affects
the impact of government expenditure on
diagram. (5 marks)
Explain whether the crowding-out effect will
definitely occur when an increase in
government expenditure leads to an increase
a diagram. (5 marks)
30
1997 C#6 (a)
Crowding-out effect means that as
r
IS1
IS2
LM government increases its expenditure,
interest rate will be bid up, which in turn
will reduce investment. The reduction
in investment will reduce the impact
of government expenditure on income
Y=k EG’
Y
31
1997 C#6 (b)
r
IS1
LM
Suppose investment is independent
of interest rate b = 0. IS curve will be
vertical. Increase in government
expenditure will shift the IS curve to
the right. The increase in interest rate
will not lead to any reduction in I.
Y
There will be no crowding out effect.
Many candidates argued that when the LM curve was horizontal, there would be
no crowding out effect. But the question specified that the interest rate will rise.
32
Effectiveness of Fiscal Policy
G’  k E  Y  d  Mt 
Excess Money Demand  e  r  b 
I  k E  Y
 The effectiveness of fiscal policy depends on

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kE
d
e
b
33
Effectiveness of Fiscal Policy
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The greater the simple Keynesian multiplier
k E (= Y/G’), the larger the multiplying
effect & the more effective/ potent will be
the fiscal policy
k E is larger when MPS is smaller / MPC is
larger, proportional tax rate t is smaller,
MPM is smaller
34
Effectiveness of Fiscal Policy
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The smaller income elasticity of money demand d (=
Mt/Y), the more effective will be the fiscal policy.
Given any increase in Y, the increase in Mt will be
smaller.
Smaller excess money demand means smaller
increase in interest rate, which cuts back Ma, is
enough
Smaller increase in interest rate means smaller
decrease in investment, i.e., smaller crowding-out
effect.
35
Effectiveness of Fiscal Policy
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The greater interest elasticity of money
demand e (= Ma/r), the more effective will
be the fiscal policy.
Given any excess money demand, smaller
increase in interest rate is enough to cut back
Ma to restore equilibrium in the money market.
Smaller increase in interest rate means smaller
decrease in investment and smaller crowding
out effect.
36
Effectiveness of Fiscal Policy


The smaller the interest elasticity of
investment b (= I/r), the more
effective will be the fiscal policy.
Given any increase in interest rate, the
reduction in investment is smaller, and
hence a smaller crowding out effect.
37
Effectiveness of Fiscal Policy
more effective fiscal policy means less crowding-out
effect, so compare with the cases of zero crowding-out

Fiscal policy will be more effective when

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simple Keynesian income multiplier rises k E 
income elasticity of money demand falls d 
interest elasticity of money demand rises e 
interest elasticity of investment falls b 
Fiscal policy will be more effective when

IS curve is steeper when b  not because of s 


s will affect the shift of the IS curve
LM curve is flatter when e  or d 
38
Effectiveness of Fiscal Policy
r
The increase in Y is greater when
LM
the IS curve is steeper, i.e.,
smaller interest elasticity of
investment b
Y
39
Effectiveness of Fiscal Policy
The increase in Y is greater when the LM curve is flatter, i.e,
interest elasticity of money demand e greater
income elasticity of money demand d smaller
40
Expansionary Monetary Policy
+ve Ms’
r
IS
LM
Y
41
Contractionary Monetary Policy
-ve Ms’
r
IS
LM
Y
42
Expansionary Monetary Policy
+ve Ms’
Ms’  ESM  r   e  Ma

 b  I   kE  Y 

 d  Mt
43
Expansionary Monetary Policy
+ve Ms’



A rise in money supply (Ms’) will lead to
excess supply of money (ESM) initially.
Interest rate will fall (r ), the asset
demand for money will increase (Ma) to
absorb part of the excess money supply
Ma  = Ma’ - er 
44
Expansionary Monetary Policy
+ve Ms’



When interest rate falls (r ), investment
will increase (I )
I  = I’ - br 
Here, the adjustment in the money market
has already been transmitted to the goods
market.
45
Expansionary Monetary Policy
+ve Ms’




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The rise in investment (I )will cause income
to increase (Y ) in a multiplying way.
Y = k E I
When income increases, transaction demand
for money will also increase (Mt ).
Mt  = dY 
This will then help to absorb the excess
money supply
46
Effectiveness of Monetary Policy

The effectiveness of monetary policy
depends on


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
e
b
kE
d
47
Effectiveness of Monetary Policy

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The smaller the interest elasticity of money
demand e (= Ma/r), the more effective is the
monetary policy
Given an increase in money supply, interest rate
has to fall by a greater extent to stimulate
sufficient Ma  to absorb the excess money
supply.
The greater the fall in interest rate, the greater
the rise in investment and the greater the
increase in income.
48
Effectiveness of Monetary Policy
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The greater the interest elasticity of
investment b (= I/r), the more effective
is the monetary policy.
Given the excess money supply, interest
rate will fall.
If investment is more elastic to interest
rate, investment will then increase by a
greater extent and so will the income
49
Effectiveness of Monetary Policy
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The greater the income multiplier k E
(=Y/E’), the more effective is the
monetary policy.
Given any increase in money supply, interest
rate will fall and investment will increase.
If the income multiplier is larger, income will
increase by a greater extent.
k E is larger if the marginal leakage rate w
(i.e. s, t, m) is smaller
50
Effectiveness of Monetary Policy


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The smaller the income elasticity of money
demand d (=Mt/Y), the more effective
is the monetary policy.
Given any increase in money supply,
interest rate will fall, investment and
income will increase.
If the money demand is less income
elastic, the rise in transaction demand will
be smaller.
51
Effectiveness of Monetary Policy
cont’d
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
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Thus, interest rate has to fall by a greater
extent in order to generate sufficient Ma
to absorb the excess money supply.
With a greater fall in interest rate, the rise
in investment and income will be larger.
The shift of the LM curve will be affected
by d .
52
Effectiveness of Monetary Policy

Monetary policy will be more effective when

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

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interest elasticity of money demand rises e 
interest elasticity of investment falls b 
simple Keynesian income multiplier rises k E 
income elasticity of money demand falls d 
Monetary policy will be more effective when


IS curve is flatter when b  or w 
LM curve is steeper when e  not because of d 

d will affect the shift of the LM curve
53
Effectiveness of Monetary Policy
The increase in Y is greater when the IS curve is flatter, i.e.,
r
larger interest elasticity of investment b
smaller marginal leakage rate w
Flatter IS
Y
54
Effectiveness of Monetary Policy
The increase in Y is greater when LM is steeper, i.e.,
smaller interest elasticity of money demand e
r
BUT d has also to be small, otherwise the shift will be smaller
Y
55
Monetary Policy will be most
effective with horizontal IS
r
Horizontal IS: w/b = 0
when b = 
OR
when w= 0
Y
56
Monetary Policy will be most
effective with vertical LM
r
Vertical LM: d/e = 
when e = 0
!!!
BUT when d = 
Y
57
Monetary Policy will be totally
ineffective with vertical IS
Vertical IS: w/b = 
r
when b = 0
OR
when w = 
Y
58
Monetary Policy will be totally
ineffective with horizontal LM
Horizontal LM: d/e = 0
r
when e = 
Y
59
Monetary Policy will be totally
ineffective with horizontal LM


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If money demand is perfectly interest elastic,
people are willing to hold whatever amount of
money as asset demand Ma at the prevailing
interest rate
Accordingly, any excess money supply caused by
an expansionary monetary policy will then
immediately be absorbed as asset demand
without leading to a fall in interest rate.
With interest rate constant, no change in
investment and income can then be conceived.
60
If money demand is perfectly
elastic to interest rate e = 
r
Y
Ma
Mt
61
Expansionary Fiscal Policy
Full Employment


When government expenditure rises,
aggregate expenditure increases.
Given flexible prices and full employment,
the excess demand in the goods market
will raise the price level, rather than output.
62
Expansionary Fiscal Policy
Full Employment

The increase in the price level will lead to a
fall in real money supply [refer IS-LM.model 2
slide 12]



Ms / P = ms
Real interest rate will rise which leads to a
reduction in investment.
The excess demand in the goods market
will be eliminated.
63
Expansionary Fiscal Policy
Full Employment



Full crowding-out will occur.
Since the subsequent fall in investment
must equal the initial rise in government
spending for aggregate demand to fall
back to the full employment level.
Hence, an expansionary fiscal policy will
only cause the price level and real interest
rate to rise but have no effect on income.
64
Expansionary Monetary Policy
Full Employment



If an expansionary monetary policy is
applied, interest rate will fall to stimulate
investment, causing aggregate demand to
rise.
Given flexible prices and full employment,
the rise in aggregate demand will raise
prices.
This will cause the real money supply to fall
65
Expansionary Monetary Policy
Full Employment


Interest rate will then increase and cut
back the aggregate demand for goods.
As a whole, real money supply, real
interest rate and aggregate demand will
will remain unchanged. Only price level
has risen.
66
Deflationary Income Gap
Expansionary Monetary Policy
Expansionary Fiscal Policy
r
r
Y
Yf
Y
Yf
67
Inflationary Income Gap
Contractionary Monetary Policy Contractionary Fiscal Policy
r
r
Y
Yf
Y
Yf
68
Numerical Example

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C = 150 + 0.5Yd
I = 100 - 400r
G = 150
T = 100
69
Numerical Example
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Mt = 0.25 Y
Ma = 50 - 100r
Ms = 180
70
Numerical Example
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Yf = 1000
Ye =
Inflationary / Deflationary Gap
71
More on fiscal policy

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Refer Three-sector.model slide 61-68
Location of Effects
Reversibility of Policy
Time Lags

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Recognition, Decision, Action/Executive, Outside
Efficiency of Taxation
Total tax burden = Tax payment + Excess burden
72
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