What causes the LM and IS curves to shift and why?
Policymakers can use the IS-LM model developed in
Chapter 21to help them decide between two major
types of policy responses, fiscal (or government expenditure and
tax) or monetary (interest rates and money). As you probably
noticed when playing around with the IS and LM curves at the end of
the previous chapter, their relative positions matter quite a bit
for interest rates and aggregate output. Time to investigate this
matter further.
The LM curve, the equilibrium points in the market for money,
shifts for two reasons: changes in money demand and changes in the
money supply. If the money supply increases (decreases),
ceteris paribus, the interest rate is lower (higher) at each level
of Y, or in other words, the LM curve shifts right (left).
That is because at any given level of output Y, more money (less
money) means a lower (higher) interest rate. (Remember, the price
level doesn’t change in this model.) To see this, look at Figure
22.1 .
An autonomous change in money demand (that is, a change not
related to the price level, aggregate output, or i) will also
affect the LM curve. Say that stocks get riskier or the
transaction costs of trading bonds increases. The theory of asset
demand tells us that the demand for money will increase (shift
right), thus increasing i. Interest rates could also
decrease if money demand shifted left because stock returns
increased or bonds became less risky. To see this, examine Figure
22.2 . An increase in autonomous money demand will shift the LM
curve left, with higher interest rates at each Y; a decrease will
shift it right, with lower interest rates at each Y.
An autonomous change in money demand (that is, a change not
related to the price level, aggregate output, or i) will also
affect the LM curve. Say that stocks get riskier or the
transaction costs of trading bonds increases. The theory of asset
demand tells us that the demand for money will increase (shift
right), thus increasing i. Interest rates could also
decrease if money demand shifted left because stock returns
increased or bonds became less risky. To see this, examine Figure
22.2 . An increase in autonomous money demand will shift the LM
curve left, with higher interest rates at each Y; a decrease will
shift it right, with lower interest rates at each Y.
The IS curve, by contrast, shifts whenever an autonomous
(unrelated to Y or i) change occurs in C, I, G, T, or NX.
Following the discussion of Keynesian cross diagrams in
Chapter 21, when C, I, G, or NX increases
(decreases), the IS curve shifts right (left). When T increases
(decreases), all else constant, the IS curve shifts left (right)
because taxes effectively decrease consumption. Again, these
are changes that are not related to output or interest rates, which
merely indicate movements alongthe IS curve. The discovery
of new caches of natural resources (which will increase I), changes
in consumer preferences (at home or abroad, which will affect NX),
and numerous other “shocks,” positive and negative, will change
output at each interest rate, or in other words shift the entire IS
curve.
We can now see how government policies can affect output. As
noted above, in the short run, an increase in the money supply will
shift the LM curve to the right, thereby lowering interest
rates and increasing output. Decreasing the MS would have
precisely the opposite effect. Fiscal stimulus, that is,
decreasing taxes (T) or increasing government expenditures (G),
will also increase output but, unlike monetary stimulus (increasing
MS), will increase the interest rate. That is because it works
by shifting the IS curve upward rather than shifting the LM curve.
Of course, if T increases, the IS curve will shift left, decreasing
interest rates but also aggregate output. This is part of the
reason why people get hot under the collar about taxes.See, for
example,
www.nypost.com/p/news/opinion/opedcolumnists
/soaking_the_rich_AW6hrJYHjtRd0Jgai5Fx1O (Of course,
individual considerations are
paramount!)www.politicususa.com/en/polls-taxes-deficit. Note
that the people supporting tax increases typically support raising
other people’s taxes: “The poll also found wide support for
increasing taxes, as 67% said the more high earners income should
be subject to being taxed for Social Security, and 66% support
raising taxes on incomes over $250,000, and 62% support closing
corporate tax loopholes.”
Stop and Think Box
During financial panics, economic
agents complain of high interest rates and declining economic
output. Use the IS-LM model to describe why panics have those
effects.
The LM curve will shift left during
panics, raising interest rates and decreasing output, because
demand for money increases as economic agents scramble to get
liquid in the face of the declining and volatile prices of other
assets, particularly financial securities with positive default
risk.
Figure 22.3 summarizes.
Stop and Think Box
Describe Hamilton’s Law (née Bagehot’s
Law) in terms of the IS-LM model. Hint: Hamilton and
Bagehot argued that, during a financial panic, the lender of last
resort needs to increase the money supply by lending to all comers
who present what would be considered adequate collateral in normal
times.
During financial panics, the LM curve
shifts left as people flee risky assets for money, thereby inducing
the interest rate to climb and output to fall. Hamilton and Bagehot
argued that monetary authorities should respond by nipping the
problem in the bud, so to speak, by increasing MS directly,
shifting the LM curve back to somewhere near its pre-panic
position.
key takeaways
The LM curve shifts right (left) when the money supply (real
money balances) increases (decreases).
It also shifts left (right) when money demand increases
(decreases).
The easiest way to see this is to first imagine a graph where
money demand is fixed and the money supply increases (shifts
right), leading to a lower interest rate, and vice versa.
Then imagine a fixed MS and a shift upward in money demand,
leading to a higher interest rate, and vice versa.
The IS curve shifts right (left) when C, I, G, or NX increase
(decrease) or T decreases (increases).
This relates directly to the Keynesian cross diagrams and the
equation Y = C + I + G + NX discussed in Chapter 21,
and also to the analysis of taxes as a decrease in consumption
expenditure C.