In the short term, what is the difference between monetary and
fiscal stimulus and why is it important?
What happens when the IS-LM model is used to tackle the long
term by taking changes in the price level into account?
The IS-LM model has a major implication for monetary policy:
when the IS curve is unstable, a money supply target will lead to
greater output stability, and when the LM curve is unstable, an
interest rate target will produce greater macro stability. To
see this, look at Figure 22.4 and Figure 22.5 . Note that when LM
is fixed and IS moves left and right, an interest rate target will
cause Y to vary more than a money supply target will. Note too that
when IS is fixed and LM moves left and right, an interest rate
target keeps Y stable but a money supply target (shifts in the LM
curve) will cause Y to swing wildly. This helps to explain why many
central banks abandoned money supply targeting in favor of interest
rate targeting in the 1970s and 1980s, a period when autonomous
shocks to LM were pervasive due to financial innovation,
deregulation, and loophole mining. An important implication of this
is that central banks might find it prudent to shift back to
targeting monetary aggregates if the IS curve ever again becomes
more unstable than the LM curve.
As noted in Chapter 21, the policy
power of the IS-LM is severely limited by its short-run assumption
that the price level doesn’t change. Attempts to tweak the IS-LM
model to accommodate price level changes led to the creation of an
entirely new model called aggregate demand and supply. The key
is the addition of a new concept, called the natural rate
level of output, Ynrl, the rate of output at
which the price level is stable in the long run. When actual output
(Y*) is below the natural rate, prices will fall; when it is above
the natural rate, prices will rise.
The IS curve is stated in real terms because it represents
equilibrium in the goods market, the real part of the economy.
Changes in the price level therefore do not affect C, I, G, T, or
NX or the IS curve. The LM curve, however, is affected by
changes in the price level, shifting to the left when prices rise
and to the right when they fall. This is because, holding the
nominal MS constant, rising prices decrease real money balances,
which we know shifts the LM curve to the left.
So suppose an economy is in equilibrium at Ynrl, when
some monetary stimulus in the form of an increased MS shifts the LM
curve to the right. As noted above, in the short term, interest
rates will come down and output will increase. But because Y* is
greater than Ynrl, prices will rise, shifting the LM
curve back to where it started, give or take. So output and the
interest rate are the same but prices are higher.
Economists call this long-run monetary neutrality.
Fiscal stimulus, as we saw above, shifts the IS curve to the
right, increasing output but also the interest rate. Because Y* is
greater than Ynrl, prices will rise and the LM curve
will shift left, reducing output, increasing the interest rate
higher still, and raising the price level! You just can’t win
in the long run, in the sense that policymakers cannot make Y*
exceed Ynrl. Rendering policymakers impotent did
not win the IS-LM model many friends, so researchers began to
develop a new model that relates the price level to aggregate
output.
Stop and Think Box
Under the gold standard (GS), money
flows in and out of countries automatically, in response to changes
in the price of international bills of exchange. From the
standpoint of the IS-LM model, what is the problem with that aspect
of the GS?
As noted above, decreases in MS lead to
a leftward shift of the LM curve, leading to higher interest rates
and lower output. Higher interest rates, in turn, could lead to a
financial panic or a decrease in C or I, causing a shift left in
the IS curve, further reducing output but relieving some of the
pressure on i. (Note that NX would not be affected under the GS
because the exchange rate was fixed, moving only within very tight
bands, so a higher i would not cause the domestic currency
to strengthen.)
key takeaways
Monetary stimulus, that is, increasing the money supply, causes
the LM curve to shift right, resulting in higher output and lower
interest rates.
Fiscal stimulus, that is, increasing government spending and/or
decreasing taxes, shifts the IS curve to the right, raising
interest rates while increasing output.
The higher interest rates are problematic because they can
crowd out C, I, and NX, moving the IS curve left and reducing
output.
The IS-LM model predicts that, in the long run, policymakers
are impotent.
Policymakers can raise the price level but they can’t get Y*
permanently above Ynrl or the natural rate level of
output.
That is because whenever Y* exceeds Ynrl, prices
rise, shifting the LM curve to the left by reducing real money
balances (which happens when there is a higher price level coupled
with an unchanged MS).
That, in turn, eradicates any gains from monetary or fiscal
stimulus.