LECTURE 4 LM Curve with Price Flexibility—

IS MP IA Analysis by Romer

Slope of LM Curve h LM Slope Mathematical Reason Economic implication

Low Steeper h is in the denominator of slope of LM equation i = 1/h (k Y - M ̅ / P ̅ )

As the responsiveness of MD for interest rate is low, to accommodate a given change in in money demand , greater change in interest rate is required

High Flatter h is in the denominator of slope of LM equation i = 1/h (k Y - M̅ / P ̅ )

As the responsiveness of MD for interest rate is high , to accommodate a given change in money demand smaller change in interest rate is required

Slope of the LM Curve: Classical Vs.

Keynesian • The greater the responsiveness of the demand for money

to income, as measured by k , and the lower the responsiveness of the demand for money to the interest rate, h , the steeper the LM curve will be.

• If the demand for money is relatively insensitive to the interest rate and thus h is close to zero, the LM curve is nearly vertical. CLASSICAL Case

• If the demand for money is very sensitive to the interest rate and thus h is large, the LM curve is close to horizontal.

• In that case, a small change in the interest rate must be accompanied by a large change in the level of income in order to maintain money market equilibrium.

Position of the LM Curve • The real money supply is held constant along the LM curve.

• It follows that a change in the real money supply will shift the LM curve.

• If the real money supply increases ,( a rightward shift of the money supply schedule)LM curve shifts to the right.

• The money market is in disequilibrium to restore equilibrium,

• at each level of income the equilibrium interest rate has to be lower to induce people to hold the larger real quantity of money.

• Alternatively, at each level of the interest rate the level of income has to be higher to raise the transactions demand for money and thereby absorb the higher real money supply

At equilibrium,

• The same interest rate and income

• levels ensure equilibrium in both the goods and the money market.

• Rearranging the above equation we get the equation for AD curve

• Hence ,

• Substituting i from LM curve equation into IS curve equation, we get ,

• Y = αG [A ̅ - b/h(kY –M̅ / P)]

• Fiscal and Monetary Policy multipliers

• Which policy is effective ?

Fiscal and Monetary Policy Multipliers

Value of h Policy Effectiveness

Mathematical explanation

Economic Reasoning

Tends to zero Both Ineffective Value of second term in equation is indeterminate as h is in denominator

Classical case – No consideration of speculative MD and h, Quantity theory– MD =f(Y) so entire analysis is redundant

Tends to infinity

Fiscal policy very effective

Value of second term in equation is zero so entire equation is determined by the first term

Keynesian case – effective fiscal policy in case of highly liquid speculative demand for money

Steeper LM – Monetary policy

effectiveness • If the demand for money is not very sensitive to the

interest rate (corresponding to a relatively steep LM curve),

• a given change in the money supply will cause a large change in the interest rate and have a big effect on investment.

• Relatively steep LM curve is derived from a relatively inelastic demand for money.

• Money market disequilibrium will cause interest rates to fall and investments to rise.

Flatter LM Curve • 1)This shows money demand is very sensitive to the

interest rate , a given change in the money stock can be absorbed in the assets markets with only a small change in the interest rate.

• 2)If the demand for money is very sensitive to income, a given increase in the money stock can be absorbed with a relatively small change in income and the monetary multiplier will be smaller

• The effects of an open market purchase on investment spending would then be small.

Important Concepts

• Monetary transmission Mechanism

• Liquidity Trap

• Crowding Out

IS and LM curves under Keynesian

and Classical assumptions

IS LM Monetary policy

Fiscal Policy

Classical Downward sloping

Vertical or very steep

Effective as rise in MS will cause the shift of the vertical LM

Shift in IS curve will be along the vertical LM no change in Y

Keynesian Downward sloping

Flat or horizontal

Ineffective as no change in Y on horizontal LM

Very effective as on horizontal LM zero crowding out is experienced

Why there is a need to revisit IS LM

analysis?

• 1) In terms of ideological debate – less relevant for policy effectiveness in short term

• 2) In terms of policy instrument and targeting –

• In reality , instead of monetary aggregates interest rates are targeted

• The Reserve Bank of India on Tuesday kept the key policy rates unchanged even as it retained the growth target for 2015-16 at 7.6 per cent. The repo rate has been kept unchanged at 7.25 per cent, while the reverse repo stays at 6.25 per cent The move was widely expected after a spike in food prices sent consumer inflation to an eight-month high.

• Repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation. Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.

IS LM Model

• Two relations

• 1) goods market– Inverse relation between interest rate and investment and thus interest rate and output-- Because a higher interest rate reduces demand, it lowers the level of output at which the quantity of output demanded equals the quantity produced.

• There is thus a negative relationship between output and the interest rate. This relationship is known as the IS curve;

• 2) money market-- The quantity of money Demanded-increases with income and decreases with the interest rate.

• If the money supply is fixed, a rise in aggregate income, by increasing the demand for liquidity, raises the interest rate at which the quantity of money demanded equals the supply.

• This positive relationship between output and the interest rate, based on the liquidity preference-money supply relationship, is known

• as the LM curve.

Criticism of IS LM

• The basic version of the model assumes a fixed price level; thus it cannot be used to analyse inflation.

IS LM AS alternative

• Higher output leads to a higher price level

• Higher output, higher demand for labour and other factors, higher nominal wages but no perfect flexibility, lag and rigidity in wage price adjustments

• So aggregate supply curve is upward sloping

• Three equations in three unknowns

• Interest , output and aggregate supply

IS LM AS alternative

• Two step approach-

• step 1 arrive at the equilibrium output and interest rate at given money supply

• Step 2 Higher price level ,

• reduces real balances, at given nominal money supply , equilibrium interest rate rises,

• LM curve shifts up and output falls

• –AD curve

• Combination of AD and AS determine the output.

Assumptions of IS LM AS Model

• 1) the price level does not adjust completely and immediately to disturbances.

• This lack of perfect nominal adjustment causes monetary changes to affect real output in the short run.

• It also creates a channel through which other changes in aggregate demand, such as changes in government purchases, have real effects.

Assumptions of ISLM AS Model

• 2) Ignores microeconomic foundations.

• “ The demands for consumption, investment, and money, the nature of price adjustment, and so on are simply postulated and defended on the basis of intuitive arguments,

• rather than derived from analyses of households’ and firms’ objectives and constraints.

• The benefit of this lack of foundations is enormous simplification.” (Romer,2000, Journal of Economic Perspectives)

three aspects of the model that are

difficult, inconsistent, or unrealistic • 1) the model assumes ‘the’ interest rate for goods as well

as money market

• --different interest rates are relevant to different parts of the model:

• the real interest rate is relevant to the demand for goods and thus to the IS curve,

• while the nominal rate is relevant to the demand for money and thus to the LM curve.

Policy Repo Rate : 7.25%

Reverse Repo Rate : 6.25%

Marginal Standing Facility Rate : 8.25%

Bank Rate : 8.25%

Money Market

Call Rates : 5.70% - 7.25% *

* as on previous day

Government Securities Market

8.40% GS 2024 :7.9819%

91 day T-bills : 7.4769%*

182 day T-bills : 7.5326%*

364 day T-bills : 7.6172 %

three aspects of the model that are

difficult, inconsistent, or unrealistic • 3) the aggregate demand and aggregate supply curves are

relationships between output and the price level, while

• what we are typically interested in understanding is the behavior of output and inflation.

• negative shocks to aggregate demand lead to fall in inflation, not to declines in the price level

three aspects of the model that are

difficult, inconsistent, or unrealistic • 3) Money supply is held constant . Unrealistic

• Romer gives a concrete alternative to the IS-LM-AS

• model. Like IS-LM-AS, the alternative assumes imperfect nominal adjustment and lacks microeconomic foundations.

• The main change is that it replaces the assumption

• that the central bank targets the money supply with an assumption that it follows a simple interest rate rule.

The IS-MP-IA Model

• The key assumption of the new approach is that the central bank follows a real interest rate rule; that is, it acts to make the real interest rate behave in a certain way

• as a function of macroeconomic variables such as inflation and output.

• More realistic assumption

• Central banks in almost all industrialized countries focus on the interest rate on loans between banks in their short-run policy-making.

•

RBI interest rate targeting • “The RBI on Tuesday slightly raised its projection for consumer price inflation to 6 percent in January 2016.

• At the current repo rate of 7.25 percent that would effectively leave real interest rates below the 1.5 percent and 2 percent.

• Unpredictable monsoon rains have long bedevilled India's central bankers. Since adopting the repo rate as a main tool for interest rate policy in 2004, the RBI has never eased during the monsoon season running from mid-June to September. By contrast, the RBI has tightened monetary policy 12 times during those months - a prospect seen as unlikely this year as the economy is widely seen as struggling even as data last week showed growth overtook China in the March quarter. Analysts say the only chance of a rate cut this year would come if inflation was forecast to be within the target range for January 2016. 2015

• Advantage 1. The assumption that the central bank follows an interest rate rule is more realistic than the assumption that it targets the money supply.

Advantage 2

• real interest rate rule : r = r(π),

• Real rate an increasing function only of inflation

• The central bank would like to have low inflation and high output.

• When inflation is high, its concern about inflation

• predominates, and so it chooses a high real rate to contract output and dampen inflation.

• When inflation is low, it is no longer as concerned about inflation,(but about growth) and so it chooses a lower real rate to increase output.

• This real interest rate rule replaces the LM curve of conventional Keynesian models.

Advantage 3 simplicity

• The real interest rate rule is a direct assumption about the central bank’s behavior,

• whereas the LM curve has to be derived from an analysis of the money market. ( We can ignore discussion of money market!)

• Diagrammatic representation :

• Since the central bank’s choice of the real interest rate depends only on inflation, for a given inflation rate the real rate rule is just a horizontal line in output-real rate space.

IS MP Diagram by Romer

IS MP equilibrium

• The intersection of IS curve and Monetary Policy (MP) curve determines output and the real interest rate for a given inflation rate.

• To put it differently, inflation determines the central bank’s choice of the real rate, and the IS curve then determines output.

• an increase in inflation causes the central bank to raise the real rate.

• Thus the MP curve shifts up.

• The economy moves up along the IS curve, and so output falls.

• Thus, there is an inverse relationship between inflation and output

AD Curve in IS MP analysis

• Since this relationship summarizes the demand side of the economy, it is natural to call it the aggregate demand curve.

• It differs from the aggregate demand curve of the traditional approach,

• Here , higher inflation causes the central bank to increase the real interest rate, which reduces output.

• In IS-LM, in contrast, a higher price level reduces the real money stock, and thus raises the equilibrium interest rate at a given level of output.

Advantage 4

• Here , the aggregate demand curve relates inflation and output.

• While in the traditional AD-AS approach, the aggregate demand curve relates the price level and output.

• “One therefore has to explain that the model implies that a negative aggregate demand shock does not actually lead to a lower price level, but to a price level lower than it otherwise would have been. “Romer.

AS curve in IS LM IA Model • assume that : 1) inflation at any point in time is given

• 2) Inflation rises when output is above its natural rate and falls when output is below its natural rate

• When output equals natural rate then inflation is steady

• there is inflation inertia,

• as a result inflation cannot normally be reduced without a period when output is below its natural rate.

• The assumption that inflation is given at a point in time implies that the short-run aggregate supply curve is horizontal in output-inflation space.

• inflation adjustment (IA) line: short-run aggregate supply curve -- how inflation changes with output

In the Long run

• Inflation is inherited from the economy’s

past.

• Inflation determines the real interest rate, and the real rate determines output.

• Here , the AD and IA curves intersect at a point where output is below its natural rate , Y .

• The inflation-adjustment assumption is that below-normal output causes inflation to fall.

• Thus the IA line shifts down. it shifts down continuously rather than in discrete steps, economy moves down along the AD curve, with inflation falling and output rising.

• The process continues until output reaches its natural rate .

• At that point, inflation is steady, and there are no further changes until the economy is

hit by a shock.