Chapter 24
Monetary and Fiscal
Policy in the ISLM
Model
1. C : at given iA, Yad , Y 
 IS shifts right
2. Same reasoning when I ,
G , NX , T 
Shift in
the IS
Curve
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Shift in the LM Curve from a Rise in Ms
s
1. M : at given YA, i  in panel (b) and (a)  LM shifts to the right
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Shift in the LM Curve from a Rise in M
d
d
1. M : at given YA, i  in panel (b) and (a)  LM shifts to the left
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Response to an Increase in M
s
s
1. M : i , LM shifts
right  Y  i 
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Response to Expansionary Fiscal Policy
ad
1. G  or T : Y , IS
shifts right  Y  i 
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Summary:
Factors
that Shift
IS and LM
Curves
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Effectiveness
of Monetary
and Fiscal
Policy
d
d
s
1. M is unrelated to i  i , M = M at
same Y  LM vertical
2. Panel (a): G , IS shifts right  i , Y stays
same (complete crowding out)
s
d
3. Panel (b): M , Y so M , LM shifts
right  i  Y 
d
Conclusion: Less interest sensitive is M ,
more effective is monetary policy relative
to fiscal policy
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Optimal Choice of Monetary Policy
Instruments (Poole, QJE 1970)
Assume that random variables  and  have
normal distribution and their means are 0 and
2
2
variances   and  .
Y  C (Y  T )  I (i )  G  
M
L(i, Y )  
P
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s
M vs. i Targets When IS Unstable
1. IS unstable:
fluctuates from IS'
to IS''
2. i target at i*: Y
fluctuates from YI'
to YI''
3. M target, LM =
LM*: Y fluctuates
from YM' to YM''
4. Y fluctuation is less
with M target
Conclusion: If IS
curve is more
unstable than LM
curve, M target is
preferred
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s
M vs. i Targets When LM Unstable
1. LM unstable:
fluctuates from
LM' to LM''
2. i target at i*: Y =
Y*
3. M target: Y
fluctuates from
YM' to YM''
4. Y fluctuation is
less with i target
Conclusion: If LM
curve is more
unstable than IS
curve, i target is
preferred
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The ISLM Model in the Long Run
Panel (a)
s
1. M , LM right to LM2, go to point 2, i to i2, Y to Y2
2. Because Y2 > Yn, P , M/P , LM back to LM1, go back to point 1
Panel (b)
1. G , IS right to IS2, go to point 2 where i = i2 and Y = Y2
2. Because Y2 > Yn, P , M/P , LM left to LM2, go to point 2', i = i2` and Y = Yn.
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Deriving AD Curve
P , M/P , LM shifts in, Y 
Points 1, 2, 3
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Shift in AD from Shift in IS
At given PA, IS shifts right: Y  in panel (b)  AD shifts right in panel (a)
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Shift in AD from Shift in LM
At given PA, LM shifts right: Y  in panel (b)  AD shifts right in panel (a)
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Deriving the AD curve from IS-LM
dY  CYd (dY  dT )  I i di  dG
PdM  MdP
LY dY  Li di 
P2
• Combine these two equation by substituting di,
PdM  MdP LY dY
dY  CYd (dY  dT )  I i (

)  dG
2
P Li
Li
• Or ,
dM M
Li (dG  CYd dT )  I i (
 2 dP)
P P
dY 
(1  CYd ) Li  LY I i
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Deriving the AD curve from IS-LM
• The slope of AD (let dG = dT = dM = 0)
(1  CYd ) Li  LY I i
P
| AD 
0
M
Y
 Ii 2
P
• Shift of AD caused by dG (let dP = dT = dM = 0)
Li
Y
| AD 
0
G
(1  CYD ) Li  LY I i
• Shift of AD caused by dM (let dP = dT = dG = 0)
Ii / P
Y
| AD 
0
M
(1  CYD ) Li  LY I i
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Deriving the AD curve from IS-LM
• If there is liquidity trap:
(1  CYD ) Li  LY I i
P
lim
 lim
 
Li  Y
Li 
M
 Ii 2
P
• AD curve is vertical.
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