Behavioral Parameters, the Slopes of the IS and LM Curves, and Policy Effectiveness

The text does not discuss the slopes of the IS and LM curves and the influence of behavioral parameters on the effectiveness of policy. With respect to the slopes, the more sensitive money demand is to income relative to the interest rate, the steeper the LM curve. Likewise, the more sensitive goods demand (C+I+G) is to income relative to the interest rate (through investment), the steeper the IS curve.

On the effectiveness of policy, there are two options to bring out the basic points. The first is to choose a simple linear specification and work out the relationship between the output effect of policy and behavioral parameters. A second option is to discuss the issue more heuristically. For example, consider an increase in government spending, and proceed in three steps.

i. For any given interest rate, the effect of fiscal policy on output will depend on the multiplier, modified to include endogenous investment. The larger the multiplier, i.e., the greater the sensitivity of consumption and investment to output, the larger the initial response of output.

ii. Since an increase in G will increase Y, it will also increase the quantity of money demanded for any interest rate, and thus increase the interest rate, in order to maintain money market equilibrium. The increase in the interest rate will be small to the extent that money demand is not very sensitive to income, but is very sensitive to the interest rate. If money demand is not very sensitive to income, then the excess demand for money created by the increase in G will be small. If money demand is very sensitive to the interest rate, the increase in the interest rate needed to restore equilibrium in the money market will be small.

iii. Finally, the increase in the interest rate will tend to reduce investment and thus offset some of the initial increase in output. This effect will be small to the extent that investment is not very sensitive to the interest rate.

In sum, fiscal policy will have a greater effect on output to the extent that the multiplier is large, money demand is not very sensitive to income, money demand is very sensitive to the interest rate, and investment is not very sensitive to the interest rate.

One could carry out the same exercise with respect to monetary policy. An increase in the money supply affects output by reducing the interest rate and increasing investment. Thus, an increase in the money supply will tend to have a large effect on output when it has a large effect on the interest rate, which will be true when money demand is not very sensitive to the interest rate. The interest rate will have a large effect on output when investment is very sensitive to the interest rate, which calls forth the initial response of output, and, again, when the multiplier is large. The increase in output increases the quantity of money demanded for any interest rate and tends to increase the interest rate, offsetting some of the initial effect of the increase in the money supply. This effect will be small when the demand for money is not very sensitive to income.

In sum, monetary policy will have a greater effect on output to the extent that money demand is not very sensitive to the interest rate, investment is very sensitive to the interest rate, the multiplier is large, and money demand is not very sensitive to income.

These exercises are relatively sophisticated, but they make clear the linkages between the goods market and the money market through the interest rate.

Date: 2015-02-16; view: 912